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Friday, 21 November 2008

The Historical Cost Mistake


Updated on 31 May 2014

The Historical Cost Mistake is the implementation of the stable measuring unit assumption under Historical Cost Accounting during inflation and deflation. Stopping the stable measuring unit assumption, i.e., implementing Capital Maintenance in Units of Constant Purchasing Power in terms of the Daily Index fixes the Historical Cost Mistake.

Historical Cost accountants are unknowingly and unintentionally responsible for the destruction of the real value of constant real value non-monetary items never or not fully updated daily /maintained constant in real value daily over time when they choose to measure financial capital maintenance in nominal monetary units in terms of the IASB´s Conceptual Framework (2010), Par. 4.59 (a) as it forms part of IFRSs. Almost all accountants choose the Historical Cost Accounting model which includes the stable measuring unit assumption.

Inflation can be any value, for example 2000 % per annum in the case of Brazil during phases in their 30 years of hyperinflation. When accountants choose to measure financial capital maintenance in terms of units of constant purchasing power in terms of the Daily CPI instead of in terms of nominal monetary units as per Par. 4.59 (a) - all constant real value non-monetary items are maintained constant at their constant real values – at any level of inflation/lhyperinflation as happened in Brazil - or deflation. It is thus clearly not inflation but accountants choosing the HCA model - under which they implement the stable measuring unit assumption who are unknowingly and unintentionally responsible for the destruction of the real value of constant real value non-monetary items never or not fully updated daily/maintained constant in real value daily over time.

Brazil in effect implemented Capital Maintenance in Units of Constant Purchasing Power (CMUCPP)  in terms of a Daily Index (their Unidade Real de Valor in 1994) when various different governments implemented various different Daily indexes to Daily index all non-monetary items as well as many monetary items (money loans/deposits) in the Brazilian economy for 30 years from 1964 to 1994 as stated to me by the Brazilian Central Bank.

Inflation also does not destroy the real values of fixed nominal payments of constant real value non-monetary items like salaries, wages, rents, pensions, etc. Inflation can only erode the real value of money and other  monetary items over time, nothing else. Accountants choosing the HCA model, under which they implement the stable measuring unit assumption, are unintentionally and unknowingly responsible for the destruction of the real values of fixed nominal payments of constant real value non-monetary items. When CMUCPP in terms of a Daily CPI is implemented the real value of payments of constant real value non-monetary items are maintained constant at any level of inflation or deflation. See Brazil from 1964 to 1994.

It is thus accountants choosing the HCA model that do the destroying with the stable measuring unit assumption (in the case of constant real value non-monetary items never or not fully maintained) and not inflation. Inflation only erodes the real value of monetary items, nothing else. Accountants freely choose to implement the HCA model instead of the CMUCPP model. No-one forces them to implement HCA during low and high inflation or deflation.

The level of inflation simply indicates the level of daily constant purchasing power adjustments in terms of the Daily CPI necessary to maintain the real value of constant real value non-monetary items over time. It is accountants choosing the HCA model – in fact, their choice to implement the stable measuring unit assumption - that is destroying the real value of constant real value non-monetary items never or not fully updated over time and not inflation. Inflation only erodes the real value of money and other monetary items over time.

IFRS / US GAAP authorized solution to the Historical Cost Mistake: Daily Indexing

Financial capital maintenance in units of constant purchasing power is authorized in both IFRS and US GAAP as the alternative to Historical Cost Accounting, i.e., financial capital maintenance in nominal monetary units (or the Historical Cost Mistake).

The Historical Cost Mistake is, obviously, fixed with Daily Indexing: Capital Maintenance in Units of  Constant Purchasing Power in terms of the Daily CPI during low inflation and high inflation and deflation and in terms of the US Dollar parallel rate during hyperinflation.

Daily Indexing

1. Accounting Daily Indexing
2. Comprehensive Daily Indexing

1. Accounting Daily Indexing is implementing CMUCPP in terms of the Daily CPI instead of HCA. That only eliminates the destruction of the real value of constant real value non-monetary items never or not fully maintained constant in real value by HCA. Accounting Daily Indexing keeps the constant real value non-monetary economy perfectly stable my stopping the stable measuring unit assumption in accounting, i.e. stopping HCA.

2. Under Comprehensive Daily Indexing, Accounting Daily Indexing is combined with daily indexing of the entire money supply in terms of the Daily CPI. This only eliminates the effect of inflation and deflation from only monetary items. Nothing else. It does not stop inflation or deflation. It stops the destruction of the real value of monetary items over time by inflation and it stops the increase in the real value of monetary items over time during deflation. It only eliminates the effect of inflation and deflation on only monetary items. It would be as if there is no inflation or deflation - while actual inflation or deflation continues.

For example, Daily Inflation Indexing the $3 trillion in global government inflation-indexed bonds maintains the real value of this USD 3 trillion perfectly stable over time on a daily basis, but it does not stop the inflation or deflation in the countries concerned. The inflation or deflation continues, but it is as if there is not inflation or deflation for the holders of the $3 trillion sovereign capital inflation-adjusted bonds inflation-indexed daily.

Daily indexing only removes the effect of inflation and deflation. It does not stop the inflation or deflation. It is as if there is no inflation or deflation.

This is free, authorized under IFRs and US GAAP and available to all countries and economies.

Daily Indexing is free. It kills the need for very costly Dollarization or a currency board at no cost while the countries'  central banks maintain their full monetary creation and monetary policy powers (what they lose under Dollarization and a currency board).

Copyright © 2008 Nicolaas Smith