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Wednesday, 30 December 2009

Three popular accounting fallacies: two IFRS approved

SA accountants preparing their companies’ financial reports in compliance with IFRS are required, in terms of the IASB´s Framework, Par 104 (a), to choose between measuring financial capital maintenance in nominal monetary units or in units of constant purchasing power. They actually have to choose the one or the other measurement basis. The choice is not made for them like under GAAP where Historical Cost Accounting is the generally accepted accounting model.

The Framework, Par 104 states that the financial and physical concepts of capital stated in Par 102 give origin to the financial and physical capital maintenance concepts.

The Framework, Par 104 (a) states:

“Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power.”

Consequently, it does not simply state that the economic item financial capital can be measured in nominal monetary units, but, financial capital maintenance can be measured in nominal monetary units. Generally stated financial capital maintenance implies maintaining the real value of financial capital stable – all else being equal. However, under the Historical Cost model it is assumed that the monetary unit of account is stable: the very destructive stable measuring unit assumption. Under the HC model it is thus assumed that the real value of financial capital is maintained stable with measurement in nominal monetary units. The statement that financial capital maintenance can be measured in nominal monetary units which implies that financial capital is maintained stable in real value is a very popular fallacy amongst accountants. It is mostly a deceptive, misleading and false statement. It is only true per se in theory at sustainable zero inflation. It is always false per se during inflation and deflation in real terms. It is only true during low inflation when qualified to the effect that it is required that a company invests 100% of its Issued Share Capital, Share Premium Account and Non-distributable Reserves in revaluable fixed assets which always have a revalued or not revalued total real value equal to the updated real value of the original real values of those items.

The IFRS statement “Financial capital maintenance can be measured … in nominal monetary units” would only be true – per se – in nominal and real value terms in one single theoretical instance: it would only be possible to maintain the nominal and real value of financial capital stable in nominal monetary units per se – all else being equal – at sustainable zero inflation: an economic environment that has never been achieved in monetary history and is not very likely to be achieved any time soon or in the distant future. The above IASB statement is not a fallacy at zero inflation. It is, however, a purely theoretical statement: we have never had, we do not have and we most probably will never have sustainable zero inflation anywhere in the monetary economy.

It is impossible to maintain the real value of financial capital stable with measurement in nominal monetary units per se during low inflation and deflation. The above IFRS statement is thus false in terms of real value during low inflation and deflation. The real value of financial capital measured in nominal monetary units is being destroyed at a rate equal to the inflation rate during low inflation when a SA company has no revaluable fixed assets by its accountant’s choice of the HCA model during low inflation. The nominal value of financial capital is maintained in nominal value by measuring it in nominal monetary units during low inflation and deflation. This is, however, a popular fallacy: a false, misleading, unsound, inappropriate and deceptive notion in real value terms. HCA is an inappropriate accounting model authorized by the IASB which adds to general economic instability in SA´s low inflationary economy. It causes massive destruction of reported constant items´ real values, e.g. the real value of all existing reported Retained Earnings, during low inflation in the SA economy. It causes economic instability in the real economy as the real value of companies´ profits and capital is destroyed in this manner. This is mistakenly blamed on inflation by accounting standard setters, accounting authorities, accounting professors and lecturers as well as accountants.

The above IFRS statement is true in nominal value, false in real value and a fallacy during deflation. It results in economic instability during deflation by creating real value in constant items valued in nominal monetary units.

The IASB approved fallacy of financial capital maintenance in nominal monetary units during low inflation leads to SA accountants unnecessarily, unknowingly and unintentionally destroying about R200 billion per year in the real value of SA companies´ existing reported constant items because of their implementation of the stable measuring unit assumption in SA´s low inflationary environment.

The above is one of the three popular accounting fallacies. They are the following:

1. The stable measuring unit assumption: IFRS approved
2. Inflation erodes companies´ profits and capital (The FASB loves this one)
3. Financial capital maintenance in nominal monetary units: IFRS approved (The IASB loves this one)

These three fallacies constitute the very destructive basis of the traditional generally accepted IFRS authorized Historical Cost Accounting model fully approved in most probably all SA companies.

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