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Friday 30 July 2010

Inflation myths in layman terms – Part 2

SA accountants, implementing traditional 700-year-old Historical Cost Accounting, unknowingly, unnecessarily and unintentionally destroy the real value of that portion of SA companies´ equity (capital) that is not backed or covered 100% by revaluable fixed assets at a rate EQUAL TO the annual inflation rate - because they account companies´ capital in money - the Rand in SA - and inflation destroys the real value of the Rand, but, SA accountants ignore that basic fact when they value companies´ equity (capital) and most other constant real value non-monetary items at original historical cost.

How do SA accountants destroy the real value of SA companies´ capital doing traditional Historical Cost Accounting?

As follows:

They implement the stable measuring unit assumption during inflation. They accept that inflation destroys the real value of the Rand, but, they assume that makes no real difference and is not harmful at all (from 0.001 to 25% per annum for three years in a row). So, for certain items, not all items, they, in principle, assume there is no inflation; they assume the Rand is perfectly stable even at 25% per annum inflation for three years in a row recurring.

Which items? Issued share capital, retained profits, capital reserves, all other items in shareholders´ equity, for example.

R1 million on 1st Jan 1981 was the same as R14 million today.

So if you invested the R1 million on 1st Jan 1981 in revaluable fixed property your balance sheet from 1st Jan 1981 till today would always be the same: Capital R1 million and Fixed Property R1 million. You can keep it like that forever. The real value of your capital would be maintained although you value both Capital and Fixed Property in nominal monetary units, i.e. at Historical Cost. You can only maintain the real value of your capital like that if you invest 100% of the original real value of all contributions to equity in revaluable fixed property – under HCA during inflation.

Let´s say you only invested half in fixed property and half in beer for resale on 1st Jan 1981, you pay all your profit out in dividends and you keep on buying R500 000 in beer stock for resale. You keep doing that from Jan 1981 till today. Your balance sheet today will be: Capital R1 million, Fixed Property R500 000 and Stock R500 000.

Your R1 million capital on 1st Jan 1981 was worth R14 million in today´s money.

Today you can sell the property in your books at a Historical Cost of R500 000 for R7 million and the R500 000 beer stock (greatly reduced in units of beer) for a profit. So, you have paid away R6.5 million of the real value of your capital you started your business with in dividends.

That is how SA accountants, including CA(SA)s, unknowingly, unnecessarily and unintentionally destroy about R167 billion PER ANNUM in the investment base of SA companies – the S A real economy - doing traditional Historical Cost Accounting: with their stable measuring unit assumption. They, the IASB and FASB blame inflation and, they say, there is absolutely nothing they can do about it. They are all dead wrong.

All of them also do not understand the above: if they understood it, they would have done something about it by now.

What would have happened if they had inflation-adjusted their equity as they had been authorized by the International Accounting Standards Board in International Financial Reporting Standards in the Framework, Par 104 (a) in 1989?

I will explain next time.
Copyright © 2010 Nicolaas J Smith

Thursday 29 July 2010

Inflation myths in layman terms – Part 1

1. "Inflation erodes companies´ invested capital and profits" - as per the FASB.

The FASB is the US Financial Accounting Standards Board. They set accounting standards in the US. In the 1970´s their Mr Mosso famously stated the above term in one of their standards, either Financial Accounting Standard 33 or FAS 89 which superceded FAS 33.

All accountants will tell you that inflation “erodes” companies´ capital and profits. They never use the term destroy: always “erode”. Well, erode and destroy is the same thing.

Accountants truly believe that. They are trained at university like that. They write their CA exams and pass and become CA (SA)s in the best Financial Director and CEO positions in SA believing that.

One of their arguments goes something like this: the cost of an item sold is not inflation-adjusted. The selling price is at the current price level while the cost of the item is at another, past or historic, price level. So, the profit is overstated. These overstated profits eventually may all be paid out in dividends. This basically results in the capital of the company not being maintained: it may be paid away in dividends. So, companies´ capital is eroded by inflation.

Accountants do not control the level of inflation. That is determined by the central bank and the government’s economic policy. So, this happens, but, accountants can do absolutely nothing about it. It is out of their hands.

This is an absolutely generally accepted “fact” appearing in most accounting and economics text books.

However: inflation is always and everywhere a monetary phenomenon as so eloquently stated by the late American Nobel Laureate Milton Friedman. Inflation can only affect, i.e. destroy, the real value of money and other monetary items, i.e. items with an underlying monetary nature – nothing else. Inflation per se has no effect on the real value of any non- monetary item ever. It is impossible for inflation to destroy the real value of any non-monetary item – ever.

Companies´ issues share capital and retained profits are all non-monetary items. All accountants would confirm that. So, it is impossible for inflation to erode or destroy companies´ invested capital and profits.

I am not the only person understanding that and stating that.

This is what two Turkish academics state:

“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.

http://www.mufad.org/index2.php?option=com_docman&task=doc_view&gid=9&Itemid=100

So, if it is not inflation eroding or destroying companies´ capital - then, what is?

It is accountants´ choice of accounting model; more specifically the stable measuring unit assumption that is part of the traditional Historical Cost Accounting model.

Accountants choose the accounting model? Not really. Historical Cost Accounting is the generally accepted basic accounting model world-wide for more than 700 years.

However, they are not forced to use HCA. No-one forces them.

In 1989 the International Accounting Standards Board, the other main accounting standard setter, authorized the following in their Framework, Par 104 (a):

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

So, all accountants in companies implementing International Financial Reporting Standards, i.e. in SA all JSE listed companies, actually do have to choose: they are given a specific choice in the Framework, Par 104 (a): either the one of the other: they all “choose” HCA. In fact, when they changed over to IFRS they just carried on doing traditional HCA. Most probably not a single accountant in the world implementing IFRS realized that they are actually given a choice in IFRS.

What is the stable measuring unit assumption?

SA accountants simple assume that the Rand is perfectly stable; i.e. that there is no inflation, only as far as certain, not all, items in their companies are concerned.

However, we all know that money is not perfectly stable. There is something called inflation and deflation.

So, under inflation SA accountants unknowingly destroy the real value of that portion of SA companies´ equity (capital) that is not backed or covered by revaluable fixed assets.

I will explain how tomorrow.
Copyright © 2010 Nicolaas J Smith

Wednesday 28 July 2010

Inflation myths - updated

INFLATION MYTHS

1. "Inflation erodes companies´ invested capital and profits" - as per the FASB.

Inflation is always and everywhere a monetary phenomenon – Milton Friedman. Inflation only destroys the real value of money and other monetary items – nothing else. Inflation has no effect on the real value of any non-monetary item.

Historical Cost accountants unknowingly destroy companies´ invested capital and profits with their stable measuring unit assumption. The moment they freely change over from traditional Historical Cost Accounting to financial capital maintenance in units of constant purchasing power as they have been authorized in IFRS in the Framework, Par 104 (a) in 1989, they would stop destroying real value in constant items never maintained.


2. "Inflation influences reported results"

The basic accounting model chosen influences reported results. Inflation - per se - can only influence or destroy the real value of monetary items - nothing else. Choose financial capital maintenance in nominal monetary units, i.e. Historical Cost Accounting (which includes the stable measuring unit assumption) and you have one result. Choose financial capital maintenance in units of constant purchasing power and you have another (the correct) result. Unfortunately, both options are authorized in IFRS.


3. "Inflation destroys the value of non-monetary items which do not hold their value in terms of purchasing power"


Inflation can only destroy the real value of monetary items - nothing else. Inflation - per se - has no effect on the real value of non-monetary items. It is impossible for inflation - per se - to destroy the real value of non-monetary items.


4. There is no inflation or money is perfectly stable as far as balance sheet constant real value non-monetary items (e.g. shareholders´ equity) are concerned:

I.e. the stable measuring unit assumption or financial capital maintenance in nominal monetary units (the traditional Historical Cost Accounting model) or, shareholders´ equity can be accounted at Historical Cost.

Inflation only destroys the real value of money and other monetary items. All constant real value non-monetary items expressed in the normal monetary unit of account have to be inflation-adjusted; i.e. accounted in units of constant purchasing power during inflation and deflation in order to maintain their real values constant in all entities that at least break even.
Copyright © 2010 Nicolaas J Smith

Tuesday 27 July 2010

Inflation myths

Inflation myths

1.Inflation erodes companies´ invested capital and profits.

Inflation is always and everywhere a monetary phenomenon – Milton Friedman. Inflation only destroys the real value of money and other monetary items – nothing else. Inflation has no effect on the real value of any non-monetary item.

Historical Cost accountants unknowingly destroy companies´ invested capital and profits with their stable measuring unit assumption. The moment they freely change over from traditional Historical Cost Accounting to financial capital maintenance in units of constant purchasing power as they have been authorized in IFRS in the Framework, Par 104 (a) in 1989, they would stop destroying real value in constant items never maintained.

2. There is no inflation or money is perfectly stable as far as balance sheet constant real value non-monetary items (e.g. shareholders´ equity) are concerned:

I.e. the stable measuring unit assumption or financial capital maintenance in nominal monetary units (the traditional Historical Cost Accounting model) or, shareholders´ equity can be accounted at Historical Cost.

Inflation only destroys the real value of money and other monetary items. All constant real value non-monetary items expressed in the normal monetary unit of account have to be inflation-adjusted; i.e. accounted in units of constant purchasing power during inflation and deflation in order to maintain their real values constant in all entities that at least break even.

Kindest regards

Nicolaas Smith
realvalueaccounting@yahoo.com

Copyright © 2010 Nicolaas J Smith

Monday 26 July 2010

Valuing monetary items - Part 2

Valuing monetary items during deflation

Accountants value and account monetary items correctly at their original nominal monetary HC values during the current accounting period during deflation too. There is no other way to do it: see above. Money and monetary items gain in real value during deflation. Monetary items are thus always correctly valued at their current always higher real values during deflation when accountants account them at their original nominal monetary HC values. HC accountants do not calculate net monetary gains or losses during deflation either.

Valuing monetary items during hyperinflation

Accountants value monetary items at their nominal monetary HC values during the current accounting period during hyperinflation too. The real value of money and other monetary items are destroyed at the rate of hyperinflation which can be anything from 100 per cent per annum to 6 million per cent per annum or more as in the case of Zimbabwe recently. HC accountants have to calculate and account net monetary losses and gains during hyperinflation as required by IAS 29 Financial Reporting in Hyperinflationary Economies. This is in total contradiction to what is done during low inflation. The IASB admits that the net monetary loss or gain from holding net monetary assets or net monetary liabilities have to be calculated and accounted in the income statement, but, not during low inflation of up to 25% per annum.

Hyperinflation is defined by the IASB as 100% cumulative inflation over three years. That is 26% annual inflation for three years in a row. At 26% annual inflation for three years in a row companies have to calculate and account the cost of hyperinflation and write it off against profit, but, not at 22% or 15% or 6% inflation. At 22% annual inflation for three years or 81.6% cumulative inflation SA would not be in hyperinflation. However, 81.6% of the real value of the Rand, all other monetary items as well as the Retained Profits of 99.99% of SA´s listed and unlisted companies would be wiped out over the short period of three years. SA would not be in hyperinflation and SA accountants would carry on implementing the HCA model.

SA has been going along at 12% average annual inflation or 40% cumulative inflation over three years for at least the last 15 years before 2000 continuously implementing HCA.

Kindest regards

Nicolaas Smith
realvalueaccounting@yahoo.com

Copyright © 2010 Nicolaas J Smith

Sunday 25 July 2010

A future converged Conceptual Framework would not necessarily be better.

Comment on IFRS in Perspective blog on AccountingWeb.com

Mr Pounder,

I agree with you that a common Conceptual Framework is essential. However, convergence of the FASB and IASB frameworks as the two Boards have been working on for the last 6 years does not necessarily mean the future converged Conceptual Framework will be better than the two individual ones. It may even be worse.

When a person reads the data available about their joint Conceptual Framework project to date, one notices that discussion of two of the most basic concepts, namely the concepts of capital and capital maintenance concepts (which determine the basic accounting model), do not form part of any of the eight phases of the joint project.

When I enquired about this a month or two ago, Kevin McBeth, the FASB project manager for the Measurement Phase of the joint project stated:
“I cannot speak for the Boards with respect to your query. I can only say that early on in the measurement phase the staff suggested that capital and capital maintenance be discussed in the measurement phase, as it was in the original FASB Conceptual Framework. However, to date the Boards have not taken a decision on where, or even whether, those topics will be included in the converged framework.”

I then put the same question to the US Financial Accounting Standards Board.

Ron Lott, the FASB director who is responsible for the joint FASB-IASB Conceptual Framework project responded by email:

“We are of course familiar with paragraphs 102 – 110 of the IASB Framework as well as paragraphs 45-48 of FASB Concepts Statement 5. Although not labeled as such, capital maintenance ideas have been raised at various points in the discussions of measurement concepts and will continue to be discussed until the board makes decisions about measurement concepts.


We do not know yet whether there will be a section in the yet-to-be-completed measurement concepts chapter labeled capital maintenance, but the concepts will almost certainly be discussed.”

Kevin McBeth stated the following by email:

“I believe that you may have misunderstood the discussions the FASB and IASB have had about measurement. Those discussions have used examples of various items, some of which you refer to as variable real value non-monetary items. That may have led you to believe that some of your concerns are being ignored. However, the scope of the measurement phase of the Conceptual Framework project does not exclude the items you refer to as constant real value non-monetary items. The Boards are concerned about the effects of selecting measurements on all elements of the financial statements.


Much remains to be done on this project. Although future discussions probably will not use the terminology and classification scheme that you are espousing, there is reason to expect that they will address the items of concern to you.”

As can be seen from the above "we do not know yet whether there will be a section in the yet-to-be-completed measurement concepts chapter labeled capital maintenance."

Imagine even contemplating leaving capital maintenance out of a common Conceptual Framework!

It has to be noted with alarm that after discussing measurement for the last 6 years on the joint Conceptual Framework project, units of constant purchasing power are not regarded as a candidate for primary measurement basis although the FASB has stated that capital maintenance will continue to be discussed in the future.

The current IASB Framework permits financial capital maintenance in units of constant purchasing power during low inflation and deflation while this is not allowed under US GAAP. A future converged Conceptual Framework that does not authorize financial capital maintenance in units of constant purchasing power will be fundamentally flawed as US GAAP are currently fundamentally flawed as a result of the absence of the only correct accounting model under inflation and deflation.

Kindest regards

Nicolaas Smith
realvalueaccounting@yahoo.com

Copyright © 2010 Nicolaas J Smith

Financial Standards are similar to universal units of measure: they need a fundamental constant.

Comment to IFRS in Perspective blog on AccountingWeb.com

Mr Pounder,

Financial standards are really the same as universal units of measure (inch, pound, gram, meter, etc.) because accountants value all items in financial statements. As your Mr Mosso (ex FASB) stated: The balance sheet is a measurement instrument.

No one in any country in the world disagrees that monetary items have to be valued at their original nominal historical cost monetary values during the current financial period. You will not find one person in the world who will disagree with that. Money (the functional currency) is money and it cannot (currently) be updated of inflation- or deflation-adjusted - during the current financial period.

You will find many people and many countries disagreeing about the definition of monetary items. We all have to agree to one single definition of monetary items too.

That goes for all financial standards too.

There are no sovereignity issues with the definition of an inch, a pound, a gram, etc. Not all countries apply the metric system, but, there is a fixed fundamental relationship between different measures for the same concept. That is what should be the case with financial standards too.

In the end any economic item stated in financial statements have one and only one real value.

Kindest regards

Nicolaas Smith
realvalueaccounting@yahoo.com

Copyright © 2010 Nicolaas J Smith

Saturday 24 July 2010

Only IFRS authorize financial capital maintenance in units of constant purchasing power.

Comment to AccountingWeb.Com blog.

Mr Pounder,

You state in your first post:

"In each of my posts, I’ll tell you something about IFRS that’s relevant, that’s reliable, and that you’re unlikely to have read or heard anywhere else."

Here is something about IFRS that is relevant, reliable and that you´re unlikely to have read or heard anywhere else:

US GAAP as stated by the FASB only recognize two forms of capital maintenance as stated in Par 45 to 48 of the FASB Concepts Statement 5, namely

(a) Financial capital maintenance in nominal monetary units applying the stable measuring unit assumption, i.e. the Historical Cost Accounting model, and

(b) Physical capital maintenance.

IFRS state in the Framework (1989), Par 104 (a)

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

IFRS thus recognize three concepts of capital maintenance during low inflation and deflation:

1. Physical capital maintenance
2. Financial capital maintenance in nominal monetary units (HCA)
3. Financial capital maintenance in units of constant purchasing power (Constant Item Purchasing Power Accounting)

Financial capital maintenance in nominal monetary units (as per US GAAP, for example) is a fallacy: it is impossible to maintain the real value of financial capital constant in nominal monetary units per se during inflation and deflation. Implementing traditional HCA (as all US companies do) results in the destruction of hundreds of billions of Dollars PER ANNUM in the real value of constant real value non-monetary items (e.g. shareholders´ equity) never maintain constant as a result of insufficient revaluable fixed assets (revalued or not) under the HCA model.

Financial capital maintenance as authorized in IFRS in the Framework, Par 104 (a) twenty one years ago is the only way to stop this unknowing, unnecessary and unintentional destruction by US accountants forever.

US GAAP do not allow financial capital maintenance in units of constant purchasing power during low inflation and deflation.

Do you think the FASB (US companies) should adopt financial capital maintenance in units of constant purchasing power?

Kindest regards

Nicolaas Smith
realvalueaccounting@yahoo.com

Copyright © 2010 Nicolaas J Smith

Friday 23 July 2010

Valuing monetary items

Measurement of Monetary Items in the Financial Statements

Measurement is the process of determining the monetary amounts at which monetary items are to be recognised and carried in the financial reports. This involves the selection of the particular basis of measurement. The original nominal values of monetary items can only be measured in nominal monetary units during the current accounting period.

During low inflation

The real value of money and other monetary items can not be updated or indexed or inflation-adjusted or maintained during the current financial period under any accounting or economic model during low inflation. Inflation destroys the real value of money and other monetary items evenly throughout the SA monetary economy currently at 4.6% per annum (May 2010) or about R120 billion per annum. Money and other monetary items only maintain their real values perfectly stable under permanently sustainable zero per cent annual inflation. This has never been achieved over an extended period of time of more than a month or two.

"The South African Reserve Bank conducts monetary policy within an inflation targeting framework. The current target is for CPI inflation to be within the target range of 3 to 6 per cent on a continuous basis." SARB

The SARB´s definition of price stability, in practice, is the destruction of the real value of the Rand at a rate of 6% or about R120 billion per annum because inflation normally rises to the top of the inflation targeting range. Real value is destroyed evenly in Rand bank notes and coins and other monetary items (loans, deposits, etc) throughout the SA monetary economy.

SA accountants value monetary items at their original nominal values – at their nominal historical cost – during the current financial period. It thus appears that it is correct when someone states that “financial reporting simply reports on what took place”. That is mistaken. Accountants value everything they account. There is no other way monetary items can be accounted and valued during the current financial period. It is an illusion that accountants only record what happened in the past: the “financial-reporting-simply-reports-on-what-took-place”-illusion as promoted by accounting professors.
SA accountants value monetary items at their current depreciated generally lower real values by accounting them during the current accounting period at their original nominal HC values during inflation. Their real values are destroyed by inflation over time. Being stated at their original nominal HC monetary values by accountants during inflation means that monetary items are automatically being valued by the continuous economic process of inflation over time.

This obviously means that monetary items are always correctly valued during the current financial period in any current account: at the current real value as determined by the current rate of inflation. In practice, money and other monetary items´ real values consequently generally decrease once per month – on the date the new CPI value is published by the statistics authorities – to a lower real value in low inflationary economies.

SA accountants do not destroy the about R120 billion in real value of the Rand and other monetary items in the SA monetary economy each year: 4.6% inflation does that. SA accountants value and account monetary items correctly in the SA monetary economy by stating them at their original nominal monetary HC values. They, however, fail to calculate and account the net monetary gains and losses from holding either net monetary liabilities or net monetary assets, as the case may be. This is a generally accepted accounting practice under HCA.

The only difference between accounting and valuing monetary items under the current HCA model and their accounting and valuation when measuring financial capital maintenance in real value maintaining units of constant purchasing power would be the calculation and accounting of net monetary gains and losses. These net monetary gains and losses are required by the IASB to be calculated and accounted in terms of IAS 29 during hyperinflation. These net monetary gains and losses are not calculated and accounted under the HCA model although it can be done. See Kapnick. No-one does that under HCA. Net monetary gains and losses are constant real value non-monetary items (income statement gains and losses) once they are accounted and have to be inflation-adjusted – measured in units of constant purchasing power - thereafter under the financial capital maintenance in units of constant purchasing power model or Constant ITEM Purchasing Power Accounting model as authorized by the IASB in the Framework, Par 104 (a) in 1989 as well as in terms of IAS 29 during hyperinflation.

Side note: The FASB and IASB have been working on their joint Conceptual Framework project for the last 6 years. However, they have not stated one word about valuing monetary items - or items like shareholders equity. It is called the Historical Cost mentalité - like there used to be the gold standard mentalité.
Copyright © 2010 Nicolaas J Smith

Thursday 22 July 2010

Unit of account

Inflation destroys the assumption that money is stable which is the basis of classic accountancy. In such circumstances, historical values registered in accountancy books become heterogeneous amounts measured in different units. The use of such data under traditional accounting methods without previous correction makes no sense and leads to results that are void of meaning.

Massone, 1981a. p.6

Money’s third function is that it is the unit of account in the economy. It is a monetary standard of measure of the real value of economic items to facilitate exchange without barter in order to overcome the double coincidence of wants problem. Inflation destroys the real value of money and deflation increases the real value of money. Money has never been perfectly stable in real value over an extended period of time. However, money illusion makes people believe that money maintains its real value over the short to medium term. Money is the only standard unit of measure that is not a fundamentally stable or fixed unit of value. All other standards of measure are perfectly stable units.

Accountants transformed money illusion into an official generally accepted accounting principle with their stable measuring unit assumption, also called the Measuring Unit Principle.

The unit of measure in accounting shall be the base money unit of the most relevant currency. This principle also assumes the unit of measure is stable; that is, changes in its general purchasing power are not considered sufficiently important to require adjustments to the basic financial reports.

Paul H. Walgenbach, Norman E. Dittrich and Ernest I. Hanson, (1973), Financial Accounting, New York: Harcourt Brace Javonovich, Inc. Page 429.

The stable measuring unit assumption is based on the fallacy that changes in the general purchasing power are not sufficiently important to require adjustments to the basic financial reports; i.e. not sufficiently important for accountants to measure financial capital maintenance in units of constant purchasing power during inflation and deflation.

In a low inflationary economy depreciating money is used as a depreciating monetary unit of account to value and record economic activity. It is very tempting to state that it is very clear that you can not have a unit of account that is not stable – as in fixed – in real value for accounting purposes. However, we have been doing exactly that for the last 700 years. The problem stems from the difficulty in defining a universal unit of real value.

Luckily there is a perfect way of eliminating completely the destructive effect of having a depreciating monetary unit of account during inflation as well as its increasing monetary real value effect during deflation in constant real value non-monetary items in an economy implementing the basic double entry accounting model. I am not referring to the HCA model, but, simply the double entry accounting model. It is the measurement of constant item values in units of constant purchasing power by inflation-adjusting their nominal values in terms of the change in the CPI as authorized by the IASB in the Framework, Par 104 (a) in 1989. Unfortunately this is currently only used in hyperinflationary economies and with the valuation of certain income statement items, e.g. salaries, wages, rentals, etc during low inflation. SA accountants in general (do not understand the real value maintaining function (effect) of measuring financial capital maintenance in units of constant purchasing power as it relates to balance sheet constant items never maintained. If they understood it, they would not continue with their very destructive stable measuring unit assumption – as they are doing right now – and unknowingly destroy about R200 billion per annum of real value in the SA constant item economy.

They do understand it as far as salaries, wages, rentals, etc are concerned. But, not as far as balance sheet constant items never maintained are concerned.

Inflation is the real problem or enemy - as everyone knows - with depreciating money since real value is the most fundamental economic concept in any economy under any economic model including the Historical Cost Accounting model and not money as is generally accepted under the mistaken belief (money illusion) or assumption (stable measuring unit assumption) that money is stable in real value. The combination of the stable measuring unit assumption (HCA) with inflation elevates money’s function as depreciating unit of account to one of critical importance. SA accountants´ implementation of this very destructive assumption in SA´s low inflationary economy is the second unknown and hidden real value destruction process or enemy whereby they unknowingly destroy significant amounts of real value in the real economy each and every year.
Copyright © 2010 Nicolaas J Smith

Wednesday 21 July 2010

Money is a store of value

Money is a depreciating store of value during inflation and an appreciating store of value during deflation.

Money has to maintain most of its value over time in order to be accepted as a medium of exchange. It would not solve barter’s double coincidence of wants problem if it could not be stored over time and still remain valuable in exchange.

The fact that inflation is destroying the real value of money means it is a store of depreciating real value during inflation. Money was a store of value right from the start. First types of money consisted of gold or silver coins. The metals from which the coins were made had an actual real value in themselves and these coins could be melted down and the metal could be sold in its bullion form when the bullion price was above the coin price. Next money was not made of precious metal coins but money consisted of bank notes, the real values of which were fully backed by gold reserves. Today depreciating money simply represents depreciating real value since depreciating bank notes and bank coins have no intrinsic value. Although the store of value function and nominal values of depreciating bank notes and bank coins are legally defined, their depreciating real values are determined by the economic process of inflation or deflation.

The abuse of money’s store of value function led to inflation.

Money is very liquid; i.e. it is readily available as cash and it is normally easy to obtain on demand in most economies. A property, e.g. a well-located plot of land with a well-maintained and well-equipped building is also a store of value. It is however quite an illiquid store of value. The real value is not immediately available in easily transportable and divisible cash. Money’s high liquidity makes it more desirable as a store of value in comparison with other stores of value like gold, property, marketable securities, bonds, etc. Money is obviously not the best store of value in an inflationary economy where its real value is being destroyed by inflation. Money is normally available in convenient smaller denominations which facilitate everyday small purchases. As such, money is very user friendly. It is easily transportable especially with electronic transfer facilities.

Inflation actually manifests itself in money’s store of value function since inflation always and everywhere destroys the real value of money. Inflation does not manifest itself in money’s medium of exchange function or unit of account function which vindicates the fact that inflation can only destroy the real value of money and monetary items; i.e. inflation has no effect on the real value of non-monetary items. Money is always a medium of exchange of equal real value at the moment of exchange. Free market prices are adjusted in the market in a price setting process that takes the decreasing real value of money into account (amongst many other factors) so that economic items (the product or service and the amount of money) of equal real value are exchanged at the moment of exchange.
Depreciating money has a constantly decreasing real value. Depreciating “bank money” deposits have the same attributes of depreciating money with the single exception that they are not physical depreciating bank notes and bank coins but accounted depreciating monetary values. The depreciating money represented by depreciating bank money also has a depreciating store of value function.

Kindest regards

Nicolaas Smith
realvalueaccounting@yahoo.com

Copyright © 2010 Nicolaas J Smith

Tuesday 20 July 2010

Functions of money

Money performs the following three functions:

1.Medium of exchange

2.Store of value

3.Unit of account


1. Medium of Exchange

Money has the basic function that it is a medium of exchange of equivalent real values at the moment of exchange. It overcomes the inconveniences of a barter economy where there must be a double coincidence of wants before a trade can take place. For a trade to take place in a barter economy one person must want exactly what the other person has to offer, at the exact time and place where it is offered.

In a monetary economy the real value of goods and services are measured in terms of money, the monetary medium of exchange, which is generally accepted to buy any other good or service. Without this function or attribute the invention cannot be money.

We use payment with money instead of barter to exchange real values in our economies in the transactions we enter into when we buy and sell goods, services, ideas, rights and any kind of property whether physical, virtual or intellectual. Money is the lifeblood of an economy even though it is continuously changing in real value. Without money the creation and exchange of real value in an economy would be severely restricted, as it would become a barter economy.

Kindest regards

Nicolaas Smith
realvalueaccounting@yahoo.com

Copyright © 2010 Nicolaas J Smith

Monday 19 July 2010

CPI + CIPPA = Zero destruction

The significant destruction of the real value of SA companies´ and banks´ retained profits never maintained constant, unknowingly done by SA accountants implementing their very destructive stable measuring unit assumption during low inflation would have been impossible to stop without the Consumer Price Index. The CPI and financial capital maintenance in units of constant purchasing power [Constant Item Purchasing Power Accounting or CIPPA] make it easy to fix the problem and to stop our accountants destroying about R167 billion each and every year in the SA real economy.

When our accountants freely start measuring financial capital maintenance in units of constant purchasing power as the IASB-authorized them to do 21 years ago in the Framework, Par 104 (a), then they will maintain all constant items generally never maintained in the SA economy for an unlimited period of time by updating them in terms of the change in the CPI instead of destroying their real values at a rate equal to the inflation rate as they are unknowingly doing right now. They would do that even in companies with no fixed assets at all. The "equivalent revaluable fixed assets requirement" is only applicable with the stable measuring unit assumption.



Copyright © 2010 Nicolaas J Smith

Friday 16 July 2010

Sine qua non

There is no CPI in a barter economy as there is no money in such an economy. The CPI is essential to update or index or inflation-adjust the real value of constant items in the economy with continuous measurement of financial capital maintenance in units of constant purchasing power being used as the fundamental model of accounting. The CPI is used to calculate the destruction of real value in constant items never maintained in low inflationary economies using HCA as the fundamental model of accounting.

The real value of money is automatically updated by inflation and deflation. Whereas the price of a constant item should change inversely with the change in the real value of money, the real value of money changes inversely with the change in the level of the CPI.

The CPI is the sine qua non in an inflationary and deflationary economy for correcting the problem created by the fact that money is the only universal unit of account that is not a stable unit of measure: it is applied without a fundamental constant. It would be impossible to measure inflation and deflation without the CPI. Consequently it would also have been impossible to stop the destruction of the real value in constant real value non-monetary items never maintained (generally equity of companies using HCA with no fixed assets or not sufficient revaluable fixed assets to maintain equity’s real value) during low inflation.

Kindest regards

Nicolaas Smith
realvalueaccounting@yahoo.com

Copyright © 2010 Nicolaas J Smith

Thursday 15 July 2010

Units of constant purchasing power

We use the change in the CPI as a measure to calculate the destruction of real value in monetary items (which cannot be indexed) and constant items never maintained (thus being treated as monetary items) over time in an inflationary economy implementing the Historical Cost Accounting model as all companies in SA do. We also use the change in the CPI as a measure to calculate the creation of real value in monetary items (never indexed) and constant items never maintained (never decreased) over time in a deflationary economy that uses the HCA model – as all companies in Japan do.

The CPI can be used to measure financial capital maintenance in units of constant purchasing power and thus index (adjust nominal values for inflation’s destruction of or deflation´s increase in the real value of money which is the monetary unit of account) wages, salaries, pensions, all income statement items, issued share capital, retained profits, capital reserves, other shareholders´ equity items, trade debtors, trade creditors, taxes payable, taxes receivable and all other balance sheet constant items.


Copyright © 2010 Nicolaas J Smith

Tuesday 13 July 2010

Consumer Price Index

“The consumer price index was first used in 1707. In 1925 it became institutionalized when the Second International Conference of Labour Statisticians, convened by the International Labour Organization, promulgated the first international standards of measurement.”

Agrekon, Vol 43, No 2 (June 2004), Vink, Kirsten and Woermann.

The CPI is a non-monetary index number measuring changes in the weighted average of prices quoted in the functional currency of a typical basket of consumer goods and services. The per cent change in the CPI is used to measure inflation. It is a price index determined by measuring the price of a standard group of goods and services representing a typical market basket of a typical urban consumer. It measures the change in average price for a constant market basket of goods and services from one period to the next within the same area (city, region, or nation). It can be used to measure changes in the cost of living. It is a measure estimating the average price of consumer goods and services purchased by a typical urban household.

Kindest regards

Nicolaas Smith
realvalueaccounting@yahoo.com

Copyright © 2010 Nicolaas J Smith

Friday 9 July 2010

Gold is something without intrinsic value

Hi,
Who said that?

Not me.

"Willem Buiter, a former professor at the London School of Economics who is now the chief economist of Citigroup, has called gold the subject of “the longest-lasting bubble in human history”. He says that he would not invest more than a sliver of his wealth “into something without intrinsic value, something whose positive value is based on nothing more than a set of self-confirming beliefs.”"

People often google for the "real value of money" and then visit this blog. 
There are so many people who lament the fact that fiat money has no intrinsic value. They all call for going back to the gold standard.

Meanwhile, gold is also something without intrinsic value according to the chief economist of Citigroup and former professor at the London School of Economics.

Oh, what a wonderful place the market is. Without so many different view points, there would be no market at all. For every buyer there is a ..... yes, you guessed it right, a seller!!

So then, what is real value if neither gold nor fiat money has any intrinsic value?

Kindest regards


Nicolaas Smith
realvalueaccounting@yahoo.com

Copyright © 2010 Nicolaas J Smith

Wednesday 7 July 2010

What backs money?

Our money today has no intrinsic value in itself. It is fiat money that is created by government fiat or decree. The government declares fiat money to be legal tender. In the past monetary coins were made of, for example, silver or gold which were valuable in themselves. The actual metal of which the coin was made had a real or intrinsic value supposedly equivalent to the nominal value inscribed on the coin. Today fiat money is a government decreed and legally recognized medium of exchange, unit of account and store of value in the economy.

Our money today has no intrinsic value as it is the natural product of the development of the concept of money through time. In the beginning a monetary unit was a full value metal coin. Later it was not a full value metal coin but it was the next best thing as far as economic agents were concerned: it was 100 per cent backed by gold. Today it has no intrinsic value and it is not backed by gold but is backed by the combined macroeconomic real value of all the underlying value systems in a particular economy or monetary union.

These underlying value systems include, but, are not limited to sound governance, a sound economic system, a sound manufacturing system, a sound industrial system, a sound monetary system, a sound political system, a sound social system, a sound educational system, a sound defence system, a sound health system, a sound security system, a sound legal system, a sound accounting system and so on, to name but a few.

Kindest regards

Nicolaas Smith
realvalueaccounting@yahoo.com

Copyright © 2010 Nicolaas J Smith

The FASB and IASB do not agree on capital maintenance

The FASB defines capital maintenance in its Concepts Statement No 5, Paragraphs 45 to 48.

According to the FASB there are only two concepts of capital
1.Financial capital

2.Physical capital

and consequently two concepts of capital maintenance
i Financial capital maintenance

ii Physical capital maintenance

The IASB states the same, but, defines THREE concepts of capital and THREE concepts of capital maintenance.

The IASB´s Concepts of Capital and Capital Maintenance are defined in the Framework, paragraphs 102 to 110.

The IASB states virtually the same as the FASB above. However, in Paragraph 104 (a) the IASB went one step further and stated twenty one years ago:

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

There is no mention of units of constant purchasing power in the FASB´s definition of financial capital maintenance.

The three concepts of capital defined in IFRS during low inflation and deflation are:

(A) Physical capital. See par. 102.

(B) Nominal financial capital. See par. 104 (a).

(C) Constant purchasing power financial capital. See par. 104 (a).

The three concepts of capital maintenance authorized in IFRS during low inflation and deflation are:

(1) Physical capital maintenance: optional during low inflation and deflation. Current Cost Accounting model prescribed by IFRS. See Par 106.

(2) Financial capital maintenance in nominal monetary units (Historical cost accounting): authorized by IFRS but not prescribed—optional during low inflation and deflation. See Par 104 (a). Unfortunately, financial capital maintenance in nominal monetary units per se during inflation and deflation is a fallacy: it is impossible to maintain the real value of financial capital constant with measurement in nominal monetary units per se during inflation and deflation. This fallacy did not and does not stop all companies and entities to use Historical Cost Accounting as the generally accepted tradition basic accounting model for the last 700 years. Historical cost accountants overcame this fallacy by simply assuming that the unit of account (money) is perfectly stable as far as the measurement of most constant real value non-monetary items (shareholders equity, trade debtors, trade creditors, taxes payable, taxes receivable, etc) is concerned. They do however admit that the unit of account is not stable only in the case of certain income statement items: e.g. salaries, wages, rentals, etc. They inflation-adjust these items annually.

(3) Financial capital maintenance in units of constant purchasing power: i.e. Constant Item Purchasing Power Accounting (CIPPA) authorized in IFRS but not prescribed—optional during low inflation and deflation. See the Framework, Par 104 (a). Only constant items are measured in units of constant purchasing power during low inflation and deflation. Net monetary gains and losses have to be accounted.

Prescribed in IAS 29 during hyperinflation; i.e. Constant Purchasing Power Accounting (CPPA): all non-monetary items – constant real value non-monetary items as well as variable real value non-monetary items – have to be measured in units of constant purchasing power during hyperinflation. Net monetary gains and losses have to be accounted.

Only financial capital maintenance in units of constant purchasing power [Constant Item Purchasing Power Accounting (CIPPA) during low inflation and deflation and Constant Purchasing Power Accounting (CPPA) during hyperinflation] per se can maintain the real value of financial capital constant during inflation and deflation in all entities that at least break even—ceteris paribus—for an indefinite period of time. This would happen whether these entities own revaluable fixed assets or not and without the requirement of more capital or additional retained profits to simply maintain the existing constant real value of existing shareholders´ equity constant.

There is thus a major difference between the FASB´s and the IASB´s definitions of the concepts of capital and the concepts of capital maintenance. It is their stated objective to converge their two Frameworks.

However, after working six years on their joint Conceptual Framework project, Kevin McBeth, the FASB Project Manager for the Measurement Phase stated:

“To date the Boards have not taken a decision on where, or even whether, those topics (the concepts of capital and capital maintenance) “will be included in the converged framework."

The FASB afterwards clarified the matter as follows:

“We are of course familiar with paragraphs 102 – 110 of the IASB Framework as well as paragraphs 45-48 of FASB Concepts Statement 5. Although not labeled as such, capital maintenance ideas have been raised at various points in the discussions of measurement concepts and will continue to be discussed until the board makes decisions about measurement concepts. We do not know yet whether there will be a section in the yet-to-be-completed measurement concepts chapter labeled capital maintenance, but the concepts will almost certainly be discussed.”

This is after 6 years on the Project.

Kindest regards

Nicolaas Smith
realvalueaccounting@yahoo.com

Copyright © 2010 Nicolaas J Smith

Tuesday 6 July 2010

It´s the real value, stupid!

Real value is the most important fundamental economic concept although it is the lesser studied and understood compared to the study of money. Money and real value are, unfortunately, not one and the same thing during inflation and deflation. Money and monetary items always have lower real values during inflation and higher real values during deflation under any accounting model.

Money is an invention. We can terminate its existence while real value is a fundamental economic concept, which exists, while we exist. Economies have already functioned without money. Barter economies operated without a medium of exchange. Cuba in the past bought oil from Venezuela and paid part in money and part by the provision of the services of sports coaches and medical doctors. Corn farmers in Argentina stored their corn in silos and paid for new pick-up trucks and other expensive mechanized farm implements with quantities of corn - the unit of real value Adam Smith described more than 230 years ago as a very stable unit of real value.

There will always be real value while the human race exists. The need for a medium of exchange, which is money’s first and basic function, is equally true. Money is one of the greatest human inventions of all time. It ranks on par with the invention of the wheel and the Gutenberg press in terms of importance to human development. Without money modern human development would have been very slow indeed.

Monetary items have the exact same attributes as money with the single exception that they are not actual bank notes and bank coins.

Non-monetary items are all items that are not monetary items.

Kindest regards

Nicolaas Smith
realvalueaccounting@yahoo.com

Copyright © 2010 Nicolaas J Smith

Monday 5 July 2010

Time line for a Unit of Constant Purchasing Power

1707

The Consumer Price Index (CPI) was first used in 1707.

1896

The Market Gage Plan for stabilizing the purchasing power of the dollar was originated in 1896.

1918

The article “The Market Gage Dollar: A Unit of Constant Purchasing Power” was published in The American Economic Review.

The Market Gage Dollar: A Unit of Constant Purchasing Power
D.J. Tinnes
The American Economic Review, Vol. 8, No. 3 (Sep., 1918), pp. 579-584

1925

In 1925 the CPI became institutionalized when the Second International Conference of Labour Statisticians, convened by the International Labour Organization, promulgated the first international standards of measurement.

1989

The International Accounting Standards Board Committee authorized financial capital maintenance in units of constant purchasing in The Framework for the Preparation and Presentation of Financial Statements, Paragraph 104 (a) which states:

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

2004

“In October 2004, the FASB and IASB added to their agendas a joint project to develop an improved, common conceptual framework that builds on their existing frameworks (that is, the IASB’s Framework for the Preparation and Presentation of Financial Statements and the FASB’s Statements of Financial Accounting Concepts).” *

2007

The Boards held roundtable discussions on measurement during January and February 2007. *

Capital maintenance mentioned once in the summary.

“Measurement Basis Candidates (April 2007)


The Boards discussed issues related to the following primary measurement basis candidates:


1.Past entry price
2.Past exit price
3.Modified past amount
4.Current entry price
5.Current exit price
6.Current equilibrium price
7.Value in use
8.Future entry price
9.Future exit price.” *

Please note: A unit of constant purchasing power was not stated as a primary measurement basis candidate.

2008

“New Approach (November 2008)

The Boards discussed the beginnings of an approach to making standards-level decisions about measurement of assets and liabilities.


Five factors that might be considered in selecting from among alternative measurement bases are:


1.Value/flow weighting and separation.
2.Confidence level.
3.The measurement of items that generate cash flows together.
4.Cost-benefit” *

Please note: Nothing about a unit of constant purchasing power as a measurement basis.

2009

Possible Measurement Approaches (January 2009)


On January 14, 2009, the Board discussed which possible measurement methods should be included in the conceptual framework and tentatively decided to include the following categories:


1.Actual or estimated current prices (which will become past prices in future periods if an item is not remeasured)
2.Actual past entry prices adjusted for interest accruals, depreciation, amortization, impairments, and similar things
3.Other prescribed computations based on discounted or undiscounted estimates of future cash flows (which would include value in use and fair-value-based measurements, among other things).” *

Please note: Nothing about a unit of constant purchasing power as a measurement basis.

“Draft Measurement Chapter of the Conceptual Framework (June 2009)


At the June 10, 2009, meeting, the Board discussed a draft measurement chapter for the conceptual framework that is based on measurement factors the Board has discussed in earlier meetings. Those factors are:


1.Method of value realization
2.Cost of preparing and using measures
3.Relative level of confidence in different measures
4.Use of consistent measures for similar items and items used together
5.Separability of changes in measures.” *

Please note: Nothing about a unit of constant purchasing power as a measurement basis.

*As per The Joint Conceptual Framework Project Update.

2010

On 1st July 2010 the US Financial Accounting Standards Board finally stated in email correspondence that the Concepts of Capital and Capital Maintenance will be discussed under the Measurement Phase of The Joint Conceptual Framework Project:

“We do not know yet whether there will be a section in the yet-to-be-completed measurement concepts chapter labeled capital maintenance, but the concepts will almost certainly be discussed.”

Units of constant purchasing power have not been stated once as a measurement basis during the first six years of The Joint Conceptual Framework Project, but, there is reason to expect that they will be discussed in the Measurement Phase in the future.

Kindest regards
 
Nicolaas Smith
realvalueaccounting@yahoo.com
 
Copyright © 2010 Nicolaas J Smith

Friday 2 July 2010

Capital maintenance to be discussed in Measurement phase

The IASB and FASB are jointly updating and converging their Frameworks. The joint Conceptual Framework project has eight phases, one of which is the Measurement phase.


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The Boards held roundtable discussions on measurement during January and February 2007. No public Discussion Paper has yet been presented for comment.

Reading the reports about the items discussed thus far in the Measurement Phase I noticed that the discussions are almost entirely about variable real value non-monetary items (property, plant, equipment, stock, shares, financial instruments, etc.) and almost nothing about monetary items and constant real value non-monetary items (all items in the income statement, all items in shareholders equity, trade debtors, trade creditors, taxes payable, taxes receivable, etc).

I emailed Kevin McBeth, the FASB Project Manager responsible for the Measurement Phase in the joint project and asked him in which phase the Concepts of Capital and Capital Maintenance are going to be discussed.

He responded by email:

“I cannot speak for the Boards with respect to your query. I can only say that early on in the measurement phase the staff suggested that capital and capital maintenance be discussed in the measurement phase, as it was in the original FASB Conceptual Framework. However, to date the Boards have not taken a decision on where, or even whether, those topics will be included in the converged framework.” (my bold lettering).

I then put the same question to the US Financial Accounting Standards Board.

Ron Lott, the FASB director who is responsible for the joint FASB-IASB Conceptual Framework project responded by email:

“We are of course familiar with paragraphs 102 – 110 of the IASB Framework as well as paragraphs 45-48 of FASB Concepts Statement 5. Although not labeled as such, capital maintenance ideas have been raised at various points in the discussions of measurement concepts and will continue to be discussed until the board makes decisions about measurement concepts.

We do not know yet whether there will be a section in the yet-to-be-completed measurement concepts chapter labeled capital maintenance, but the concepts will almost certainly be discussed.”

Kevin McBeth stated the following by email:

“I believe that you may have misunderstood the discussions the FASB and IASB have had about measurement. Those discussions have used examples of various items, some of which you refer to as variable real value non-monetary items. That may have led you to believe that some of your concerns are being ignored. However, the scope of the measurement phase of the Conceptual Framework project does not exclude the items you refer to as constant real value non-monetary items. The Boards are concerned about the effects of selecting measurements on all elements of the financial statements.


Much remains to be done on this project. Although future discussions probably will not use the terminology and classification scheme that you are espousing, there is reason to expect that they will address the items of concern to you.” (my bold lettering).

The Concepts of Capital and Capital Maintenance will thus be discussed in the Measurement Phase.
 
Kindest regards

Buy the ebook for $2.99 or £1.53 or €2.68
 
Nicolaas Smith
realvalueaccounting@yahoo.com
 
Copyright © 2010 Nicolaas J Smith

Thursday 1 July 2010

Bye bye CPI, Hello Dollarization

A non-barter economy needs an internal medium of exchange, i.e. money. The rate of change in the Consumer Price Index indicates the rate of inflation, i.e. the annual rate at which the real value of the your money is being destroyed inside your economy.

There are three fundamentally different basic economic items in the economy:

1. Monetary items: money held and items with an underlying monetary nature; basically money and money loans.

2. Variable real value non-monetary items; e.g. property, plant, equipment, raw materials, finished goods, etc.

3. Constant real value non-monetary items; e.g. salaries, wages, rentals, issued share capital, retained profits in companies, debtors, creditors, taxes payable, taxes receivable, etc.

1. Inflation automatically determines the real value of your money inside your economy; i.e. the value of money and other monetary items in the economy. You cannot inflation-adjust or update money or monetary items during the current financial period.

2. Variable item prices are ideally determined in a free market where demand and supply determine the prices of these items. Inflation is automatically taken into account in the process.

3. Constant item values (prices) e.g. salaries, wages, rentals, issued share capital, retained profits in companies, capital reserves, debtors, creditors, taxes payable, taxes receivable, etc., have to be inflation-adjusted on a monthly basis in an inflationary economy by applying the change in the CPI in order to keep the economy stable.

If a country does not calculate its CPI correctly, then it is playing with fire – like Argentina and Venezuela are doing.

The final solution in these cases are always Dollarization.

Why? Because you need a relatively stable unit of measure in an economy.

When you inflation-adjust all constant real value non-monetary items e.g. salaries, wages, rentals, issued share capital, retained profits in companies, capital reserves, debtors, creditors, taxes payable, taxes receivable, etc., on a monthly basis by means of the monthly change in the CPI, then you keep your economy stable because you measure you constant real value non-monetary economy in units of constant purchasing power – as Brazil did with a daily index supplied by the government during 30 years of high and hyperinflation.

For that you need a correctly calculated CPI.

When you mess around with your CPI which is a basic essential in your economy, then you are on your way to Dollarization.

Kindest regards

Nicolaas Smith
realvalueaccounting@yahoo.com

Copyright © 2010 Nicolaas J Smith