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Tuesday, 24 January 2012

Zero cost of inflation

It is noted that:

‘Inflation is always and everywhere a monetary phenomenon,’ per Milton Friedman.

Purchasing power of non monetary items does not change in spite of variation in national currency value.’

Gucenme, U. and Arsoy, A. P. (2005). Changes in financial reporting in Turkey, Historical Development of Inflation Accounting 1960 – 2005. Special Issue Accounting for the Global and the Local: The Case of Turkey. Critical Perspectives on Accounting, Volume 20, Issue 5, July 2009, p. 568–590.

Inflation and deflation have no effect on the real value of non-monetary items. Capital contributed and comprehensive income, for example, are constant real value non-monetary items. IAS 29 defines them as non-monetary items. The definition of a constant real value non-monetary item is derived in IFRS.

It is not inflation and deflation affecting the real value of constant real value non-monetary items not maintained constant over time. It is the implementation of the stable measuring unit assumption as part of the traditional Historical Cost Accounting model during inflation and deflation.

Inflation erodes the real value of only monetary items not inflation-adjusted on a daily basis in terms of a Daily Consumer Price Index over time. Deflation creates real value in only monetary items not inflation-adjusted on a daily basis in terms of a Daily Consumer Price Index over time. It is currently (2012) impossible to inflation-adjust or deflation-adjust bank notes and coins.

Inflation in many different countries has no effect on the real value of monetary items inflation-adjusted on a daily basis, for example the more than 2.68 trillion US Dollars (2009)1 of government inflation-indexed bonds currently inflation-adjusted daily in the world economy in terms of a Daily Consumer Price Index which is a lagged, daily interpolation of the respective monthly published CPI.

1 (Standard Life Investments. (2012). An Investor´s Guide to Inflation–Linked Bonds. Retrieved 7 January 2012, from Standard Life Investments’s Web site.)

According to the Banco Central de Chile, 20 to 25 per cent of the broad M3 money supply in Chile is inflation-adjusted on a daily basis in terms of the Unidad de Fomento (Written communication. (2011)) which is a monetized daily indexed unit of account started in 1967 and published daily by the Banco Central de Chile since 1990.

The above are all monetary items that exist in a zero cost of inflation (not zero inflation) space. They are all monetary items, but, their real values are not affected by inflation.
The entire cost of inflation can be eliminated under complete co-ordination when the entire money supply in an economy (excluding bank notes and coins that generally make up about seven per cent of the money supply in an advanced economy) is inflation-adjusted on a daily basis in terms of a Daily Consumer Price Index.

The requirement in IAS 29, Par. 9 that ‘the gain or loss on the net monetary position shall be included in profit or loss and separately disclosed,’ deals with the ‘effects of inflation’ and deflation on monetary items only during hyperinflation.

However, the definitions of monetary items in IAS 29, Par. 12 and IAS 21, Par. 8 need to be improved because non-monetary items are all items that are not monetary items. The definition of monetary items thus determines which items are non-monetary items per IFRS. When the definition of monetary items is incorrect then the division of monetary and non-monetary items is incorrect as it currently is in terms of IFRS.

Everything else in IAS 29 unsuccessfully2 deals with the effect of the stable measuring unit assumption (not the ‘effects of inflation’) on constant real value non-monetary items, e.g. capital contributed and comprehensive income, not maintained constant during hyperinflation.

2 See my comment letter on the IASB Agenda Consultation 2011.

A monetary item is one of the three basic economic items:

(a) Monetary items

(b) Variable real value non-monetary items

(c) Constant real value non-monetary items

Definition

Monetary items are units of money held and items with an underlying monetary nature which are substitutes for units of money held.

Examples of units of money held are bank notes and coins of the fiat currency created within an economy by means of fractional reserve banking. Examples of items with an underlying monetary nature which are substitutes of money held include the capital amount of: bank loans, bank savings, credit card loans, car loans, home loans, student loans, consumer loans, commercial and government bonds, Treasury Bills, all capital and money market investments, notes payable, notes receivable, etc. when these items are not in the form of money held.

Nicolaas Smith

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