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Wednesday, 30 May 2012

The second enemy

The second enemy



There are two processes of systemic real value erosion in the economy although almost everybody thinks there is only one economic enemy. The one enemy is very well known. It is inflation. Inflation manifests itself in money´s store of value function and only erodes the real value of money and other monetary items in the monetary economy (the money supply). Inflation is the enemy in only the monetary economy and the governor of the central bank is the enemy of inflation.



Inflation has no effect on the real value of non–monetary items.

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

(Gucenme and Arsoy, 2005)



Inflation cannot erode the real value of variable real value non–monetary items or constant real value non–monetary items.  It is impossible. Inflation eroded the real value of money and other monetary items only in the SA monetary economy at the rate of 6 per cent per annum (March, 2012). The actual amount of value eroded in the real value of Rand notes and coins and other monetary items (capital amounts of capital and money market investments, bank loans, other monetary loans and deposits, etc.) over the twelve months to the end of March, 2012 amounted to about R132 billion.



The second process of systemic real value erosion – the second enemy – is a Generally Accepted Accounting Practice (GAAP), namely the stable measuring unit assumption: the unknowing, unintentional and unnecessary erosion by the stable measuring unit assumption (the HCA model) of the existing constant real value of only constant items never maintained constant only in the constant item economy.



‘The Measuring Unit principle: The unit of measure in accounting shall be the base money unit of the most relevant currency. This principle also assumes the unit of measure is stable; that is, changes in its general purchasing power are not considered sufficiently important to require adjustments to the basic financial statements.’

(Walgenbach, Dittrich and Hanson, 1973: p. 429)

Increases in the general price level (inflation) erode the real value of only money and other monetary items with an underlying monetary nature (e.g., loans and bonds) only in the internal monetary economy. Inflation has no effect on the real value of variable items (e.g., land, buildings, goods, commodities, cars, gold, real estate, inventories, finished goods, foreign exchange, etc.) and constant items (e.g., issued share capital, retained profits, capital reserves, other shareholder equity items, salaries, wages, rentals, pensions, trade debtors, trade creditors, taxes payable, taxes receivable, deferred tax assets, deferred tax liabilities, etc.).

Entities generally choose the traditional HCA model which includes the stable measuring unit assumption during inflation and deflation.  They value constant items in nominal monetary units; i.e., they choose to measure financial capital maintenance in nominal monetary units which is a popular accounting fallacy authorized in IFRS. In fact, it is impossible to maintain the constant purchasing power of financial capital constant in nominal monetary units per se during inflation. Entities´ choice of implementing financial capital maintenance in nominal monetary units instead of in units of constant purchasing power, also authorized in IFRS, results in the real values of constant items never maintained constant being eroded by the stable measuring unit assumption at a rate equal to the annual rate of inflation.

It is not inflation doing the eroding as the IASB, the FASB and most people mistakenly believed. It is entities´ free choice of the very erosive stable measuring unit assumption during inflation as it forms part of the Historical Cost Accounting model – authorized in IFRS in the original Framework (1989), Par. 104 (a).

Entities would knowingly maintain the real value of all constant items constant for an indefinite period of time when they at least break even in real value – ceteris paribus – when they reject the stable measuring unit assumption and implement financial capital maintenance in units of constant purchasing power at all levels of inflation and deflation (CIPPA). The stable measuring unit assumption is, in principle, never implemented under financial capital maintenance in units of constant purchasing power (CIPPA).

Constant items never maintained constant are treated like monetary items when their nominal values are never updated as a result of the implementation of the stable measuring unit assumption during inflation and deflation.

In practice, it is assumed that the unit of measure (money) is perfectly stable during low inflation and deflation; that is, it is assumed that changes in money´s general purchasing power are not sufficiently important to require financial capital maintenance in units of constant purchasing power during inflation and deflation. In so doing, the implementation of the HCA model unknowingly, unintentionally and unnecessarily erodes the real values of constant items never maintained constant during low inflation to the amount of hundreds of billions of US Dollars in the world´s constant item economy each and every year while the stable measuring unit assumption is being implemented as part of the traditional HCA model.



The stable measuring unit assumption is a stealth enemy very effectively camouflaged by GAAP, IASB and FASB authorization as well as the generally accepted accounting fallacy that the erosion of companies´ capital and profits is caused by inflation. Hardly anyone knows or understands that when the very erosive stable measuring unit assumption is implemented, the HCA model is unknowingly, unintentionally and unnecessarily eroding the real values of constant items never maintained constant at a rate equal to the annual rate of inflation.



Almost everybody thinks the accounting profession can do nothing about it. They still believe that inflation is doing the eroding and financial reporting can do nothing about inflation: the monetary authorities, not the accounting profession, are responsible for controlling inflation. They do not realize that it is the very erosive stable measuring unit assumption doing the eroding in the real value of constant items never maintained constant during inflation.

There are thus two enemies eroding real value systematically in the economy. The first enemy, inflation, is a complex economic process. The second enemy, the stable measuring unit assumption, is a Generally Accepted Accounting Practice authorized in IFRS and US GAAP under the current Historical Cost paradigm.

This Generally Accepted Accounting Practice of systemic real value erosion operates only in the constant item part of the non–monetary or real economy when it is freely chosen to measure financial capital maintenance in nominal monetary units when entities implement the traditional HCA model during inflation as approved in IFRS in the original Framework (1989), Par. 104 (a).

Almost everyone makes the mistake of blaming the erosion of companies´ profits and capital by the stable measuring unit assumption on inflation.

The problem is known and identified: namely, the real value of companies´ profits and capital is being eroded over time when implementing the HCA model during inflation. The mistake is made of blaming inflation instead of the free choice of the stable measuring unit assumption. It is impossible for inflation to erode the real value of any non–monetary item. Companies´ issued share capital and retained profits (as well as all other items in owners´ equity) are constant real value non–monetary items. This erosion is very effectively camouflaged by IFRS approval in the 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.’ The stable measuring unit assumption is a stealth enemy in the constant item economy maybe wreaking more havoc than inflation in the monetary economy. The stable measuring unit assumption as authorized in IFRS and US GAAP - its convenient cover.

The US Financial Accounting Standards Board blamed inflation:

‘Conventional accounting measurements fail to capture the erosion of business profits and invested capital caused by inflation.’

(FAS 33, Par. 69)

Almost veryone only sees one enemy being responsible for all of the invisible and untouchable systemic real value erosion in the economy. It is mistakenly thought that inflation is responsible for all real value erosion in the economy. It is mistakenly thought that the cost of the stable measuring unit assumption - the erosion by the stable measuring unit assumption of the real value of constant items never maintained constant - is the same as the net monetary loss from holding an excess of monetary items assets over monetary item liabilities, i.e., the cost of inflation.

This second enemy is a stealth enemy almost perfectly camouflaged by IFRS and FASB approval since the way it operates is not generally understood. If it were understood, it would have been stopped by now (2012) with financial capital maintenance in units of constant purchasing power as authorized in IFRS in 1989.


Nicolaas Smith

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