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Monday, 11 July 2011

The second enemy

The second enemy


There are two processes of systemic real value erosion in the economy, although everybody thinks there is only one economic enemy. The one enemy is very well known. It is inflation. Inflation manifests itself in money´s store of value function and only erodes the real value of money and other monetary items in the monetary economy (the money supply). Inflation is the enemy only in the monetary economy and the Governor of the Reserve Bank is the enemy of inflation.

Inflation has no effect on the real value of non–monetary items.

“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.

Inflation cannot erode the real value of variable real value non–monetary items or constant real value non–monetary items. It is impossible. Inflation is always and everywhere a monetary phenomenon per Milton Friedman. Inflation is eroding the real value of money and other monetary items only in the SA monetary economy at the rate of 4.6 % per annum (value date: May, 2011). The actual amount of value eroded in the real value of Rand notes and coins and other monetary items (bank loans, other monetary loans and deposits, etc.) over the twelve months to May, 2011 amounted to about R100 billion.

The second process of systemic real value erosion – the second enemy – is a generally accepted accounting principle, namely the stable measuring unit assumption: the unknowing, unintentional and unnecessary erosion by the stable measuring unit assumption (the HCA model) of the existing constant real value of only constant items never maintained constant only in the constant item economy.

“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.”

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

Increases in the general price level (inflation) erode the real value of money and other monetary items with an underlying monetary nature (e.g. loans and bonds) only in the internal monetary economy. Inflation has no effect on the real value of variable items (e.g. land, buildings, goods, commodities, cars, gold, real estate, inventories, finished goods, foreign exchange, etc.) and constant items (e.g. issued share capital, retained profits, capital reserves, other shareholder equity items, salaries, wages, rentals, pensions, trade debtors, trade creditors, taxes payable, taxes receivable, deferred tax assets, deferred tax liabilities, etc.).

Entities generally choose then traditional HCA model which includes the stable measuring unit assumption during low inflation and deflation. They value constant items never maintained constant, e.g. that portion of companies´ shareholders´ equity never covered by sufficient revaluable fixed assets (revalued or not), in nominal monetary units; i.e. they choose to measure financial capital maintenance in nominal monetary units which is a popular accounting fallacy authorized in IFRS: in fact, it is impossible to maintain the real value of financial capital constant with financial capital maintenance in nominal monetary units per se during inflation and deflation. Entities´ choice of implementing financial capital maintenance in nominal monetary units instead of measuring constant items´ real values in units of constant purchasing power also authorized in IFRS results in the real values of these constant items never maintained constant being eroded by the stable measuring unit assumption at a rate equal to the annual rate of inflation.

It is not inflation doing the eroding as the IASB, the FASB, economists and most people mistakenly believe. It is entities´ free choice of the very erosive stable measuring unit assumption during low inflation as it forms part of financial capital maintenance in nominal monetary units – the Historical Cost Accounting model – authorized in IFRS in the original Framework (1989), Par 104 (a).

For example: SA companies would knowingly maintain the real value of all constant items constant forever (amounting to about R200 billion per year while inflation stays at about 4.6% per annum) in all entities that at least break even – ceteris paribus – no matter what the level of inflation when they reject the stable measuring unit assumption and implement financial capital maintenance in units of constant purchasing power during inflation (CIPPA). This is done without requiring extra money or extra retained profits simply to maintain the existing constant real value of existing constant real value non–monetary items (e.g. shareholders´ equity) constant. This is also possible in an entity with no fixed assets at all.

Constant items never maintained constant are treated like monetary items when their nominal values are never updated as a result of the implementation of the stable measuring unit assumption during low inflation and deflation.

The second enemy operating only in the constant item economy is the implementation of the stable measuring unit assumption during inflation. In principle, it is assumed that the unit of measure (money) is perfectly stable during low inflation and deflation; that is, it is assumed that changes in money´s general purchasing power are not sufficiently important to require the updating of the nominal values of all constant items in the constant item economy in order to maintain their real values constant. In so doing, the implementation of the HCA model unknowingly, unintentionally and unnecessarily erodes the real values of constant items never maintained constant during low inflation to the amount of about R200 billion in the SA constant item economy and hundreds of billions of US Dollars in the rest of the world´s constant item economy each and every year while the stable measuring unit assumption is being implemented as part of the traditional HCA model.

The stable measuring unit assumption is a stealth enemy very effectively camouflaged by GAAP, IASB authorization which makes it IFRS compliant and the generally accepted accounting fallacy that the erosion of companies´ capital and profits is caused by inflation: hardly anyone knows or understands that when the very erosive stable measuring unit assumption is implemented, the HCA model is unknowingly, unintentionally and unnecessarily eroding the real values of constant items never maintained constant at a rate equal to the annual rate of inflation during low inflation. The fact that the stable measuring unit assumption erodes about R200 billion per annum in the SA real economy and hundreds of billions of US Dollars in the rest of the world´s constant item economy year after year, does make a difference.

There are thus two enemies eroding real value systematically in the economy. The first enemy, inflation, is an economic process. The second enemy, the stable measuring units assumption, is a generally accepted accounting practice under the current Historical Cost paradigm.

The second economic enemy is the very erosive stable measuring unit assumption. This generally accepted accounting practice of systemic real value erosion operates only in the constant item part of the non–monetary or real economy when it is freely chosen to measure financial capital maintenance in nominal monetary units when entities implement the traditional HCA model during inflation as approved in IFRS in the original Framework (1989), Par 104 (a).

Everyone makes the mistake of blaming the erosion of companies´ profits and capital by the stable measuring unit assumption on inflation.

The problem is known and identified; namely, the real value of companies´ profits and capital is being eroded over time when implementing the HCA model during inflation. The mistake is made of blaming inflation instead of the free choice of the stable measuring unit assumption. It is impossible for inflation to erode the real value of any non-monetary item. Companies´ issued share capital and retained profits (as well as all other items in shareholders´ equity) are constant real value non-monetary items. This is very effectively camouflaged by IFRS approval in the original Framework (1989), Par 104 (a) which states “Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power”. The stable measuring unit assumption: the stealth enemy in the economy wreaking more havoc than inflation, its convenient cover.

The US Financial Accounting Standards Board also blames inflation:

Conventional accounting measurements fail to capture the erosion of business profits and invested capital caused by inflation.”

Statement of Financial Accounting Standard No. 33, P. 24

Everyone only sees one enemy being responsible for all of the invisible and untouchable systemic real value erosion in the economy. It is mistakenly thought that inflation is responsible for all real value erosion in the economy. It is mistakenly thought that the cost of the stable measuring unit assumption (the erosion by the stable measuring unit assumption of the real value of constant items never maintained constant) is the same as the net monetary loss from holding an excess of monetary items assets over monetary item liabilities, i.e., the cost of the inflation (the erosion of the real value of money and other monetary items by inflation).

It is not inflation eroding the real value of companies´ profits and capital. It is the choice of traditional HCA which includes the very erosive stable measuring unit assumption. This second enemy is a stealth enemy camouflaged by IFRS approval since the way it operates is not realized. If it were realized, it would have been stopped by now with financial capital maintenance in units of constant purchasing power (CIPPA) as authorized in IFRS.


Nicolaas Smith

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