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Sunday, 30 March 2008

Alan Greenspan´s definition of price stability.

2% Inflation is 98% stable value or 98% Real Value Accounting.

However, it will still destroy 51% of the value of money and constant values not updated over 35 years.

With the size of our economies today, 2% is a gigantic number.

Low or moderate 2% annual inflation is regarded as "price stability" by many entities including the European Central Bank.

"The ECB’s Governing Council has announced a quantitative definition of price stability:
"Price stability is defined as a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%."
"The Governing Council has also clarified that, in the pursuit of price stability, it aims to maintain inflation rates below, but close to, 2% over the medium term."

Low or moderate continuous 2% annual inflation will destroy 51% of the real value of money and retained income as well as all other constant real value non-monetary items never updated over 35 years as any inflation calculator will demonstrate. Low or moderate 2% inflation being "price stability" is thus a very dubious definition.

Alan Greenspan´s definition of price stability is very accurate:

"Price stability obtains when economic agents no longer take account of the prospective change in the general price level in their economic decision-making."

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The annual destruction under low or moderate inflation of 2% of the real value of retained income of all companies with retained income world wide amounts to hundreds of billions of Euros (March 2008 value). That is a significant amount of unnecessary and easily avoidable real value destruction in the world economy each and every year.

2% inflation is a high degree of price stability. It is not actual price stability.

Price stability is a year-on-year increase in the Consumer Price Index of 0% as clearly indicated by Mr Greenspan´s definition.

0% cash inflation has never been achieved over a significant period of time.

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Real Value Accounting will result in 0% non-monetary inflation in the real (non-monetary) economy by simply ignoring accountants´ assumption that money is stable only for the purpose of valuing constant value items, eg. retained income.

Thursday, 27 March 2008

Accountants killing the real economy.

Tito Mboweni asked the following question: “Is there a danger that we are killing the real economy?”

Inflation always destroys real value in two ways: (1) Cash inflation destroys the real value of the Rand. (2) At the same time the combination of inflation and normal accounting destroys constant real value non-monetary items that are never updated, for example, retained income.

Accountants have good rules to value variable value items.

Unfortunately they assume that the destruction of the value of money has no effect on constant value items that are never updated (eg. retained income). They assume money is stable ONLY for this purpose. The above combination thus destroys the value of constant value items at the annual rate of inflation. This amounts to hundreds of billions of Euros in the world economy and probably hundreds of billions of Rand in the South African economy annually. It kills off quite a bit of the real economy each and every year as everyone in SA is experiencing at the moment - and all the more the higher inflation.

Hardly anyone in SA realises that SA accountants are responsible for killing the real economy.

This killing of the real economy will stop forever when accountants stop this assumption.

This will result in 0% inflation only in constant real value non-monetary items. There will still be cash inflation in SA. A person can avoid losing value under cash inflation by holding no cash; that is, rather buy things that keep their value with your money.

Companies as well as the SA government can order their accountants to stop this assumption immediately. Salaries, taxes and companies´ issued share capital values will be updated monthly. All other constant values too - including retained income.

This way of doing things is already possible, but, only under hyperinflation. The reason it does not currently work under hyperinflation is that the International Accounting Standard Board tells Zimbabwe to update non-monetary items annually (income statement items monthly as per PricewaterhouseCoopers) at the hyperinflation rate instead of telling them that they should update everything that is not money daily at the parallel rate or a daily index rate like Brazil did.

It is vital for SA to do this under low (2%) and high (9.8%) inflation on a monthly basis every time the Consumer Price Index changes (daily updating at a daily index or parallel rate under hyperinflation) to make it impossible for Chartered Accountants to kill the real economy - as they are doing at present.

References:
http://www.accountancysa.org.za/resources/ShowItemArticle.asp?ArticleId=1235&Issue=857

http://en.wikipedia.org/wiki/Historical_cost

© 2005-2010 by Nicolaas J Smith. All rights reserved

No reproduction without permission.

Monday, 24 March 2008

There are three different items in the economy

1. Money
2. Variable value items
3. Constant value items

The first economies only consisted of people and variable value items. Trade was by barter. Variable value items for variable value items.

Then money was invented.

Finally double entry accounting was introduced and constant value items came about.

Money´s value is being destroyed by cash inflation. Low inflation (2%) can reduce this destruction to a minimum. Monetary values more than 31 days old in low inflationary economies are all out of date/wrong.

Variable value items are adequately valued in markets and by International Accounting Standards/GAAPs. Variable values more than 31 days old in low inflationary economies are all out of date/wrong.

Constant value items are being destroyed by the combination of inflation and normal accounting. Ignoring/banning the assumption that money is stable will stop this destruction forever. Constant values more than 31 days old in low inflationary economies are all out of date/wrong.

All values and financial statements more than 31 days old in low inflationary economies are out of date/wrong.

All values in hyperinflationary economies are out of date/wrong at the next parallel rate. This can be from the one day to the next.

All constant value items never updated are destroyed at the inflation or parallel rate.

0% cash inflation which has never been achieved over any sustained period of time will make the real and monetary economy work at 0% inflation.

Stopping the assumption that money is stable which is Real Value Accounting and easy to implement will result in 0% inflation ONLY in CONSTANT real value non-monetary items.

References:

http://www.accountancysa.org.za/resources/ShowItemArticle.asp?ArticleId=1235&Issue=857

http://en.wikipedia.org/wiki/Historical_cost

Sunday, 23 March 2008

The historical cost accounting model destroys real value on a massive scale in the world economy.


Updated on 20 January 2012

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This a verbatim copy of the my article Financial Statements, Inflation & The Audit Report published in Accounting SA, the accounting journal of the South African Institute of Chartered Accountants in September 2007.

I do not use the provocative style I used in 2008 any more. But, I prefer to maintain the original article heading as this blog is a chronological history of the development of the Constant Item Purchasing Accounting model.

This Accounting SA article is the first publication in a peer reviewed accounting journal where the terms constant real value non-monetary item and variable real value non-monetary item appeared.

Obviously, there is no such thing as Historical Cost Inflation as I used the term in this article. Inflation has only one component: a monetary component. This is, however, all part of the historical developement of Constant Item Purchasing Power Accounting that started in 1995 in Angola´s hyperinflationary economy.

In 2008 I still believed, like most people today still believe, that inflation affects the real value of non-monetary items. Inflation has no effect on the real value of non-monetary items. The stable measuring unit assumption affects the real value of constant real value non-monetary items never maintained constant.

"In most countries, primary financial statements are prepared on the historical cost basis of accounting without regard either to changes in the general level of prices or to increases in specific prices of assets held, except to the extent that property, plant and equipment and investments may be revalued."¹

The International Accounting Standards Board (IASB) only recognises two economic items:

1.) Monetary items defined as "money held and items to be received
or paid in money;" and

2.) Non-monetary items: All items that are not monetary items.

Non-monetary items include variable real value non-monetary items valued, for example, at fair value, market value, present value, net realisable value or recoverable value.
They also include Historical Cost items based on the stable measuring unit assumption.

One of the basic principles in accounting is "The Measuring Unit principle: The unit of measures in accounting shall be the base money unit of the most relevant currency.

This principle also assumes the unit of measure is stable; that is, changes in its general purchasing power are not considered sufficiently important to require adjustments to the basic financial statements."2

This makes these Historical Cost items equal to monetary items in the case of companies´ Retained Income balances and the issued share capital values of companies with no well located and well maintained land and/or buildings or other variable real value non-monetary items able to be revalued at least equal to the original real value of each contribution of issued share capital.

Retained Income is a constant real value non-monetary item valued at Historical Cost which makes it subject to the destruction of its real value by cash inflation - exactly the same as in cash.
It is an undeniable fact that South Africa's functional currency's internal real value is constantly being destroyed by cash inflation in the case of our low inflationary economy, but this is not considered important enough to adjust the real values of constant real value non-monetary items in the financial statements - the universal stable measuring unit assumption.

The combination of the Historical Cost Accounting model and low inflation is thus indirectly responsible for the destruction of the real value of Retained Income equal to the annual average value of Retained Income times the average annual rate of inflation. This value is easy to calculate in the case of each and very company in South Africa with Retained Income. It is also possible to calculate this value for all companies in the world economy with Retained Income.

It is broadly known that the destruction of the internal real value of the monetary unit of account is a very important matter and that inflation thus destroys the real value of all variable real value non-monetary items when they are not valued at fair value, market value, present value, net realisable value or recoverable value.

But, everybody suddenly agrees, in the same breath, that for the purpose of valuing Retained Income - a constant real value non-monetary item - the change in the real value of money is not regarded as important to update the value of Retained Income in the financial statements. Everybody suddenly then agrees to destroy hundreds of billions of Dollars in real value in all companies´ Retained Income balances all around the world.

Yes, inflation is very important!

All central banks and thousands of economists and commentators spend huge amounts of time on the matter. Thousands of books are available on the matter. Financial newspapers and economics journals dedicate thousands of columns to the fight against inflation.

But, when it comes to constant real value non-monetary items, it doesn't seem as if inflation is important. We happily destroy hundreds of billions of Dollars in Retained Income real value year in year out.

However, when you are operating in an economy with hyperinflation (perhaps only Zimbabwe at the moment with 3 713% inflation), then we all agree that you have to update everything in terms of International Accounting Standard IAS 29 Financial Reporting in Hyperinflationary Economies. You have to update variable AND constant real value non-monetary items.

But, ONLY as long as your annual inflation rate has been 26% for three years in a row adding up to 100% - the rate required for the implementation of IAS 29.

Once you are not in hyperinflation anymore, for example, 15% annual inflation for as many years as you want, then you are not allowed to update constant real value non-monetary items any more. Then you must destroy their real value again - at 15% per annum. Or 7.0% per annum in the case South Africa (April 2007).

For example:

Shareholder value permanently destroyed by the implementation of the Historical Cost Accounting model in Exxon Mobil's Retained Income during 2005 exceeded $4.7bn for the first time. This compares to the $4.5bn shareholder real value permanently destroyed in 2004 in this manner. (Dec 2005 values).

The application by BP, the global energy and petrochemical company, of the stable measuring unit assumption in the accounting of their Retained Income resulted in the destruction of at least $1.3bn of shareholder value during 2005. (Dec 2005 values).

Royal Dutch Shell Plc, a global group of energy and petrochemical companies, permanently destroyed $2.974 billion of shareholder value during 2005 as a result of the application of the stable measuring unit assumption in the accounting of their Retained Income. (Dec 2005 values).

Should this value be reflected in the financial statements?

Maybe it should.

Footnotes

¹ International Accounting Standards Committee, (1995), International Accounting Standard 1995, London, IASC, Page 502

http://www.accountancysa.org.za/resources/ShowItemArticle.asp?ArticleId=1235&Issue=857
² Paul H. Walgenbach, Norman E. Dittrich and Ernest I. Hanson, (1973), Financial Accounting, New York: Harcourt Brace Javonovich, Inc. Page 429.

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Saturday, 22 March 2008

Implied authorisation by the IASB to revoke the stable measuring unit assumption in low inflationary economies.

Paragraph 40 of IAS 29 can be taken as revoking the stable measuring unit assumption in low inflationary economies as the word inflation is used instead of hyperinflation.

"Par 40 The disclosures required by this Standard are needed to make clear the basis of dealing with the effects of inflation in the financial statements."
Authorisation to revoke the stable measuring unit assumption in low inflationary economies can also be taken to be implied from the IASB´s Framework for the Preparation and Presentation of Financial Statements, Concepts of Capital Maintenance and the Determination of Profit:

Par 104. The concepts of capital in paragraph 102 give rise to the following concepts of capital maintenance:

(a) Financial capital maintenance.

Under this concept a profit is earned only if the financial (or money) amount of the net assets at the end of the period exceeds the financial (or money) amount of net assets at the beginning of the period, after excluding any distributions to, and contributions from, owners during the period. Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power.

Units of constant purchasing power is generally taken as updating constant real value non-monetary items in terms of the monthly change in the Consumer Price Index in low inflationary economies and daily at a daily index rate (see Unidade Real de Valor: "The exchange rate of URVs to cruzeiros reais was recalculated and published daily by the government.") or the parallel exchange rate (in the absence of a daily index rate) in hyperinflationary economies (See Hyperinflation).

Historical Cost Accounting destroying hundreds of billions of Dollars of real value in the world economy year in year out.

The application of the historical cost principle by the accounting profession results in the destruction of "hundreds of billions of dollars in retained income real value year in year out" [5] - as well as in all other constant real value non-monetary items never or not fully updated throughout the world economy.

This can be stopped by the revoking of the stable measuring unit assumption. This has been authorised by the International Accounting Standards Board in International Accounting Standard IAS 29 Financial Reporting in Hyperinflationary Economies.

"Par 8 The financial statements of an entity whose functional currency is the currency of a hyperinflationary economy, whether they are based on a historical cost approach or a current cost approach, shall be stated in terms of the measuring unit current at the balance sheet date.
Par 11 Balance sheet amounts not already expressed in terms of the measuring unit current at the balance sheet date are restated by applying a general price index.
Income statement
Par 26 This Standard requires that all items in the income statement are expressed in terms of the measuring unit current at the balance sheet date. Therefore all amounts need to be restated by applying the change in the general price index from the dates when the items of income and expenses were initially recorded in the financial statements."
Paragraph 40 can be taken as revoking the stable measuring unit assumption in low inflationary economies as the word inflation is used instead of hyperinflation.

"Par 40 The disclosures required by this Standard are needed to make clear the basis of dealing with the effects of inflation in the financial statements."

Neither US GAAP nor the IASB allows the updating of constant real value non-monetary items, for example retained income, in low inflationary economies thus contributing to the destruction of "hundreds of billions of Dollars in real value in all companies´ Retained Income balances all around the world" [6] as well as in all constant real value non-monetary items never or not fully updated.

From: Wikipedia: Historical Cost: http://en.wikipedia.org/wiki/Historical_cost

Friday, 21 March 2008

Historical Cost

In historical cost accounting, historical cost is the original monetary value of an economic item.

When an historical cost item, for example money or retained income, is never updated its real value is destroyed at the rate of inflation in low inflationary economies. Money cannot be updated. Retained income is currently not updated in low inflationary economies as a result of the application of the stable measuring unit assumption. Retained income is:

The accumulated net income retained for reinvestment in a business, rather than being paid out in dividends to stockholders.

One of the basic principles in accounting is:

“The Measuring Unit principle: The unit of measure in accounting shall be the base money unit of the most relevant currency. This principle also assumes the unit of measure is stable; that is, changes in its general purchasing power are not considered sufficiently important to require adjustments to the basic financial statements.” .

The combination of the historical cost accounting model and low inflation is thus indirectly responsible for the destruction of the real value of retained income equal to the annual average value of retained income times the average annual rate of inflation.

From Wikipedia: Historical Cost: http://en.wikipedia.org/wiki/Historical_cost

Thursday, 20 March 2008

What is the real value of money?

The real value of money within an economy or monetary union is determined by all the underlying value systems within that economy or monetary union.

The daily changes in the real value of money are determined by the daily changes in the rate of inflation or hyperinflation or deflation as indicated by the Daily CPI.

Daily indexing of all monetary items within the banking system in terms of the Daily CPI eliminates the EFFECT of inflation, hyperinflation or deflation within an economy or monetary union. It does nothing immediately to inflation, hyperinflation or deflation. 

Daily indexing of all constant real value non-monetary items in terms of the Daily CPI removes the EFFECT of the stable measuring unit assumption within an economy implementing the nominal Historical Cost paradigm during inflation, hyperinflation and deflation.

Variable real value non-monetary items´ real values are determined in terms of fair value - generally in free and open markets. Daily indexing of these values in terms of the Daily CPI between fair valuing them in the market keeps their real values up to date with daily changes in the general price level.

Updated on 29 May 2016

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Copyright (c) 2012 Nicolaas Smith

Wednesday, 19 March 2008

What is real value?

Real value is what you can sell things for right now. That means, someone is willing to buy them from you for a specific value payable immediately.

There are three basic things in the economy:

1. Things that have changing real values.

2. Money.

3. Things that have constant real values.

We express these values in money terms. Everything has a money value but that does not mean it is money because be buy and sell it in money terms and we use money to pay for things. Only money is money.

The real values of things you do not own are the market values of those things right now.

The above real values change all the time as the supply and demand for these things change.

The above relate to the real values of things that have changing real values.

There are two more basic things in the economy: money and things that have constant real values.

We will look at money´s real value in the next post.

Saturday, 15 March 2008

The difference between price increases and inflation.

Very few people understand the difference between inflation and a price increase. Inflation is an increase in the general price level. A price increase is the increase of any single price.

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Copyright (c) 2012 Nicolaas Smith

Thursday, 13 March 2008

Business confidence will increase if South Africa revokes the stable measuring unit assumption.

BusinessDay reports that business confidence is the lowest in seven years.

Business confidence in South Africa will increase considerably if accountants and the accounting faculties of SA universities get together to develop a plan to revoke the stable measuring unit assumption in the South African economy.

Businesses and workers will then know that as soon as the accountants in South Africa revoke the stable measuring unit assumption no more real value will be destroyed in the real value of constant real value non-monetary items never updated in the SA economy.

Salaries, capital, taxes, income and expenses will be updated monthly at the new Consumer Price Index value.

The South African non-monetary economy will operate at 0% inflation since all constant real value non-monetary items will be updated.

Cash inflation will still destroy the value of the Rand and all other monetary items.

Hold no cash and monetary items and you can avoid the destruction of real value in monetary items.

Revoking the stable measuring unit assumption will make the destruction of real value in the non-monetary economy impossible.

Business confidence will surge in SA when everyone knows that what is happening in Zimbabwe now will forever be impossible in South Africa as long as the stable measuring unit assumption is revoked.

© 2005-2010 by Nicolaas J Smith. All rights reserved

No reproduction without permission.

Tuesday, 11 March 2008

Poor Accounting

Unfortunately these black students are learning Historical Cost Accounting which includes the stable measuring unit assumption.

They will most probably never be taught that the combination of inflation and the stable measuring unit assumption annually destroys hundreds of billions of Rand of the real value of constant real value non-monetary items never updated in the South African economy. This include the real value of all Retained Income of all SA companies (listed and unlisted) which they will never be allowed to update as long as South Africa is not experiencing hyperinflation.

Most of them will most probably not even know anything about the stable measuring unit assumption as it is hardly ever mentioned in accounting lectures in South Africa. I wonder if the term even appears at all in any accounting textbook in South Africa.

This is very sad since it is exactly the combination of inflation and the stable measuring unit assumption as applied by Zimbabwean accountants that destroyed the Zimbabwean economy over the last 20 years of high and hyperinflation in that country.

I can foresee that the very same accountants may in the future help to destroy the SA economy when they apply the stable measuring unit assumption in the companies where they will be working or whose accounts they will be auditing. Just like it is now happening in Zimbabwe.

If they are taught that the combination of inflation and the stable measuring unit assumption is destroying hundreds of billions of Rands in the real value of all constant real value non-monetary items never updated (eg. retained income) in the SA economy annually and that by revoking it they can stop this destruction, they may have the guts to do that and to save the SA economy from the disaster that is currently happening in Zimbabwe.

© 2005-2010 by Nicolaas J Smith. All rights reserved

No reproduction without permission.

Monday, 10 March 2008

Inflation´s destruction of the SA non-monetary economy can be stopped by SA accountants.

It was once generally accepted that the world was flat.

It is now generally accepted that Robert Mugabe´s policies destroyed the Zimbabwean economy.

In time people will come to understand that it was the combination of inflation and the stable measuring unit assumption that destroyed the Zimbabwean economy.

That same combination is currently destroying 9.4% per annum of all monetary items in South Africa as well as 9.4% per annum of the real value of Retained Income in all South African companies.

At continuous 9.4% per annum inflation all the real value of all Retained Income that remain in SA companies for the next 8 years will be completely destroyed. Today´s Retained Income balances will be there in 8 years time but they will be worth nothing - all else being equal.

When SA revokes the stable measuring unit assumption, this destruction of constant real value non-monetary items currently NEVER updated can be stopped.

Any SA company can revoke the stable measuring unit assumption and stop this destruction.

The International Accounting Standard Board authorised the updating of non-monetary items in IAS 29 in 1989.

If SA companies/accountants do not revoke the stable measuring unit assumption and inflation keeps on rising, then the combination of high inflation and the stable measuring unit assumption will definitely destroy the SA economy - exactly as it did in Zimbabwe over the last 14 years of hyperinflation in that country.

Three years of continuous 26% inflation is hyperinflation as defined by the IASB.

At the moment this destruction is taking place at 9.4% per annum. That means that the real value of all constant real value non-monetary items today that are never updated (eg. retained income) will see 100% of their real value destroyed over the next 8 years. The accounting values will still be in the books, but they will have zero real value - like the accounting values in Zimbabwean company accounts not updated.