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Saturday, 26 February 2011

Current inflation accounting

Presently, inflation accounting describes a complete price-level inflation accounting model, namely the Constant Purchasing Power Accounting (CPPA) inflation accounting model defined in IAS 29 Financial Reporting in Hyperinflationary Economies required to be implemented only during hyperinflation which is an exceptional circumstance according to the IASB. It serves to make Historical Cost and Current Cost financial statements more useful at the period end by restating all non-monetary items – variable real value non-monetary items and constant real value non-monetary items - by inflation-adjusting them by applying the period-end Consumer Price Index during hyperinflation.
“In a hyperinflationary economy, reporting of operating results and financial position in the local currency without restatement is not useful. Money loses value at such a rate that comparison of amounts from transactions and other events that have occurred at different times, even within the same accounting period, is misleading.” IAS 29.2

The fallacy that inflation erodes the real value of non-monetary items is currently still generally accepted. It is still mistakenly accepted as a fact that the erosion of companies´ capital and profits is caused by inflation. “The erosion of business profits and invested capital caused by inflation was clearly stated in FAS 33 and “the erosive impact of inflation on profits and capital” was stated in both FAS 33 and FAS 89.

Since 2008 it became very clear to me that inflation has no effect on the real value of non-monetary items over time. The understanding of the real value eroding effect of the stable measuring unit assumption on constant real value non-monetary items never maintained during inflation is an on-going process. Not inflation, per se, but the implementation of the very erosive stable measuring unit assumption as it forms part of the traditional Historical Cost Accounting model erodes the real value of constant real value non-monetary items never maintained constant over time as a result of insufficient revaluable fixed assets during low inflation. There is no substance in the statement that inflation destroys the real value of non-monetary items which do not hold their real value over time. Inflation has no effect on the real value on non-monetary items.

The late Milton Friedman, Nobel Laureate and US economist, clearly stated that “inflation is always and everywhere a monetary phenomenon.” Friedman was not the only economist who realized that.
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

Accountants unknowingly, unintentionally and unnecessarily erode or knowingly maintain (please note: not create) the real value of constant real value non-monetary items (please note: not variable real value non-monetary items) depending on whether they choose the IASB-approved traditional Historical Cost Accounting model under which they implement their very erosive stable measuring unit assumption for an unlimited period of time during indefinite inflation or the IASB-approved constant item real value maintaining financial capital maintenance in units of constant purchasing power model (Constant Item Purchasing Power Accounting) under which they select to reject the stable measuring unit assumption at all levels of inflation and deflation for an unlimited period of time.

Inflation is a uniquely monetary phenomenon and can only erode the real value of money and other monetary items over time. It has no effect on the real value of non-monetary items. The traditional Historical Cost Accounting model unknowingly, unintentionally and unnecessarily do the eroding of the real value of constant real value non-monetary items never maintained constant over time, e.g. Retained Earnings, Issued Share capital, other items in Shareholder’s Equity, etc when accountants choose financial capital maintenance in nominal monetary units as authorized in IFRS in the Framework (1989), Par 104 (a) during low inflationary periods.

It is correct, essential and compliant with IFRS to inflation-adjust or update constant real value non-monetary items by means of the monthly change in the CPI which is a general price index during low inflation and deflation. The reason for this is that constant real value non-monetary items are expressed in terms of money, i.e. in terms of an unstable monetary unit of account which is the same as the unstable monetary medium of exchange within an economy or monetary union. Inflation erodes the real value of the unstable monetary medium of exchange - which is also the unstable monetary unit of account in accounting and the economy in general. Constant real value non-monetary items thus have to be updated or inflation-adjusted at a rate equal to the rate of low inflation or deflation, i.e. valued or measured in units of constant purchasing power, in order to maintain their real values constant during low inflation and deflation because the unit of measure in accounting is an unstable monetary unit of account and consequently hardly ever absolutely stable during periods of low inflation and deflation. Months of zero annual inflation are very few and far between. Sustainable zero annual inflation has never been achieved before and it does not seem very likely that it will be achieved any time soon in the future.

Variable real value non-monetary items do not need to be and are not valued in units of constant purchasing power during low inflation because they are valued in terms of GAAP or IFRS at, for example, fair value, market value, present value, recoverable value, net realizable value, etc which always automatically take inflation - amongst many other things - into account. Variable real value non-monetary items are only valued in units of constant purchasing power during hyperinflation as required by the IASB in IAS 29 since the Board regards hyperinflation as an exceptional circumstance.

There is a school of thought that 2% inflation is completely unharmful and that it has no disadvantages compared to absolute price stability (sustainable zero inflation). That is not correct. 2% inflation will erode, for example, 51% of the real value of all monetary items and all constant real value non-monetary items never maintained constant, e.g. Retained Profits never maintained constant, over 35 years – all else being equal – when the stable measuring unit assumption is implemented for an indefinite period of time during indefinite low inflation.

It is not necessary for accountants to inflation-adjust by means of the CPI, which is a general price index, variable real value non-monetary items (e.g. properties, plant, equipment, shares, raw material, etc.) which are subject to product specific price increases for the purpose of valuing these variable real value non-monetary items during the accounting period on a primary valuation basis during non-hyperinflationary periods. These variable real value non-monetary items are generally subject to market-based real value changes determined by supply and demand. They incorporate product specific price changes or product specific inflation where the word inflation is, very unfortunately, also used to simply mean a product or product group price increase instead of the general use of the word in economics to mean the erosion of the real value of money and other monetary items over time, i.e. an erosion of the general purchasing power of money which is caused by/results in an increase in the general price level over time. It is thus generally accepted in economics that the word inflation has two different meanings:

(1) inflation meaning the erosion of the real value of only money and other monetary items over time and

(2) inflation meaning any price increase.

1970-style Constant Purchasing Power Accounting (CPPA) inflation accounting was a popular but failed attempt at inflation accounting at the time. It was a form of inflation accounting which tried unsuccessfully to make corporate accounts more informative when comparing current transactions with previous transactions by updating all non-monetary items (without distinguishing between variable real value non-monetary items and constant real value non-monetary items) equally by means of the Consumer Price Index during high and hyperinflation. 1970-style CPPA inflation accounting was abandoned as a failed and discredited inflation accounting model when general inflation decreased to low levels thereafter.

Constant Item Purchasing Power Accounting (CIPPA) is not an inflation accounting model to be used during high and hyperinflation. IAS 29 requires CPPA for that. CIPPA is the IASB´s alternative to Historical Cost Accounting during low inflation and deflation . CIPPA implements financial capital maintenance in units of constant purchasing power to be used during low inflation and deflation which was authorized in IFRS in the Framework (1989), Par 104 (a).

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