Friday, 14 January 2011

Constant Real Value Non-monetary Items

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)

The Taxation of Income from Business and Capital in Colombia: Fiscal Reform in the Developing World, By Charles E. McLure, John Mutti, Victor Thuronyi, George R. Zodrow, Contributor Charles E. McLure, Published by Duke University Press, 1990, ISBN 0822309254, 9780822309253, Page 259

Constant items are non-monetary items with constant real values over time.

The double entry accounting model was first comprehensively codified by the Italian Franciscan monk, Luca Pacioli in his book Summa de arithmetica, geometria, proportioni et proportionalita, published in Venice in 1494.

Accountants use the Consumer Price Index to maintain the real values of certain – not all - income statement constant items, e.g. salaries, wages, rentals, etc stable during low inflationary periods. They value these particular constant items in units of constant purchasing power while they generally implement the Historical Cost Accounting model. The Framework, Par 101 states that the measurement basis most often used by companies in preparing their financial reports is historical cost. This is normally used together with other measurement bases.

Constant items during Hyperinflation

Accountants are required by the IASB to implement IAS 29 Financial Reporting in Hyperinflationary Economies during hyperinflation being an exceptional circumstance. Hyperinflation is defined by the IASB as a cumulative inflation rate approaching or exceeding 100% over three years, i.e. 26% annual inflation for three years in a row. Accountants have to restate their HC or Current Cost financial statements by applying the period-end CPI during hyperinflation to make the HC or CC financial statements more useful. They have to value all non-monetary items (both variable real value non-monetary items and constant real value non-monetary items) in units of constant purchasing power by applying the CPI at the period-end date. The restated values of HC or CC financial statements in terms of IAS 29 in a hyperinflationary economy are only valid new real values when the tax authorities accept the restated values for the calculation of taxes due.

“Regarding to tax regulation, I want to emphasize that tax regulation required restatement of assets and liabilities according to inflation (in terms of IAS 29) for the date of 31.12.2003 but taxes were not taken according to restated values in 2003. In 2004, financial statements were restated and taxes were taken based on restated values.”

Cemal KÜÇÜKSÖZEN, Ph.D, Head of Accounting Standards Department, Capital Markets Board of Turkey

Constant Purchasing Power inflation accounting (not Constant ITEM Purchasing Power Accounting) as defined in IAS 29 is a complete price-level inflation accounting model where under all variable and constant real value non-monetary items are inflation-adjusted by means of the CPI at the period-end date during hyperinflation to make financial statements more useful.

IAS 29 can also be used to maintain the non-monetary economy relatively stable in a hyperinflationary economy. This is only possible when all non-monetary items (variable and constant items) are valued daily at the daily parallel US Dollar (or other hard currency) exchange rate instead of simply restating HC or CC financial statements at the period-end (normally year-end) CPI rate to make them more useful as required by IAS 29. Brazilian accountants did this very successfully from 1964 to 1994 without IAS 29 (IAS 29 was approved in 1989) by valuing all non-monetary items daily in term of a daily non-monetary index based almost entirely on the US Dollar exchange rate with their currency as supplied daily by various governments during those 30 years.

The constant item economy in a hyperinflationary environment would not be completely stable as in the case of financial capital maintenance in units of constant purchasing power applying the CPI during low inflation. Applying the daily USD parallel rate in the valuation of all non-monetary items (constant and variable items) during hyperinflation would still result in real value destruction of constant items, but, only at a rate equal to the inflation rate in the parallel hard currency used, normally the US Dollar. If this was done in the case of Zimbabwe it would have resulted in real value destruction in constant items of about 2% per annum – a rate equal to the USD inflation rate – instead of 89,700,000,000,000,000,000,000% ( 89.7 sextillion%) in case of the Zimbabwe Dollar hyperinflation rate.

Nicolaas Smith

Copyright (c) 2005 - 2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Fin24 24-03-11