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Monday, 29 August 2011

Chile´s fundamental accounting mistake


Chile´s fundamental accounting mistake

"Chilean companies maintained the real value of their capital constant in units of constant purchasing power under monetary correction´s regime, and then stopped doing that to comply with IFRS."

In my opinion it was a serious mistake for Chilean companies to have stopped financial capital maintenance in units of constant purchasing power as from 2008 when it had been authorized in 1989 in the International Accounting Standard Board´s original Framework for the Preparation and Presentation of Financial Statements, Par 104 (a) which states:

"Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power."

The above paragraph is maintained in the IASB´s current Conceptual Framework (2010), Par 4.59 (a).  The IASB and the US FASB have been working together over the last six years on a joint program to update the Conceptual Framework in IFRS. The FASB has informed me that the Capital Maintenance paragraphs would most probably stay the same.

I think I can explain why Chile unknowingly, unintentionally and unnecessarily abandoned financial capital maintenance in units of constant purchasing power in favour of financial capital maintenance in nominal monetary units in 2008.

The short explanation is that Chile simply wanted to comply with IFRS and that financial capital maintenance in nominal monetary units is the generally accepted capital maintenance concept world-wide during low inflation and deflation.

Chilean accounting authorities in 2008 accepted the general misconception that there are only two capital maintenance concepts authorized in IFRS, namely, physical and financial capital maintenance. The original Framework (1989) specifically states that there are two capital maintenance concepts. The original Framework (1989), Par 107 [now Conceptual Framework (2010) Par 4.62 ] states:

The principal difference between the two concepts of capital maintenance is the treatment of the effects of changes in the prices of assets and liabilities of the entity. (My underlinging and bold script.)

Various paragraphs of the Framework deal with only the two concepts. It is very clear that, according to the IASB, there are only two concepts of capital maintenance. It is however a fact that financial capital maintenance in units of constant purchasing power is fundamentally different from financial capital maintenance in nominal monetary units.

Thus: IFRS have authorized in 1989 what Chilean companies have been doing since 1967; namely, financial capital maintenance in units of constant purchasing power in terms of a daily index.

It was, consequently, not necessary for Chile to stop “correción monetaria” with the implementation of IFRS started in 2008.

The reason why Chile adopted financial capital maintenance in nominal monetary units in 2008 was because it was not generally accepted at that time that there are three concepts of capital maintenance, namely:

1)    Physical capital maintenance;

2)    Financial capital maintenance in nominal monetary units , and

3)    Financial capital maintenance in units of constant purchasing power

Although

(I)           it had been implemented in Brazil during 30 years from 1964 to 1994 in terms of a daily index supplied by the government ;

(II)         it had been implemented in Chile from 1967 till 2008 in terms of the Unidad de Fomento published daily since 1977;

(III)       it had been authorized in particular countries´ accounting codes, e.g. Portugal´s  since 1989, and most importantly

(IV)       it had been specifically authorized in  IFRS in the original Framework, Par 104 (a) in 1989 [now the Conceptual Framework (2010), Par. 4.59 (a)],

the concept of financial capital maintenance in  units of constant purchasing power was not generally accepted at all or even discussed or stated in accounting literature before 2008.

Today the three capital maintenance concepts are specifically stated in various articles on the internet; on  Wikipedia, e.g. the IFRS article (51 000 views per month), the Constant Item Purchasing Power Accounting article (2200 views per month) and the Financial Capital article (9400 views per month).  They were first stated on this blog in 2009.

Financial capital maintenance in nominal monetary units during inflation and deflation is a fallacy. It is impossible to maintain the real value of capital in nominal monetary units per se during inflation and deflation. That is only possible

(1)   under sustainable zero annual inflation which has never been achieved in the past and is not likely soon to be achieved in the future and

(2)   in entities which always invest 100% of the updated original constant real value of shareholders ´ equity in revaluable fixed assets with an equivalent updated fair value (revalued or not). This mostly only applies to hotel, hospital, property and other property-intensive entities.

As from 2008 the constant real non-monetary value of that portion of Chilean companies´ shareholders´ equity never covered by sufficient revaluable fixed assets as qualified above, is now being eroded (where it had not been eroded before under “correción monetaria”) at a rate equal to the annual rate of inflation – not by inflation as everyone still believes – but, by the stable measuring unit assumption as implemented under financial capital maintenance in nominal monetary units. 

Constant real value currently being eroded by the implementation of the stable measuring unit assumption in the Chilean economy is at least equal to 4% (a rate equal to the annual rate of inflation) of the aggregate accumulated retained earnings of Chilean companies per annum. This amounts to the erosion of hundreds of billions of US Dollars in the world economy per annum.

In my opinion, unnecessarily stopping financial capital maintenance in units of constant purchasing power in Chile was a very serious and unfortunate mistake. It will have a very negative cumulative effect over time on the maintenance of the capital investment base in the Chilean economy. The recent financial crisis in the world economy high-lighted the danger of under-capitalized banks and companies caused by the erosion of these entities´ equity by the very erosive stable measuring unit assumption as implemented under financial capital maintenance in nominal monetary units.

Financial capital maintenance in units of constant purchasing power - properly implemented – automatically maintains the constant purchasing power of capital constant forever in  all entities that at least break even in real value during inflation and deflation – ceteris paribus –  whether  they own any revaluable fixed assets or not.  This is done by applying a Daily Index during low inflation; the very successful Unidad de Fomento in Chile´s case.

Financial capital maintenance in units of constant purchasing power in terms of the Unidad de Fomento published daily by the Banco Central de Chile since 1990 played a very important part in Chile´s economy over the years since the UF was started in 1967 and companies maintained their capital in units of constant purchasing power in terms of the UF.

It is very unfortunate when countries which actually had been implementing financial capital maintenance in units of constant purchasing power stop that, simply as a result of a general lack of appreciating the very erosive effect of the stable measuring unit assumption (which everyone mistakenly blames on  inflation) in the economy – especially by the IASB and FASB.

Nicolaas Smith

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