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Thursday, 9 September 2010

Valuing properties at HC does not destroy their real values

Valuing properties at HC does not destroy their real values

The real values of land and buildings are not destroyed by accountants when they value these fixed assets at their original nominal HC values before the date that they are actually sold during low inflation. They would be valued at their current market values on the date of exchange in an open economy. During hyperinflation all non-monetary items (variable and constant items) are required to be valued in units of constant purchasing power to make restated HC financial reports more useful by applying the CPI at period-end or a hard currency parallel rate – normally the US Dollar daily parallel rate – on a daily basis if the country wishes to stabilize its real economy.

This is not the case with reported constant items with real values never maintained constant during low inflation and deflation under the HCA model. SA accountants unknowingly destroy the real values of reported constant items never maintained at a rate equal to the rate of inflation in a low inflationary environment with their stable measuring unit assumption under HCA.

Land and buildings´ real values are not being unknowingly destroyed by SA accountants as a result of their implementation of IFRS or SA GAAP since they exist independently of how we value them. Accountants can value land and buildings in the balance sheet at their HC 50 years ago, but, when they are sold in the market today they would be transacted at the current market price. The real values of variable items are also not being destroyed uniformly at, e.g., a rate equal to the inflation rate because of valuing them at original nominal HC. Inflation has no effect on the real values of non-monetary items.

Where real losses are made in dealing with variable items in SA, these losses are the result of supply and demand or business or private decisions, e.g. selling at a bad price, obsolescence, stock market crashes, credit crunches, etc. They do not result from the implementation by SA accountants of the HC accounting model.

A house is a variable real value non-monetary item. Let us assume a house in Port Elizabeth is fairly valued in the PE market at say R 2 million on 1st January in year one. With no change in the market a year later but with inflation at 6% in SA, the seller would increase his or her price to R2.12 million - all else being equal. The house’s real value remained the same. The depreciating monetary price for the house expressed in the depreciating Rand medium of exchange – all else being equal - was inflation-adjusted to compensate for the destruction of the real value of the depreciating Rand in the internal SA market by 6% annual inflation. It is clear that inflation does not affect the house’s variable non-monetary real value – all else being equal.

However much inflation rises, it can only make the Rand more worthless at a higher rate and over a shorter period of time. Heaven forbid that what happened in Zimbabwe recently would ever happen in SA. As inflation rises the price of the house would rise to keep pace with inflation or value destruction in the real value of the Rand – all else being equal. The real value of the property will be updated as long as the house is valued as a variable real value non-monetary item at its market price, a measurement base dictated by IFRS and also practiced in all open markets.

When a property was valued at Historical Cost in the not so distant past in a company’s balance sheet it may have stayed at its original HC of, for example, R 100 000 for 29 years since January, 1981 in the company’s balance sheet. When it is eventually sold today for R 1.4 million we can see that inflation did not destroy the property’s variable real non-monetary value – all else being equal. Inflation only destroyed the real value of the depreciating Rand, the depreciating monetary medium of exchange, over the 29 year period - all else being equal. This was taken into account by the buyer and seller at the time of the sale. The selling price in Rand was increased to compensate for the destruction of the real value of the Rand by inflation. R1.4 million today (2010) is the same as R100 000 in January, 1981 – all else being equal.

As the two lady academics from Turkey state: “Purchasing power of non monetary items does not change in spite of variation in national currency value.”

Copyright © 2010 Nicolaas J Smith