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Thursday, 3 September 2009

Two when there are actually three

It is generally accepted that the economy is divided in two parts: the monetary economy and the non-monetary or real economy. It is also generally accepted that there are two basic economic items in the economy: monetary items and non-monetary items. Monetary items are money held and items with an underlying monetary nature. Non-monetary items are all items that are not monetary items.

No distinction is generally made between the valuation of variable real value non-monetary items, e.g. property, plant, equipment, inventory, etc valued at Historical Cost and constant real value non-monetary items, e.g. Issued Share capital, Retained Earnings, other items in Shareholders´ Equity and most items in the income statement (excluding items like salaries, wages, rents, etc. valued in units of constant purchasing power or inflation-adjusted) also valued at Historical Cost.

This is the result of the fact that the economy is based on the Historical Cost paradigm. Historical Cost is the traditional measurement basis in accounting. It is thus generally accepted for accountants to choose to implement the very destructive stable measuring unit assumption during non-hyperinflationary periods.

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.”

Paul H. Walgenbach, Norman E. Dittrich and Ernest I. Hanson, (1973), Financial Accounting, New York: Harcourt Brace Javonovich, Inc. Page 429.

Non-monetary items are not all fundamentally the same. Non-monetary items are subdivided into variable real value non-monetary items and constant real value non-monetary items. The three fundamentally different basic economic items are, in fact, monetary items, variable items and constant items although it is generally accepted that there are only two basic economic items, namely, monetary and non-monetary items.

Accountants regard all non-monetary items stated at Historical Cost, whether they are variable real value non-monetary HC items or constant real value non-monetary HC items to be fundamentally the same, namely, non-monetary items – or, items that are not monetary items - when they implement the very destructive stable measuring unit assumption as part of the traditional HCA model during non-hyperinflationary periods.

This is the result of money illusion. People make the mistake of thinking that money is stable in real value in a low inflationary environment. Inflation always destroys the real value of money over time. It is thus impossible for money to be stable in real value during inflation.

On the other hand, inflation has no effect on the real value of non-monetary items over time.

Kindest regards,

Nicolaas Smith