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Thursday, 11 February 2010

Accounting for non-accountants: stable measuring unit assumption

For accountants

Accountants today still apply their stable measuring unit assumption to the valuation of companies´ capital and profits.

Under the current global Historical Cost Accounting model you can keep your capital and profits at nominal value if you always buy fixed property or land for the exact original real value of the capital and profits you keep in your company. The real value of your capital and profits - stated at nominal value - would generally be maintained by sufficient unrecorded or hidden holding gains in the revaluable fixed property assets. Only maybe hotel companies and perhaps also property companies buying properties and making money from the rent can generally maintain the real value of their capital and profits (I don’t really think so) by stating them in nominal values in their books. Most other companies do not do that.

For non-accountants

The three basic economic items in the economy are valued as follows:

1. Monetary items

Examples: Rands, bank loans, car loans, housing loans, student loans, any money loan or savings in Rand.

You can only value and account or state them at their original nominal values during the current financial period. No other way because you cannot update money.

2. Variable real value non-monetary items

Examples: property, plant, equipment, stock, shares, foreign exchange, etc.

They are valued by accountants in terms of International Financial Reporting Standards or SA Generally Accepted Accounting Practice.

3. Constant real value non-monetary items

Examples: capital, retained profits, capital reserves, trade debtors, trade creditors, taxes payable, taxes receivable, etc.

They have constant real values, but, accountants value them at historical cost: i.e. they treat them the same as money.

Now, we all know inflation destroys the real value of money.

Accountants think that inflation also destroys the real value of capital, retained profits, debtor, creditors, etc.

Obviously it is not inflation destroying these items´ real values: it is their choice of valuing these items in nominal monetary units. They can also value them in units of constant purchasing power; i.e. they can inflation-adjust them during low inflation. The IASB authorized them 21 years ago to do that.

Accountants do not do this because they are not taught to do that and because they and all accounting authorities think it is inflation doing the destroying. It is not inflation. Inflation can only destroy the real value of money. Nothing else. Inflation can not destroy the real value of non-monetary items. When accountants inflation-adjust these items, they never lose their real values, no matter what the rate of inflation.

All accountants and accounting authorities believe absolutely that the erosion of capital and profits is caused by inflation. They have absolutely no doubt about it. They are wrong. Inflation cannot destroy the real value of non-monetary items. When they inflation adjust these items, they maintain their real values forever in companies that at least break even.

What is so good about financial capital maintenance in units of constant purchasing power is that it has been authorized by the IASB 21 years ago and that it does not require any more new money or new capital to maintain companies´ capital and profits. Accountants unknowingly destroy companies´ capital and profits by treating capital and profits like money when they implement their stable measuring unit assumption.

So, they can maintain capital and profits´ real values by not destroying these existing real values. As simple as that.

How is this done? By inflation-adjusting all constant items in a company and by accounting the loss of real value in money caused by inflation. No extra new money needed.

This has been authorized by the IASB in 1989 and is compliant with International Financial Reporting Standards. So, there is nothing to worry about: it is all legal and IASB-approved.
Copyright © 2010 Nicolaas J Smith