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Monday, 7 February 2011

Price-level accounting

Accountants generally choose to measure financial capital maintenance in nominal monetary units (one of the three very popular accounting fallacies not yet extinct) and thus apply their very erosive stable measuring unit assumption (another of the three accounting fallacies) as part of the traditional HCA model based on these fallacies. They generally value balance sheet constant real value non-monetary items (e.g. equity) as well as most income statement items – which are all constant real value non-monetary items - at Historical Cost because they value them in nominal monetary units as a result of the fact that they assume that money (the functional currency) is perfectly stable for this purpose. Accountants do not regard changes in the real value of money during low inflation as important enough for them to maintain the real value of capital constant with financial capital maintenance in units of constant purchasing power as they have been authorized in IFRS in the Framework (1989) Par 104 (a). Accountants basically assume there has never ever been inflation or deflation in the past, there is no inflation and deflation in the present and there never will be inflation and deflation in the future as far as the valuation of most constant real value non-monetary is concerned. They only value certain income statement items, e.g. salaries, wages, rentals, etc in real value maintaining units of constant purchasing power and inflation-adjust them by means of the annual CPI during low inflation.
Complete price-level accounting also called Constant Purchasing Power Accounting (CPPA) was developed as an inflation accounting model whereby all non-monetary items – variable real value non-monetary items and constant constant real value non-monetary items – are inflation-adjusted by means of the period-end CPI in order to make financial statements more useful during periods of very high and hyperinflation. The non-monetary or real economy of a hyperinflationary economy can only be maintained relatively stable by applying the daily parallel US Dollar exchange rate or a Brazilian-style daily index to the valuation of all non-monetary items instead of the period-end CPI as required by IAS 29.

The Framework is applicable

The implementation of the concepts of capital, the capital maintenance concepts and the profit/loss determination concepts during non-hyperinflationary periods are not covered in IAS, IFRS or Interpretations. These concepts are covered in the Framework (1989), Par 102 to 110. There are no specific IAS or IFRS relating to these concepts. The Framework is thus applicable as per IAS8.11.

Deloitte state:

"In the absence of a Standard or an Interpretation that specifically applies to a transaction, management must use its judgement in developing and applying an accounting policy that results in information that is relevant and reliable. In making that judgement, IAS 8.11 requires management to consider the definitions, recognition criteria, and measurement concepts for assets, liabilities, income, and expenses in the Framework. This elevation of the importance of the Framework was added in the 2003 revisions to IAS 8."

IAS8 Par. 11 states:

“In making the judgement, management shall refer to, and consider the applicability of, the following sources in descending order: (a) the requirements and guidance in Standards and Interpretations dealing with similar and related issues; and (b) the definitions, recognition criteria and measurement concepts for assets, liabilities, income and expenses in the Framework.”

The valuation of the constant real value non-monetary items Issued Share capital, Retained Earnings, other items in Shareholders´ Equity and other constant real value non-monetary items is thus covered by the IASB´S Framework, Par 104 (a) which states “Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power” authorized in 1989.

Harvey Kapnick in the Sax Lecture in 1976 correctly predicted the course of the development of International Financial Reporting Standards:

“Confusion constantly arises between changes in value and changes in purchasing power. The fact is both are occurring and, while there may be an interrelationship, the effects of each should be accounted for separately. Thus, the debate concerning whether value accounting or price-level accounting should prevail is not on point, because in the long run both should prevail. The real changes in value should be segregated from changes resulting only from changes in price levels.”

Harvey Kapnick, Chairman, Arthur Andersen & Company, “Value Based Accounting – Evolution or Revolution”, Sax Lecture, 1976.

Financial capital maintenance in units of constant purchasing power

Constant Item Purchasing Power Accounting is a price-level accounting model implemented during low inflation and deflation where under only constant real value non-monetary items ( not variable real value non-monetary items) are continuously inflation-adjusted every time the CPI changes, i.e. month after month.

Continuous financial capital maintenance in units of constant purchasing power, i.e. the monthly inflation-adjustment by means of the CPI of only constant real value non-monetary items - not inflation accounting complete price-level adjustment of all non-monetary items (variable real value non-monetary items and constant real value non-monetary items) - during low inflation and deflation has also been authorized by the IASC Board thirteen years after Harvey Kapnick´s 1976 prediction. The IASC Board approved the Framework, Par 104 (a) in 1989 stating that “Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power.” However, the enormous real value eroding function of the very erosive stable measuring unit assumption when accountants choose, also in terms of the Framework, Par 104 (a), the IASB-approved very popular accounting fallacy of financial capital maintenance in nominal monetary units and apply it in the valuing of constant real value non-monetary items never maintained, e.g. retained earnings never maintained, in low inflationary economies when the stable measuring unit assumption is maintained for an unlimited period of time during indefinite inflation, is not generally understood at all. This is clearly verified by the fact that both financial capital maintenance in nominal monetary units (an accounting fallacy) as well as real value maintaining continuous financial capital maintenance in units of constant purchasing power during inflation and deflation were approved by the IASB in the Framework, Par 104 (a) in 1989. Accountants can choose the one or the other and state that they have prepared primary financial statements in terms of IFRS. However, when they choose the traditional HCA model they unknowingly, unintentionally and unnecessarily erode real value on a significant scale in the real or non-monetary economy during low inflation when they implement the very erosive stable measuring unit assumption. When they choose IASB-approved continuous financial capital maintenance in units of constant purchasing power they maintain the real values of all constant real value non-monetary items during inflation and deflation in companies which at least break even, empowering and enriching those companies, their shareholders and the economy in general with the accompanying benefits to workers and employment for an unlimited period of time – all else except inflation or deflation being equal.

As the Deutsche Bundesbank stated:

“The benefits of price stability, on the other hand, can scarcely be overestimated, especially as these are, in principle, unlimited in duration and accrue year after year.”

Deutsche Bundesbank, 1996 Annual Report, P 83.

Financial capital maintenance in units of constant purchasing power during inflation and deflation results in absolute price stability only in constant real value non-monetary items for an unlimited period of time in companies that at least break even – all else except inflation and deflation being equal – without the need for extra capital from capital providers or more retained earnings simply to maintain the existing constant real value of existing constant items constant. The IASB predecessor body, the IASC Board, approved absolute price stability in income statement and balance sheet constant items when they authorized the Framework, Par 104 (a) in 1989 approving the option of continuously measuring financial capital maintenance in units of constant purchasing power during low inflation and deflation.

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