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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