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Tuesday, 10 January 2012

Attributes of CIPPA - Part 1 of 3: Monetary items inflation-adjusted daily


Attributes of CIPPA - Part 1 of 3: Monetary items inflation-adjusted daily

[Attributes of CIPPA - Part 2 of 3: Variable items updated daily]

Financial capital maintenance in units of constant purchasing power in terms of a daily rate at all levels of inflation and deflation (CIPPA), under which the very erosive stable measuring unit assumption is never applied, requires the following:

Monetary items inflation–adjusted daily

Variable items updated daily

Constant items measured in units of constant purchasing power daily

(a)    Monetary items inflation–adjusted daily

 All monetary items – historical and current period monetary items – are required to be inflation–adjusted daily in terms of a Daily CPI or monetized daily indexed unit of account during low inflation, high inflation and deflation and daily in terms of a daily hard currency parallel rate or daily index rate during hyperinflation.

Inflation-adjusting all monetary items daily would result in the complete elimination of the cost of inflation (zero cost of inflation), but not the elimination of actual low inflation, high inflation or hyperinflation in the unstable monetary unit. There would be no net monetary loss or gain in the entire monetary economy excluding in actual bank notes and coins, only with complete co-ordination in inflation-adjusting all monetary items daily. Daily updating of a part of the money supply is currently being done in Chile in terms of the UF and in countries with inflation-indexed bond markets, e.g. the US, UK, Turkey, France, Mexico, Poland, Columbia, South Korea, Brazil, Italy, Japan, Germany, Canada, Sweden, etc. under the HC paradigm.

Monetary items would be required to be inflation–adjusted daily because there is no stable measuring unit assumption under CIPPA, or it is already a generally accepted monetary practice for part of the money supply, e.g. the daily inflation-indexing of 20 to 25 per cent of the broad M3 money supply in Chile in terms of the UF or as a result of inflation–indexed bond markets in countries like the US, UK, France, etc. implementing HCA, i.e. implementing the stable measuring unit assumption in the valuation of the greater part of the money supply in the economy.

Net monetary losses and gains are not calculated during low inflation, high inflation and deflation in terms of IFRS and US GAAP under the current HC paradigm. They are, however, required to be calculated during hyperinflation under the same HC paradigm in terms of IAS 29. This is one of the various contradictions under HCA corrected under CIPPA. Net monetary gains and losses are – very logically – calculated and accounted at all levels of inflation and deflation because they do in fact exist whenever monetary items are not inflation-adjusted and deflation-adjusted under CIPPA. There is no stable measuring unit assumption under CIPPA.

Complete co-ordination in implementing CIPPA in an economy would most probably not be achieved right from the start. Banks, companies and private individuals will take time to learn to inflation–adjust all monetary items in the economy when they do not yet understand all the benefits of inflation–adjusting all monetary items daily as well as the benefits of financial capital maintenance in units of constant purchasing power in terms of a daily rate at all levels of inflation and deflation as authorized in IFRS as far back as 1989. Chilean banks operate profitably with inflation–adjusting a portion (currently 20 to 25 per cent 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.

‘Because most accountants and users of financial statements have been inculcated with a model of financial reporting that assumes stability of the monetary unit, accepting a change of this consequence would take a lengthy period of time under the best of circumstances.’ (FAS 89, Par. 4)

Nevertheless, entities may start financial capital maintenance in units of constant purchasing power in terms of a daily rate (CIPPA) at all levels of inflation and deflation without inflation–adjusting or deflation-adjusting any more or all monetary items. They may be motivated by one or more of the following: 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 for an indefinite period of time as long as they break even in real value at all levels of inflation and deflation – ceteris paribus – whether they own any revaluable fixed assets or not.

The full cost of or gain from low and high inflation and deflation – 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  – 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, high inflation and deflation. They are required under IFRS to be calculated during hyperinflation under the same HC paradigm.

The constant purchasing power of capital can automatically be maintained constant for an indefinite period of time in entities that at least break even in real value at all levels of inflation and deflation – ceteris paribus – whether they own any revaluable fixed assets or not, only when they implement financial capital maintenance in units of constant purchasing power in terms of a daily rate (CIPPA) because the constant purchasing power of capital is equal to the real value of net assets - as qualified - in a double entry accounting model. Financial capital maintained in nominal value by means of measurement in nominal monetary units is always equal to net assets in nominal value per se, but it is not equal to net assets in real value per se even though IFRS and US GAAP authorized financial capital maintenance in nominal monetary units (the HCA model) and even though it is the 3000–year–old, generally accepted, globally implemented, traditional accounting model used by most entities during low inflation and deflation. Financial capital maintenance in nominal monetary units during inflation and deflation per se is a popular accounting 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. 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 HCA a very erosive and, in principle, an 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 HC 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 per cent of the updated original constant real value of all contributions to shareholders´ equity maintain the real non-monetary value of their capital under the concept of nominal financial capital is equal to net assets with financial capital maintenance measured in nominal monetary units during low and high inflation and deflation. This may only be the case in hotel, hospital and other property–intensive entities. CIPPA, on the other hand, automatically maintains the constant purchasing power of financial capital constant for an indefinite period of time in all entities that at least break even in real value at all levels of inflation and deflation – ceteris paribus – whether 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 concept) because the books are being balanced in real terms for the first time; i.e. the stable measuring unit assumption is never applied under CIPPA.

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.

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 under HCA amounts to hundreds of billions of US Dollars per annum in the world´s capital investment base at the current level of world inflation. The US definition of a billion, 1 000 000 000, is followed in this book.

Financial capital maintenance in units of constant purchasing power in terms of a daily rate at all levels of inflation and deflation (CIPPA) would stop this erosion for an indefinite period of time and would instead maintain hundreds of billions of US Dollars per annum in the world´s capital investment base for as long as world inflation remains at current levels.

Prof. Rachel Baskerville, Associate Professor, School of Accounting and Commercial Law at the Victoria University in Wellington, New Zealand, changed her publication 100 Questions (and Answers) about IFRS on the Social Science Research Network to confirm that there are three concepts of capital maintenance authorized in IFRS after I pointed it out to her. Prof Baskerville discussed the change with her colleague Prof Kevin Simpkins before changing her article. He is the Chairman of the New Zealand Accounting Standards Review Board. She then pointed her readers to my SA blog and added this conclusion:

‘There is much to be gained from moving away from reporting on the basis  Financial Capital Maintenance in Nominal Monetary Units.’ (Baskerville, 2010)

The Deutsche Bundesbank very 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)

[Attributes of CIPPA - Part 2 of 3: Variable items updated daily]

Nicolaas Smith

Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.