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Thursday, 18 August 2011

Financial capital maintenance in nominal monetary units per se is a fallacy

Financial capital maintenance in nominal monetary units per se is a fallacy

Financial capital maintenance in nominal monetary units per se during inflation and deflation is impossible. It is a very popular accounting fallacy not yet extinct. It was originally authorized by the IASB in IFRS in the Framework (1989), Par 104 (a). It is authorized by the US FASB. It is based on the 3000 years old stable measuring unit assumption under which changes in the purchasing power of money are not considered as sufficiently important to require financial capital maintenance in units of constant purchasing power. It is assumed, in principle, that money is perfectly stable in real vale for the purpose of valuing balance sheet constant items, variable items required to be valued at Historical Cost in terms of IFRS and all items in the income statement. It is a generally accepted accounting practice. It is the concept of capital maintenance and one of the measurement bases used in traditional Historical Cost Accounting implemented worldwide. It is an accounting fallacy that costs the world economy hundreds of billions of US Dollars per annum in existing constant real non–monetary value unknowingly, unnecessarily and unintentionally eroded in constant items by the implementation of the very erosive stable measuring unit assumption. IFRS should not be based on accounting fallacies.

Financial capital maintenance in nominal monetary units during inflation is only possible in entities that continuously invest at least 100% of the updated real value of shareholders´ equity in revaluable fixed assets (revalued or not) with an equivalent updated fair value.

Continuous financial capital maintenance in units of constant purchasing power automatically maintains the constant purchasing power of capital constant for an indefinite period of time in all entities that at least break even during inflation and deflation – ceteris paribus – by applying the CIPPA model.  The daily parallel US Dollar (or other hard currency) exchange rate or a daily Brazilian-style index rate is continuously applied in the valuation of all non–monetary items (variable and constant items) during hyperinflation (Constant Purchasing Power Accounting) which results in maintaining the real or non–monetary economy relatively – not absolutely – stable. The constant item economy in a hyperinflationary economy is still subject to real value erosion at a rate equal to the annual inflation rate applicable to the hard currency (normally the US Dollar) used in supplying the parallel rate.

Variable items are continuously valued in terms of IFRS excluding the stable measuring unit assumption by applying a Daily Index or monetized daily indexed unit of account during low inflation and deflation under Constant Item Purchasing Power Accounting (CIPPA). Variable items are continuously valued in units of constant purchasing power (CPPA) by applying the daily parallel US Dollar (or other hard currency) exchange rate or a Brazilian–style daily index rate when it is intended to keep the real economy stable during hyperinflation.

Monetary items are money held and items with an underlying monetary nature ideally always and everywhere inflation-adjusted in terms of a Daily Index or monetized daily indexed unit of account, e.g. the Unidad de Fomento in Chile. The net monetary loss or gain from holding monetary items not inflation-indexed is calculated and accounted in the income statement under both CIPPA and CPPA, i.e. during low inflation, deflation and hyperinflation in terms of IFRS.

IAS 29 Financial Reporting in Hyperinflationary Economies simply requires restatement of Historical Cost and Current Cost financial statements in terms of the period-end CPI to make these statements supposedly more useful during hyperinflation. IAS 29 is not Constant Purchasing Power Accounting; i.e. IAS 29 does not require financial capital maintenance in units of constant purchasing power during hyperinflation. It does not require daily valuation of non-monetary items in terms of a Daily Index or hard currency parallel rate. It simply requires restatement of period-end HC or CC financial statements in terms of the period-end CPI.

Nicolaas Smith

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