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Sunday, 16 November 2008

Inflation does not affect the real value of non-monetary items



Inflation affects the fundamental value of all monetary items. Inflation destroys the real value of all monetary items directly and equally.

“Inflation is always and everywhere a monetary phenomenon.” Milton Friedman

Inflation does not affect the real values of non-monetary items. The accounting model accountants choose affects the real values of constant real value non-monetary items.

The following three paragraphs are not true and correct - they are simply generally accepted, but still completely wrong:

*Inflation erodes the real value of nominally fixed payments. The real value of fixed nominal payments (like rents, pensions, wages, interest, and taxes) are eroded by inflation.

*Inflation erodes the real value of historical cost accounting items. Inflation erodes the real values of non-monetary assets and liabilities stated at historical cost; e.g., retained earnings, issued share capital, capital reserves, provisions, taxes, dividends, trade payables and receivables, etc. Two percent inflation - the European Central Bank's definition of price stability – will erode by 51 percent the real value of historical cost non-monetary items over 35 years.

*Inflation destroys the real value of non-monetary items which do not hold their value in terms of purchasing power.

Erode is exactly the same as destroy in the above cases.

It is not inflation, but, accountants implementing the stable measuring unit assumption (the traditional HC model) who unknowingly destroy the real values of nominally fixed payments and constant items stated at historical cost. The rate of inflation simply indicates the rate of real value destruction over the time period involved.

There are no fixed nominal payments and there are no constant real value non-monetary income, expenses, assets and liabilities stated at historical cost when accountants choose a CPP model. In this case the rate of inflation simply indicates the rate of adjustment required to maintain the real value of constant items expressed in the functional currency in the internal economy.

No real value is destroyed in constant items over any period of time when accountants choose to implement a CPP model at any level of inflation. It is thus accountants choosing the HC model who unintentionally destroy the real value of constant items and not inflation.

Inflation does not affect the fundamental value of constant real value non-monetary items, e.g. salaries and retained earnings.

It is accountants choosing the HC model - instead of the IASB-suggested CPP model - and implementing the stable measuring unit assumption who unwittingly destroy the real value of nominally fixed payments and the real values of constant items stated at historical cost when they choose to measure financial capital maintenance in nominal monetary units.

Copyright © 2008 Nicolaas Smith