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Tuesday, 13 April 2010

The inflation conundrum

Inflation is always and everywhere a monetary phenomenon.

Milton Friedman, A monetary history of the United States 1867 - 1960 (1963)

Inflation is a sustained annual increase in the general price level of goods and services in an economy. Prices are generally quoted in terms of money. When the general price level rises more than the annual increase in real value in the economy, each unit of the functional currency buys fewer goods and services; consequently, annual inflation only destroys the real value of each monetary medium of exchange unit evenly over time. Inflation has no effect on the real value of non-monetary items.

Annual inflation destroys real value evenly in money and other monetary items over time. There are, consequently, hidden monetary costs to some and monetary benefits to others from this destruction in purchasing power in monetary items that are assets to some while - a the same time - liabilities to others; e.g. the capital amount of loans. The debtor gains during inflation since he or she has to pay back the nominal value of the loan, the real value of which is being destroyed by annual inflation. The debtor pays back less real value during inflation. The creditor loses out because he or she receives the nominal value of the loan back, but, the real value paid back is lower as a result of inflation. Efficient lenders recover this loss in real value by charging interest at a rate higher than the expected inflation rate.

Increases in the general price level (inflation) destroy the real value of money (the functional currency) and other monetary items with an underlying monetary nature, e.g. the capital values of bonds and loans. However, inflation has no effect on the real value of variable real value non-monetary items (e.g. property, plant, equipment, cars, gold, inventories, finished goods, foreign exchange, etc) and constant real value non-monetary items (e.g. issued share capital, retained profits, capital reserves, other shareholder equity items, salaries, wages, rentals, pensions, trade debtors, trade creditors, taxes payable, taxes receivable, deferred tax assets, deferred tax liabilities, dividends payable, dividends receivable, etc).

Fixed constant real value non-monetary items never updated are effectively treated like monetary items by SA accountants implementing the stable measuring unit assumption as part of the HCA model during low inflation. SA accountants unknowingly destroy their real values at a rate equal to the rate of inflation because they choose to measure them in nominal monetary units during low inflation. Inflation destroys the real value of the Rand which is the nominal monetary unit of account in SA. This unknowing destruction in fixed constant items never maintained during low inflation will stop when SA accountants choose to measure financial capital maintenance in units of constant purchasing power. It is thus SA accountants´ choice of the HC accounting model and not inflation that is doing the destroying.

SA accountants choose to implement the stable measuring unit assumption during low inflation when they value constant items in fixed nominal monetary units. Accountants´ choice of implementing the stable measuring unit assumption instead of measuring constant items´ real values in units of constant purchasing power, as they have been authorized to do in the Framework, Par 104 (a) twenty one years ago, results in the real values of these fixed constant items being destroyed at a rate equal to the rate of inflation when they are never updated during low inflation because inflation destroys the real value of money which is the monetary unit of account. Fixed constant items never updated are effectively treated as monetary items under HCA.

The extremely rapid destruction of the real value of money during hyperinflation is compensated for by the rejection of the stable measuring unit assumption in International Accounting Standard IAS 29 Financial Reporting in Hyperinflationary Economies. IAS 29, which has to be implemented during hyperinflation, requires all non-monetary items (variable items and constant items) to be measured in units of constant purchasing power. The stable measuring unit assumption is thus rejected in presentation of restated HC or CC financial statements but not in operation since the IASB still accepts HC or CC financial statements to be restated with the implementation of IAS 29 during hyperinflation.

The main measure of inflation in low inflation economies is the inflation rate, calculated from the annualized percentage change in a general price index - normally the Consumer Price Index. The correct measure of inflation is the parallel rate in hyperinflationary economies - where a parallel rate is in use. The CPI is completely impractical as a measure of inflation during hyperinflation when the aim is to stabilize the real economy during hyperinflation.

Kindest regards

Nicolaas Smith
realvalueaccounting@yahoo.com

Copyright © 2010 Nicolaas J Smith