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Wednesday, 25 August 2010

Value does not exist independently of how we measure it.

The best example is a salary: when it is measured at Historical Cost, it has one value and when it is inflation-adjusted, i.e. measured in units of constant purchasing power, it has another - totally different - value.

This is also true for wages, rentals, etc.

Salaries, wages, rentals, etc are constant real value non-monetary items.

The same is true for all constant real value non-monetary items. Other examples are trade debtors, trade creditors, taxes payable, taxes receivable, etc.

Trade debtors, trade creditors and other non-monetary payables and receivables are mostly incorrectly defined by PricewaterhouseCoopers, the FASB, the IASB and others as monetary items and measured at Historical Cost in today´s economy.

185 million Brazilians measured all trade debtors, trade creditors, all other non-monetary payables and receivables daily in units of constant purchasing power by indexing them daily during 30 years from 1964 to 1994 with reference to a daily index supplied by the various governments during that period in the entire Brazilian economy.

This is totally ignored by PricewaterhouseCoopers, the FASB and the IASB today.

PricewaterhouseCoopers´auditors must have audited many Brazilian companies doing that during those 30 years. The message never got through to the PwC accountants who wrote their publication: Understanding IAS 29 - Financial Reporting In Hyperinflationary Economies in which PwC define trade debtors and trade creditors as monetary items. The FASB also specifically define trade debtors and trade creditors as monetary items.

Dr Gustavo Franco was the Governor of the Central Bank of Brazil during the last few years of that period of indexation. He was the head of the team that famously killed hyperinflation in Brazil in 1994 (they took 10 years to do it) with their Unidade Real de Valor (URV) or Real Value Unit.

I sent him the following email:

Dear Dr Franco,
>
> I would appreciate it very much if you could perhaps clear up a point for me regarding trade debtors and trade creditors under the URV.
>
> Were trade debtors and trade creditors treated as monetary items under the URV and not updated or were they treated as non-monetary items an updated in terms of the URV?
>
> What are trade debtors and trade creditors in your opinion? Are they monetary or non-monetary items?

He answered as follows:

"Dear Mr. Smith


Two observations are in order. First, for spot transactions the existence of the URV is immaterial, sums of means of payment are surrendered in exchange for goods, all delivered and liquidated on spot. Second, the unit of account enters the picture only when at least one leg of a commercial transaction is deferred. In this case, the URV serves the purpose of defining the price at the day of the contract. The same quantities of URVs are to be paid at the payment day, though this should represent LARGER QUANTITIES OF WHATEVER MEANS OF PAYMENT IS USED. (my capitals)


It was essential, in the Brazilian case, and this may be a general case, that the URV was defined as part of the monetary system. It has a lot to do with jurisprudence regarding monetary correction; URV denominated obligations had to be treated as if they were obligations subject to monetary correction. In the URV law it was defined that the URV would be issued, in the form of notes, and when this would happen, the URV would have its name changed to Real, and the other currency, the old, the Cruzeiro, was demonetized.


Att


GF"

So: there it is from the best possible source: trade debtors and trade creditors are non-monetary items.

PricewaterhouseCoopers, the IASB and the FASB and all of us can be educated about financial capital maintenance in units of constant purchasing power as authorized in IFRS in the Framework, Par 104 (a) from what Dr Franco confirmed.

Equity is measured at Historical Cost during low inflation and deflation in all economies world wide.

Equity is measured, not at Historical Cost, but, in units of constant purchasing power in terms of IAS 29 in Venezuela today by all Venezuelan companies which implement IFRS as well as foreign holding companies (applying IFRS) of Venezuelan subsidiaries and in all hyperinflationary economies

So, it is very clear that the value of any economic resource does not exist independently of how it is measured.

That statement is ONLY true in the case of

(1) variable real value non-monetary items, e.g. property, plant, equipment, inventory, etc. and monetary items - per se - under all accounting and economic models

and
(2) ONLY equity (not all constant items) during low inflation and deflation under Historical Cost Accounting ONLY when 100% of the updated original real value of all contributions to the equity balance are continuously invested in revaluable fixed assets (revalued or not) with an equivalent updated real value. This is – generally – rarely the case. It is most probably the case in property, hospital and hotel companies.

The statement that “value exists irrespective of how it is accounted” is thus the fourth accounting fallacy not yet extinct.

The four accounting fallacies not yet extinct are:

1.Financial capital maintenance in nominal monetary units: it is impossible to maintain the real value of financial capital constant - per se - with measurement in nominal monetary units during inflation and deflation.

2.The stable measuring unit assumption that is based on the fallacy that changes (up to 25% annual inflation for three years in a row) in the real value of the monetary unit of account are not sufficiently important for accountants to choose financial capital maintenance in units of constant purchasing power during low inflation and deflation as authorized in IFRS in the Framework, Par 104 (a).

3.The erosion of business profits and invested capital is caused by inflation as wrongly stated by the FASB in FAS 33 in 1979. This is believed by almost all accountants and economists. In fact: “inflation is always and everywhere a monetary phenomenon” as so famously stated by Milton Friedman, the late Noble Laureate. Inflation has no effect on the real value of any nonmonetary item ever. It is impossible for inflation – per se - to erode, distort or destroy any non-monetary item ever. This is confirmed by two top Turkish academics who 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.

4. “Value exists irrespective of how it is accounted.” This is only true in the case of variable and monetary items per se under all accounting and economic models and only equity during HCA during low inflation and deflation if the 100% investment requirement of the updated original real value of all contributions to the equity balance in revaluable fixed assets with an equivalent updated real value is met.

Copyright © 2010 Nicolaas J Smith

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