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Monday, 1 February 2010

Financial capital maintenance in units of constant purchasing power

Financial capital maintenance in units of constant purchasing power, i.e. the inflation-adjustment by means of the CPI of only constant items - not inflation accounting complete price-level adjustment of all (variable and constant) non-monetary items - during low inflation and deflation has also been authorized by the IASC Board thirteen years after Harvey Kapnick´s 1976 prediction. The IASC Board approved the Framework, Par 104 (a) in 1989 stating that

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

However, the enormous real value destroying function of the very destructive stable measuring unit assumption when accountants choose, also in terms of Par 104 (a), the IASB approved very popular accounting fallacy of financial capital maintenance in nominal monetary units and apply it in the valuing of constant items never maintained, e.g. reported retained earnings, in low inflationary economies when the stable measuring unit assumption is maintained for an unlimited period of time during indefinite inflation, is not generally understood by the IASB and SA accountants, at all. This is clearly verified by the fact that both financial capital maintenance in nominal monetary units as well as real value maintaining financial capital maintenance in units of constant purchasing power during inflation and deflation were approved by the IASB in the Framework, Par 104 (a) in 1989. Accountants can choose the one or the other and state that they have prepared primary financial statements in terms of IFRS.

However, when they choose the traditional HCA model they unknowingly destroy real value on a massive scale in the real or non-monetary economy during low inflation when the very destructive stable measuring unit assumption is maintained for an unlimited period of time during indefinite inflation. When they choose IASB approved financial capital maintenance in units of constant purchasing power they would maintain the real values of all constant items during inflation and deflation in companies which at least break even, empowering and enriching those companies, their shareholders and the economy in general with the accompanying benefits to workers and employment for an unlimited period of time – all else being equal.

As the Deutsche Bundesbank stated:

“The benefits of price stability, on the other hand, can scarcely be overestimated, especially as these are, in principle, unlimited in duration and accrue year after year.”

Deutsche Bundesbank, 1996 Annual Report, P 83.

Financial capital maintenance in units of constant purchasing power during inflation and deflation would result in absolute price stability only in constant items for an unlimited period of time in companies that at least break even – all else being equal. The IASB predecessor body, the IASC Board, approved absolute price stability in income statement and balance sheet constant items when they authorized the Framework, Par 104 (a) in 1989 approving the option of measuring financial capital maintenance in units of constant purchasing power during low inflation and deflation.

HCA is very destructive during inflation

Also approving the traditional HCA model in the Framework, Par 104 (a), on the other hand, has been very costly for the world economy as amply illustrated by the deficiency in bank and company capital during the recent sub-prime financial crisis. This clearly illustrates the lack of understanding the very destructive effect of the stable measuring unit assumption on balance sheet constant items during low inflationary periods.
Copyright © 2010 Nicolaas J Smith