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Wednesday, 14 April 2010

Cost of inflation to be deducted from profit before tax during low inflation

Deflation is a sustained absolute annual decrease in the general price level of goods and services. Deflation happens when the annual inflation rate falls below zero percent (a negative annual inflation rate), resulting in an increase in the real value of money. Deflation allows one to buy more goods with the same amount of money. This should not be confused with disinflation, a slow-down in the inflation rate (i.e. when inflation decreases, but still remains positive). Disinflation is a decrease in the rate of increase in the general price level. Inflation destroys the real value of money over time; conversely, deflation increases the real value of money in a national or regional economy over a period of time.

Inflation and deflation are both undesirable economic processes. As far as the understanding of inflation and deflation allows us at the moment, it can be stated that whatever level of deflation - however low - is to be avoided completely. A low level of inflation in an economy with financial capital maintenance in units of constant purchasing power as the fundamental model of accounting implementing IFRS or GAAP, is the best practice:

A low level of inflation to limit the destruction of real value in money and other monetary items; IFRS or GAAP for the correct valuation of variable items and, thirdly, financial capital maintenance in units of constant purchasing power for maintaining the real value of constant items constant during low inflation and deflation in all entities that at least break even without the requirement for extra capital or extra retained profits simply to maintain the existing real value of existing constant items constant.

Net monetary losses or gains would be calculated and accounted in the income statement during low inflation and deflation: basically, the cost of inflation would be accounted as a loss and deducted from profit before tax. Reducing the holding of monetary items (cash and other monetary items) over time would reduce the net monetary loss to a minimum during low inflation.

Kindest regards

Nicolaas Smith
realvalueaccounting@yahoo.com

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