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Sunday, 29 November 2009

Accountants destroy value

Inflation destroys the real value of money and other monetary items over time. This fact is generally accepted and appears in Wikipedia stated as "inflation erodes or decreases or reduces the real value of money" and in IFRS as "general forces may result in changes in the general level of prices and therefore in the general purchasing power of money" (IAS29.5).

HC accountants destroy the real value of reported constant real value non-monetary items never maintained, e.g. reported retained profits, when they choose to value them in nominal monetary units during low inflation. This fact is not generally accepted.

This destruction of reported Retained Profit real value is generally attributed to inflation when, in fact, it is the result of accountants´ free choice of the traditional Historical Cost Accounting model whereunder they implement the stable measuring unit assumption, i.e. they simply assume that changes in the real value of the money (inflation) is not sufficiently important during low inflation for them to choose the alternate basic accounting model of financial capital maintenance in units of constant purchasing power as approved by the IASB in the Framework, Par. 104 (a) in 1989 which would stop this destruction.

It is thus HC accountants´ free choice of accounting model and not inflation that is doing the destroying in the real value of reported Retained Profits. HC accountants would stop this destuction when they reject the stable measuring unit assumption and with it traditional Historical Cost Accounting and measure financial capital maintenance in units of constant purchasing power as authorized by the IASB in the Framework, Par. 104 (a) in 1989.

This destruction (by HC accountants) generally incorrectly attributed to inflation is generally accepted by accountants and economists and expressed in Wikipedia in phrases such as:

Inflation results in the overstatement of margins and the overpayment of dividends which results in the erosion of companies´ capital that is paid away in overstated dividends.

Example: R2.4 billion of real value is destroyed by HC accountants in the real value of R40 billion reported Retained Profits during a year in the South African real economy at 6% per annum (a rate equal to the rate of inflation) when inflation is 6% because they value reported Retained Profist in Rand monetary unit terms and the real value of the Rand is being destroyed by inflation at 6% per annum. Inflation can only destroy the real value of money and other monetary items. Inflation has no effect on the real value of non-monetary items.

HC accountants implement their very destructive stable measuring unit assumption at inflation rates ranging from 0.01% per annum to 25.99% per annum continuous inflation for 3 years in a row; i.e. they assume the destruction of 25.99% of the real value of reported Retained Profits and all other existing constant real value non-monetary items never maintained (eg. all items in shareholders equity, provisions, etc) is not sufficiently important for them to freely decide to stop this destruction by implementing financial capital maintenance in units of constant purchasing power as authorized by the IASB in the Framework, Par. 104 (a) in 1989 which is complaint with IFRS.

26% annual inflation for 3 years in a row totalling 100% cumulative inflation over 3 years would define an economy as being an hyperinflationary economy. IAS 29 requires accountants in hyperinflationary economies to value all non-monetary items (variable and constant items) in units of constant purchasing power. Accountants thus agree that 26% annual inflation for 3 years in a row is sufficiently important for them to stop destroying the real values of all reported constant items never maintained, but, not 25.99% annual inflation for 3 years in a row or inflation approaching 26% annual inflation for 3 years in a row.

This is obviously not true and correct. It results in HC accountants unknowingly and unintentionally destroying hunderds of billions of US Dollars of real value annually in existing reported constant items never maintained.

What in reality happens is that accountants do not know that they are doing this because HCA has been the traditional accounting model for the last 700 years.

They unknowingly evade fixing their massive annual destruction in companies´ reported constant real value non-monetary items never maintained by ascribing this destruction in real value to inflation when it is a fact that inflation can only destroy the real value of money and other monetary items - nothing else. It is impossible for inflation to destroy the real value of non-monetary items. Inflation can only destroy the real value of money and monetary items. As Milton Friedman so eloquently stated: inflation is always and everywhere a monetary phenomenon.

Kindest regards,

Nicolaas Smith