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Tuesday, 30 August 2011

Historical Cost illusion

Historical Cost illusion
The illusion that it is possible to measure financial capital maintenance in nominal monetary units per se during inflation and deflation.

The illusion that it is possible to maintain the real value of capital in nominal monetary units per se during inflation and deflation.

Financial capital maintenance in nominal monetary units per se 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 property companies, hotel, hospital and other property–intensive entities.

 Financial capital maintenance in nominal monetary units was authorized in IFRS in the original Framework (1989), Par 104 (a). It was unnecessarily implemented by Chile when that country started compliance with IFRS in 2008.

Chilean companies maintained the real value of their capital constant in units of constant purchasing power in terms of the Unidad de Fomento which is a monetized daily indexed unit of account under the “correción monetaria” regime before 2008, and then stopped doing that to comply with IFRS.

FRS compliance very unfortunately stopped financial capital maintenance in units of constant purchasing power in Chile. Fortunately, IFRS compliance did not stop the Unidad de Fomento.

Financial capital maintenance in units of constant purchasing power is also authorized in IFRS in the exact same 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.”

Chilean companies can thus go back to maintaining the real value of their capital in units of constant purchasing power as they did before 2008 and they will still comply with IFRS.

Financial capital maintenance in units of constant purchasing power (CIPPA) 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.

Nicolaas Smith

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