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Saturday, 12 March 2011

This project is not about inflation accounting

This project, contrary to Prof Geoffrey Whittington’s book "Inflation Accounting", is not about inflation accounting during high and hyperinflationary periods.

This project is not about accountants implementing 1970-style inflation accounting in low inflationary economies by inflation-adjusting all non-monetary items equally by means of the CPI.

The following peer reviewed article Financial Statements, Inflation & The Audit Report I wrote was published in SAICA´s journal- Accountancy SA - in September 2007.

“In most countries, primary financial statements are prepared on the historical cost basis of accounting without regard either to changes in the general level of prices or to increases in specific prices of assets held, except to the extent that property, plant and equipment and investments may be revalued.” ¹

The International Accounting Standards Board (IASB) only recognizes two economic items:

1.) Monetary items defined as “money held and items to be received or paid in money;” and
2.) Non-monetary items: All items that are not monetary items.

Non-monetary items include variable real value non-monetary items valued, for example, at fair value, market value, present value, net realizable value or recoverable value.

They also include Historical Cost items based on the stable measuring unit assumption.

One of the basic principles in accounting is “The Measuring Unit principle: The unit of measure in accounting shall be the base money unit of the most relevant currency.

This principle also assumes the unit of measure is stable; that is, changes in its general purchasing power are not considered sufficiently important to require adjustments to the basic financial statements.” ²

This makes these Historical Cost items equal to monetary items in the case of companies´ Retained Income balances and the issued share capital values of companies with no well located and well maintained land and/or buildings or other variable real value non-monetary items able to be revalued at least equal to the original real value of each contribution of issued share capital.

Retained Income is a constant real value non-monetary item valued at Historical Cost which makes it subject to the destruction of its real value by inflation – exactly the same as in cash.

It is an undeniable fact that South Africa’s functional currency’s internal real value is constantly being destroyed by inflation in the case of our low inflationary economy, but this is not considered important enough to adjust the real values of constant real value non-monetary items in the financial statements - the universal stable measuring unit assumption.

The combination of the Historical Cost Accounting model and low inflation is thus indirectly responsible for the destruction of the real value of Retained Income equal to the annual average value of Retained Income times the average annual rate of inflation. This value is easy to calculate in the case of each and every company in South Africa with Retained Income. It is also possible to calculate this value for all companies in the world economy with Retained Income.

It is broadly known that the destruction of the internal real value of the monetary unit of account is a very important matter and that inflation thus destroys the real value of all variable real value non-monetary items when they are not valued at fair value, market value, present value, net realizable value or recoverable value.

But, everybody suddenly agrees, in the same breath, that for the purpose of valuing Retained Income - a constant real value non-monetary item - the change in the real value of money is not regarded as important to update the value of Retained Income in the financial statements. Everybody suddenly then agrees to destroy hundreds of billions of Dollars in real value in all companies´ Retained Income balances all around the world.

Yes, inflation is very important!

All central banks and thousands of economists and commentators spend huge amounts of time on the matter. Thousands of books are available on the matter. Financial newspapers and economics journals dedicate thousands of columns to the fight against inflation.

But, when it comes to constant real value non-monetary items, it doesn’t seem as if inflation is important. We happily destroy hundreds of billions of Dollars in Retained Income real value year in year out.

However, when you are operating in an economy with hyperinflation (perhaps only Zimbabwe at the moment with 3 713% inflation), then we all agree that you have to update everything in terms of International Accounting Standard IAS 29 Financial Reporting in Hyperinflationary Economies. You have to update variable AND constant real value non-monetary items.

But, ONLY as long as your annual inflation rate has been 26% for three years in a row adding up to 100% - the rate required for the implementation of IAS 29.

Once you are not in hyperinflation anymore, for example, 15% annual inflation for as many years as you want, then you are not allowed to update constant real value non-monetary items any more. Then you must destroy their real value again – at 15% per annum. Or 7.0% per annum in the case of South Africa (April 2007).

For example:

Shareholder value permanently destroyed by the implementation of the Historical Cost Accounting model in Exxon Mobil's Retained Income during 2005 exceeded $4.7bn for the first time. This compares to the $4.5bn shareholder real value permanently destroyed in 2004 in this manner. (Dec 2005 values).

The application by BP, the global energy and petrochemical company, of the stable measuring unit assumption in the accounting of their Retained Income resulted in the destruction of at least $1.3bn of shareholder value during 2005. (Dec 2005 values).

Royal Dutch Shell Plc, a global group of energy and petrochemical companies, permanently destroyed $2.974 billion of shareholder value during 2005 as a result of the application of the stable measuring unit assumption in the accounting of their Retained Income. (Dec 2005 values).

Should this value be reflected in the financial statements?

Maybe it should.

Nicolaas Smith”

Footnotes

¹ International Accounting Standards Committee, (1995), International Accounting Standard 1995, London, IASC, Page 502

² Paul H. Walgenbach, Norman E. Dittrich and Ernest I. Hanson, (1973), Financial Accounting, New York: Harcourt Brace Javonovich, Inc. Page 429.

http://www.accountancysa.org.za/resources/ShowItemArticle.asp?ArticleId=1235&issue=857

This article was first published in Accountancy SA (September 2007, pg 38). Accountancy SA is published by the South African Institute of Chartered Accountants. www.accountancysa.org.za

The understanding of the global, economy-wide erosion of banks´ and companies´ capital and profits (equity) during low inflation caused by the implementation of the stable measuring unit assumption is an ongoing process. In 2007 I, like almost everyone else, still believed that inflation eroded the real value of non-monetary items. Since then I have realized that I made a mistake by believing what everyone else believes and state with regard to the erosive effect of inflation on the real value of non-monetary items. I realized since then that inflation is in fact always and everywhere only a monetary phenomenon, as the late Milton Friedman so eloquently stated. I realized since then that inflation can only erode the real value of money and other monetary items – nothing else. I realized since then that inflation has, in fact, no effect on the real value of non-monetary items as so correctly stated by Prof Dr. Ümit GUCENME and Dr. Aylin Poroy ARSOY from Uludag University, Bursa, Turkey:

“Purchasing power of non monetary items does not change in spite of variation in national currency value.”

This project  is thus not about inflation-accounting. Inflation accounting is a model of accounting to be applied only during very high and hyperinflation. Inflation accounting is specifically defined in IAS 29 Financial Reporting in Hyperinflationary Economies and required by IFRS only during hyperinflation.

The theme of this project is financial capital maintenance in units of constant purchasing power accounting during low inflation and deflation (as implemented via the Constant Item Purchasing Power Accounting model) as authorized in IFRS in the Framework (1989), Par 104 (a). Stated differently: the theme of this book is the rejection of the stable measuring unit assumption, i.e. the rejection of the generally accepted, globally implemented, traditional Historical Cost Accounting model, during low inflation and deflation as authorized in IFRS in the Framework (1989), Par 104 (a). The rejection of the stable measuring unit assumption is authorized in IFRS since financial capital maintenance in units of constant purchasing power during low inflation and deflation (CIPPA) is authorized in IFRS in the Framework (1989), Par 104 (a) as an alternative to financial capital maintenance in nominal monetary units, i.e. the Historical Cost Accounting model under which the stable measuring unit assumption is implemented.

Non-monetary items are subdivided in variable real value non-monetary items and constant real value non-monetary items. Only constant real value non-monetary items are inflation-adjusted under financial capital maintenance in units of constant purchasing power (CIPPA) in terms of the Framework, Par 104 (a) to maintain their existing constant real non-monetary values constant during low inflation and deflation in order to measure financial capital maintenance in units of constant purchasing power instead of in nominal monetary units. That is what this project is about. Variable items are valued in terms of IFRS or GAAP in a manner that takes into account all elements - including inflation - which determine the variable item’s real value at the date of valuation during low inflation and deflation. Monetary items are always valued at their original nominal monetary values under all accounting models and under all economic environments. Constant real value non-monetary items are also valued in terms of IFRS in units of constant purchasing power when financial capital maintenance is measured in units of constant purchasing power during low inflation and deflation by implementing the CIPPA model.

This project is about accountants knowingly maintaining the existing real values of constant real value non-monetary items - e.g., banks´ and companies´ Shareholders´ Equity – constant during low inflation and deflation for an unlimited period of time in all entities that at least break even – ceteris paribus – by continuously implementing the real value maintaining financial capital maintenance in units of constant purchasing power model (CIPPA) as approved in the IASB´s Framework, Par 104 (a) in 1989.

This project is about accountants knowingly indexing or inflation-adjusting or updating or measuring in units of constant purchasing power only constant real value non-monetary items by implementing the CIPPA model during low inflation and deflation as approved in IFRS in the IASB´s Framework (1989) Par, 104 (a), instead of unknowingly, unintentionally and unnecessarily eroding their real values on a massive scale with their implementation of the very erosive stable measuring unit assumption as it forms part of the traditional HCA model when they measure financial capital maintenance in nominal monetary units for an unlimited period of time during indefinite inflation.

This project is about accountants knowingly choosing to measure financial capital maintenance in banks and companies in real value maintaining units of constant purchasing power during low inflation and deflation as approved in the IASB´s Framework, Par 104 (a) instead of in real value eroding nominal monetary units as a result of their choice to implement the very erosive stable measuring unit assumption during low inflation also authorized by the IASB in the Framework, Par 104 (a) twenty two years ago.

This project is about accountants rejecting the stable measuring unit assumption and instead adopting IASB-approved real value maintaining constant purchasing power units as the measurement basis for only constant items including banks´ and companies´ Shareholders´ Equity and not only for income statement constant items, e.g. salaries, wages, rentals, etc during non-hyperinflationary conditions.

This project is about stopping the implementation of the Historical Cost Accounting model which unknowingly, unintentionally and unnecessarily erodes hundreds of billions of US Dollars per annum of existing constant real value in existing constant real value non-monetary items (bank´s and companies´ capital) in the real economy because they choose to implement the traditional HCA model when they implement the very erosive stable measuring unit assumption for an unlimited period of time during indefinite inflation instead of the IASB-approved real value maintaining CIPPA model.

Accountants make the Historical Cost Mistake by implementing the very erosive stable measuring unit assumption during inflation as part of the traditional HCA model for an unlimited period of time during indefinite inflation.

This project is about accountants being able to knowingly maintain hundreds of billions of US Dollars per annum of existing constant real non-monetary value in the real economy for an unlimited period of time in all entities that at least break even complying with IFRS instead of unknowingly, unintentionally and unnecessarily eroding that value year in year out as they unknowingly do at the moment when they maintain the stable measuring unit assumption for an unlimited period of time during indefinite inflation.

This project is about accountants abandoning the very erosive traditional HCA model and adopting the real value maintaining CIPPA model in low inflationary and deflationary economies as authorized in 1989 in the IASB´s Framework, Par 104 (a).

Monetary items

Current monetary item accounts cannot be indexed or inflation-adjusted or valued in units of constant purchasing power under any accounting model because the real value of money cannot be maintained constant during inflation or deflation.

Variable items

It is not proposed in this project that variable real value non-monetary items are to be value in units of constant purchasing power or to be consistently indexed or inflation-adjusted or updated by accountants in terms of the change in the monthly CPI as a measurement basis for the purpose of primary valuation during the current accounting period, for financial capital maintenance in units of constant purchasing power and for calculating the period-end profit or loss during low inflation and deflation. Variable items are valued by accountants in terms of IFRS during low inflation and deflation. The IASB specifically requires the implementation of IAS 29 Financial Reporting in Hyperinflationary Economies during hyperinflation. Variable items are required to be valued in units of constant purchasing power, i.e. inflation-adjusted or updated in terms of the period-end CPI, during hyperinflation in terms of IAS 29 since the IASB regards hyperinflation as an exceptional circumstance.

It is very clear from the IASB´s Framework (1989), Par 104 (a) that measuring financial capital maintenance in real value maintaining units of constant purchasing power is authorized in IFRS by the IASB as the basis for a CIPPA model at any level of inflation and deflation. The IASB does not state that financial capital maintenance can be measured in nominal monetary units (the traditional HCA model) only during low inflation and deflation, and that financial capital maintenance in units of constant purchasing power can be measured in units of constant purchasing power only during high and hyperinflation. In typical international accounting standard fashion it simply states that either the one (financial capital maintenance in nominal monetary units) or the other (financial capital maintenance in units of constant purchasing power) can be used. That means at all levels of inflation and deflation - which includes low inflation.

The IASB does, however, specifically require the implementation of IAS 29 during hyperinflation. IAS 29 is based on the Constant Purchasing Power Accounting (CPPA) inflation accounting model requiring all non-monetary items (variable real value non-monetary items and constant real value non-monetary items) to be measured in units of constant purchasing power, i.e. to be inflation-adjusted or updated by means of the period-end CPI during hyperinflation. CPPA is a generally accepted inflation accounting model required in IFRS to be implemented only during hyperinflation. Both the IFRS-authorized principle of financial capital maintenance in units of constant purchasing power (inflation-adjusting non-monetary items) and the CPPA model during hyperinflation are generally accepted. CPPA is a price-level accounting model as Prof Whittington state: “Constant Purchasing Power Accounting (CPP) is a consistent method of indexing accounts by means of a general index which reflects changes in the purchasing power of money.” While the principle of financial capital maintenance in units of constant purchasing power is generally accepted, the implementation of the Constant Item Purchasing Power Accounting model under which this principle is implemented during low inflation and deflation, is not yet generally accepted. Although CIPPA is also a price-level accounting model, this results in most accountants automatically assuming that price-level accounting always refers only to inflation accounting.

In the Framework, Par 101 the IASB states that companies most commonly use the traditional HC model to prepare their financial reports and that other measurement bases are used in combination with HC. The IASB does, however, specifically require entities only in hyperinflationary economies – being exceptional circumstances - to implement IAS 29 and, secondly, to implement the Current Cost Accounting model when entities choose a physical capital concept.

The IASB - as far as measurement bases are concerned - specifically deals with historical cost, current cost, realizable (settlement) value, present value, market value, recoverable value, fair value, ect, which accountants, in fact, use to value variable items in terms of IFRS during low inflation and deflation.

In the Framework (1989), Par 104 (a) the IASB authorizes accountants to measure financial capital maintenance in real value maintaining units of constant purchasing power at all levels of inflation and deflation – including low inflation. When they choose to do that, it indicates that they choose the CIPPA model instead of their current choice, the very erosive traditional Historical Cost Accounting model. The IASB notes that entities use various different measurement bases in varying combinations and to different degrees in their financial reports.

We commonly find that companies state in their opening notes to their balance sheet that their financial reports have been prepared based on the traditional Historical Cost model. We normally find that they use different measurement bases to different degrees and in different combinations including constant real value non-monetary items in the income statement that are indexed or inflation-adjusted or valued in units of constant purchasing power by applying the CPI in low inflationary economies: e.g. salaries, wages, rentals, utility fees, transport fees, etc. Indexation or inflation-adjustment or valuing in units of constant purchasing power is thus already a generally accepted accounting practice in low inflationary economies, but, only for some, not all, income statement constant real value non-monetary items (all income statement items are constant real value non-monetary items the moment they are accounted in the income statement) and not at all for balance sheet constant real value non-monetary items.

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