Monday, 8 February 2010

Historical Cost Accounting erodes companies´ equity

Boerseun, Thank you for your visits. You know I appreciate your comments.

Today you stated:

"I always come to read your posts and then get even more confused. I try my best and the little bit that I do grasp does at least show me something is seriously wrong."

It is really easy to understand.

People think money keeps its real value. That is not true, as you know and as we all know.

A long time ago, let´s say 200 years ago, accountants did all accounting at the original historical values of all items.

They assumed money was perfectly stable in real value; i.e. they assumed there was no inflation and there never will be inflation. They applied their stable measuring unit assumption. We all know there is inflation and money loses its real value.

Over the last 100 years they have realized that you cannot value everything at its original historical cost. You cannot value shares you bought at R1 per share in 1951 which are selling on the JSE today at R1000 per share at the original R1 per share, for example. You have to show them in your accounts at their current value.

So, accountants have rules (International Financial Reporting Standards) to value variable real value non-monetary items.

Monetary items have to be stated at their original nominal values because money cannot be updated. Inflation destroys the real value of money, but accountants ignore this real value destruction during low inflation, but, account it during hyperinflation. Obviously, if you account it under hyperinflation, you also have to account it under low inflation.

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.

Because they do not update their capital and profits, their accountants are unknowingly destroying capital and profits´ real values at the rate of inflation. When they do not update the constant real value non-monetary items capital and retained profits, then they are the same as monetary items and we all know money and monetary items lose their real values because of inflation. The same happens to capital and profits not updated. They all think for a very long time that it is inflation doing this destroying. Capital and profits are constant real value non-monetary items. They are not monetary items. If they value capital and profits in units of constant purchasing power (inflation-adjust them) then they will always maintain their real values, no matter what the inflation rate is. So, it is not inflation doing the destroying, it is their choice of the stable measuring unit assumption which they can stop any time they want to.

However, under hyperinflation they update capital and profits, but, not under low inflation. So, they admit and agree that capital and profits must be updated under hyperinflation, but, they refuse to do it under low inflation. They admit that capital and profits´ real values are destroyed under hyperinflation, i.e. 26% inflation for 3 years in a row equalling 100% cumulative inflation (the IASB´s definition of hyperinflation) but they do not consider that, say, 20% inflation forever will require them to update capital and profits. They claim that there is no destruction of the real value of capital and profits at 20% inflation – or if there is, then it is inflation´s fault: it has nothing to do with their decision to choose the stable measuring unit assumption and to implement it. A decision they can change to financial capital maintenance in units of constant purchasing power today, if they want to: but, no, it is inflation doing the destroying – according to the IASB, the US FASB and all accountants.

They thus unknowingly destroy the real value of capital and profits under low inflation.

That is all I am stating. Very easy to understand. They are all very upset with me because I say they do this unknowingly, unnecessarily and unintentionally.
The International Accounting Standards Board authorized them to update capital and profits during low inflation in the Framework, Par 104 (a) in 1989. It states:

“Financial capital maintenance can be measured either in nominal monetary units OR IN UNITS OF CONSTANT PURCHASING POWER.”

So, accountants can stop this destruction any time they want to. I am just promoting that idea. That´s all. It is not my idea. It is the IASB´s idea.

Because accounting is double entry, it means that they can maintain the real value of capital and profits in all companies that at least break even FOREVER, by just updating all constant items equally and correctly. There is no extra money required to do this. They must just stop destroying existing real value. It is a matter of maintaining existing real value. No extra money required at all. Just stop destroying real value that already exists.

The IASB forces them to do this under hyperinflation, but, under low inflation it gives them a choice. Because all accountants have been applying the stable measuring unit assumption for the last 700 years and all the accountants in the world are doing it today, except in hyperinflationary economies, no-one wants to change.

The truth is that they do not realize it is happening. They all think it is inflation doing the destroying and that they as accountants can do nothing about it. It is not true. The IASB forces them to do it correctly under hyperinflation.

Accountants and all accounting authorities state very firmly and very, very confidently that the erosion (destruction) of companies´ capital and profits is caused by inflation. The IASB, the US FASB, everybody agree with that statement. So they all agree that companies´ capital and profits are being destroyed. There is no problem with that. They all admit it. There is destruction of real value. But, they all blame inflation.

However, it is impossible for inflation to destroy companies´ capital and profits because inflation is always and everywhere a monetary phenomenon, as Milton Friedman stated. Inflation has no effect on the real value on non-monetary items.

“Purchasing power of non monetary items does not change in spite of variation in national currency value.”

Prof Dr. Ümit GUCENME, Dr. Aylin Poroy ARSOY, Changes in financial reporting in Turkey, Historical Development of Inflation Accounting 1960 - 2005, Page 9.

So, Boerseun, it is not so difficult to understand. Quite easy actually.

My estimate of the real value unknowingly destroyed by SA acountants in constant items never maintained is about R200 billion per annum. That is quite a lot of real value that is destroyed each and every year in the SA real economy. All SA accountants have to do to stop that and to boost the SA real economy with about R200 billion each and every year forever is freely choose financial capital maintenance in units of constant purchasing power; i.e. they must choose to update capital and profits instead of unkowingly destroy their real values year in year out.

Copyright © 2010 Nicolaas J Smith