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Tuesday, 13 December 2011

Monetary items under CIPPA

Monetary items under CIPPA

Financial capital maintenance in units of constant purchasing power during LOW inflation and deflation (CIPPA), under which the very erosive stable measuring unit assumption is rejected, requires the following:

        Monetary items inflation–adjusted daily

 All monetary items – historical and current period monetary items – are inflation–adjusted in terms of a Daily Consumer Price Index or monetized daily indexed unit of account like the Unidad de Fomento in Chile. This results in the complete elimination of the cost of inflation (not actual inflation in the unstable monetary unit); i.e. there would be no net monetary loss or gain in the entire economy (excluding in actual bank notes and coins), only under complete coordination and with all money in the banking system which makes this only a theoretical assumption. There are always bank notes and coins outside the banking system even if all other monetary items in and outside the banking system were inflation–indexed; as partially done in Chile since 1967 in terms of the UF – since 1990 on a daily basis.

         There would thus always be net monetary losses and gains to be calculated and accounted only in the monetary economy under CIPPA. Net monetary losses and gains are not calculated during low inflation and deflation under the current Historical Cost paradigm. In stark contradiction, they are required to be calculated during hyperinflation under the current HC paradigm in terms of IAS 29 Financial Reporting in Hyperinflationary Economies which requires the restatement of Historical Cost and Current Cost financial statements in terms of the period–end monthly CPI during hyperinflation. Inflation, deflation and hyperinflation have no effect on the real value of non–monetary items.

There are generally net monetary losses and gains during low inflation, deflation and hyperinflation under traditional generally accepted and globally implemented HCA. They are not calculated and accounted during low inflation and deflation in terms of IFRS and US GAAP under HCA. However, they are required to be calculated and accounted during hyperinflation in terms of IFRS as required by IAS 29. This is one of the various contradictions under HCA corrected under CIPPA. Under financial capital maintenance in units of constant purchasing power net monetary gains and losses are – very logically – calculated and accounted during low inflation, deflation and hyperinflation.

Complete coordination in implementing CIPPA in an economy would most probably not be that easy to achieve right from the start. Banks cannot be forced to inflation–adjust all monetary items in the banking system when entities do not yet understand all the benefits of inflation–adjusting all monetary items in an economy as well as financial capital maintenance in units of constant purchasing power as authorized in IFRS as far back as 1989. Chilean banks operate profitably with inflation–adjusting a portion (currently 20 to 25% of their broad M3 money supply) of deposits from clients since 1967. They inflation–index daily, for example, mortgages, car loans, student loans, consumer loans, business loans, personal loans, etc. which include their profit margins, to clients in terms of the UF.

Nevertheless, entities may start financial capital maintenance in units of constant purchasing power, as authorized in IFRS, without any inflation–adjustment of monetary items at all. They may be motivated by the invisible hand of self–interest, shareholder pressure or more financial crises caused by often undercapitalized banks and companies. They may wish to immediately benefit from automatically maintaining the constant purchasing power of their own shareholders´ equity constant forever as long as they break even during inflation and deflation – ceteris paribus – whether they own any revaluable fixed assets or not. (See CIPPA increases a company´s net asset value.)

There is much to be gained from moving away from reporting on the basis of Financial Capital Maintenance in Nominal Monetary Units.

           Prof Rachel Baskerville, Associate Professor of Accounting at the School of Accounting and Commercial Law at the Victoria University of Wellington, New Zealand in her publication 100 Questions (and Answers) about IFRS,  Question 38, 2010 on the Social Science Research Network. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1526846

The full cost of or gain from inflation – net monetary loss or gain – would be recognized by these entities in their operations. It would be calculated and accounted in financial reports prepared under CIPPA. Under partial inflation–adjustment of monetary items – e.g. in Chile, the US, UK, Canada and all countries issuing inflation–indexed sovereign and commercial bonds (see above) – the net monetary loss or gain would be calculated and accounted for the part not inflation–indexed; i.e., currently for the greater part of the money supply under CIPPA. This is presently not being done in Chile, the US, UK, Canada, etc. because these countries implement the HCA model under which net monetary losses and gains are not calculated and accounted during low inflation and deflation: they are, paradoxically, correctly required by the IASB to be calculated during hyperinflation under the same HC paradigm.

The calculation and accounting of net monetary losses and gains are required under CIPPA because the stable measuring unit assumption is never applied under financial capital maintenance in units of constant purchasing power during low inflation, deflation and hyperinflation.

The constant purchasing power of capital can automatically be maintained constant forever by the real value of net assets in entities that at least break even in real value during inflation and deflation – ceteris paribusper se whether they own any revaluable fixed assets or not – only when they implement financial capital maintenance in units of constant purchasing power (CIPPA) because capital is equal to the real value of net assets as qualified. Financial capital maintained in nominal value by means of measurement in nominal monetary units is not equal to net assets in real value per se (always and everywhere) even though IFRS and US GAAP authorized financial capital maintenance in nominal monetary units (the HCA model) and although it is the 3000–year–old generally accepted globally implemented traditional accounting model used by all entities. Financial capital maintenance in nominal monetary units during inflation and deflation per se is a fallacy approved in IFRS.

Under HCA the cost of inflation in the monetary economy is not calculated and accounted because the books are not being balanced in real terms but in nominal monetary terms with the implementation of the very erosive stable measuring unit assumption under financial capital maintenance in nominal monetary units. The concept of capital being equal to net assets is also applied under HCA, but, in illusionary nominal monetary terms. Historical Cost illusion that it is possible to maintain the real value of capital in nominal monetary units per se during inflation and deflation makes Historical Cost Accounting a very erosive and in principle inappropriate accounting policy.

Entities, on the one hand, apply the stable measuring unit assumption under HCA in the valuation of their own shareholders´ equity in their own financial reports in nominal monetary units under which they may not take into account unreported hidden reserves for fixed assets not revalued when they apply the Historical Cost approach to the valuation of fixed assets in terms of IFRS. On the other hand, they always value third parties´ shareholders´ equity taking into account unreported hidden reserves for fixed assets not revalued, e.g. in the share price of listed companies which they value at market value in terms of IFRS, as well as in their valuations of unlisted companies.

This means that under HCA only entities with revaluable fixed assets (revalued or not) with an updated fair value equal to 100% of the updated constant real value of shareholders´ equity maintain the real value of their capital under the concept of nominal financial capital is equal to net assets measured in nominal monetary units during inflation and deflation. This may only be the case in hotel, hospital and other property–intensive entities. CIPPA maintains the constant purchasing power of financial capital constant forever in all entities that at least break even during inflation and deflation – ceteris paribuswhether they own any revaluable fixed assets or not. This requires the calculation and accounting of net monetary losses and gains as well as net constant item losses and gains (a new accounting term) because the books are being balanced in real terms; i.e. the stable measuring unit assumption is never applied.

This also means that, under HCA, the portion of shareholders´ equity never covered by sufficient revaluable fixed assets (revalued or not) has always been and is still – currently –  unnecessarily, unintentionally and unknowingly being eroded at a rate equal to the annual rate of inflation; not by inflation, but, by the implementation of the stable measuring unit assumption during inflation.

The erosion is equal to the annual rate of inflation because economic items are valued in terms of unstable money which is the legal unstable monetary unit of account and inflation erodes the real value of only unstable money and other unstable monetary items. Inflation has no effect on the real value of non–monetary items.

Shareholders´ equity is a constant real value non–monetary item. This unnecessary erosion in constant item real value by the implementation of the stable measuring unit assumption amounts to hundreds of billions of US Dollars per annum in the world´s constant item economy.

Financial capital maintenance in units of constant purchasing power during low inflation and deflation (CIPPA) would stop that forever and would instead maintain hundreds of billions of US Dollars per annum in the world´s shareholders´ equity investment base for as long as world inflation remains at the current level.

As the Deutsche Bundesbank so wisely stated:

The benefits of price stability, on the other hand, can scarcely be overestimated, especially as these are, in principle, unlimited in duration and accrue year after year.

Deutsche Bundesbank, 1996 Annual Report, P 83.

Nicolaas Smith

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