IFRS apply to
two paradigms
IFRS apply to the following two paradigms:
- Historical
Cost (HC) paradigm
- Constant
Item Purchasing Power (CIPP) paradigm
The reason for this is the fact that both financial capital maintenance in
nominal monetary units (the Historical Cost Accounting model) and financial capital
maintenance in units of constant purchasing power (the Constant Item Purchasing
Power Accounting model) were authorized in IFRS in the original Framework
(1989), Par. 104 (a) [now the Conceptual Framework (2010), Par. 4.59 (a)] which
states: ‘Financial capital maintenance can be measured in either nominal
monetary units or units of constant purchasing power.’
The
fact that IFRS authorized three instead of the generally accepted two concepts
of capital maintenance already in 1989 was only identified on this blog in 2008:
still quite a revelation to the accounting profession in general. The Framework
actually state that there are ‘two’ concepts of capital maintenance, but, in
fact, authorize three: physical capital maintenance plus the two authorized in the
Framework (1989), Par. 104 (a) (see above). The three capital maintenance
concepts authorized in IFRS are now becoming generally accepted as a result of
the power of the internet: especially via Wikipedia, Amazon.com, various blogospheres
and reflections via millions of other sites.
The underlying principle of the HC paradigm is the HC principle which is
not based on fact. It is based on an assumption, namely, the stable measuring
unit assumption under which changes in the purchasing power of money (and
consequently the monetary unit of account) are not considered sufficiently
important to require financial capital maintenance in units of constant
purchasing power during inflation and deflation. Under the HC paradigm it is assumed, in practice, that money was,
is and will always be perfectly stable in real value. It is assumed, in practice, that there never
was, is or ever will be inflation and deflation in the economy. They are
obviously all wrong assumptions.
The underlying principle of the CIPP paradigm is the measurement in units
of constant purchasing power principle which is based on fact, namely, the fact
that money (the monetary unit of account) is never stable in real value on a
sustainable basis. The stable measuring unit assumption is never applied under
the CIPP paradigm.
In science, a fact will eventually prevail over a wrong assumption
regarding that fact.
The capital concept applied under the HC paradigm is the Nominal Financial
Capital concept.
The capital concept applied under the CIPP paradigm is the Constant Item
Purchasing Power Financial Capital concept.
Financial Capital Maintenance is measured in Nominal Monetary Units under
the HC paradigm. It is impossible to maintain the real value of capital
constant in nominal monetary units per se
during inflation and deflation despite the fact that the Framework states that
it can be done. Financial capital maintenance in nominal monetary units is a
popular accounting fallacy authorized in IFRS.
‘It is essential
to the credibility of financial reporting to
recognize that the recovery
of the real cost of investment is not earnings
— that there can be no earnings unless and until the purchasing power of capital is maintained.’
FAS 33 1979: 24
Financial Capital Maintenance is measured in Units of Constant Purchasing
Power in terms of a Daily CPI or other daily index under the CIPP paradigm.
Under financial capital maintenance in units of constant purchasing power the
constant purchasing power of capital is automatically maintained constant for
an indefinite period of time in all entities that at least break even in real
value – ceteris paribus – at all
levels of inflation and deflation.
Under the HC paradigm there are only two basic economic items in the
economy, namely, monetary and non-monetary items and the economy is divided in
the monetary and non-monetary or real economy.
Under the CIPP paradigm there are three basic economic items in the
economy, namely, monetary items, variable real value non-monetary items and
constant real value non-monetary items and the economy is divided in the
monetary, variable and constant item economy.
Under
the HC paradigm the accounting equation is applied in nominal monetary units,
namely, the nominal value of capital is always equal to the nominal value of
net assets.
Under
the CIPP paradigm, the accounting equation is applied in units of constant
purchasing power, namely, the constant purchasing power of capital is always
equal to the real value of net assets.
The
CIPP paradigm equals the natural laws of accounting. The HC paradigm equals the
assumed laws of accounting.
Under
the HC paradigm, the original nominal Historical Cost values of HC items (e.g.
inventory items measured at cost) are measured in fixed nominal monetary units,
i.e. they are not updated in real value. The stable measuring unit assumption
(not inflation) thus results in the overstatement of profits and dividends
under the HC paradigm and the erosion of that portion of capital not maintained
constant with the real value of net assets.
Under
the CIPP paradigm, the original nominal Historical Cost reference values of HC
items (e.g. inventory items measured at cost) are updated in real value to the
current (today’s) value in terms of the Daily CPI or other daily index value.
Under
the HC paradigm, the real value of that portion of capital not maintained by
the real value of net assets is eroded by the stable measuring unit assumption (not
inflation) at a rate equal to the annual rate of inflation because the real
value of the monetary unit of account is eroded by inflation. This erosion
amounts to hundreds of billions of US Dollars per annum in the world economy.
Under
the CIPP paradigm, the constant purchasing power of capital is automatically
maintained constant for an indefinite period of time in all entities that at
least break even in real value – ceteris
paribus – at all levels of inflation and deflation including
hyperinflation.
The
implementation of the CIPP paradigm would stop the erosion mentioned above and
would instead maintain hundreds of billions of US Dollars per annum in the
world’s constant item economy (capital investment base) at the current world
inflation rate.
Under
the HC paradigm, it is incorrectly believed that the erosion of companies´
capital and invested profits is caused by inflation. Inflation has no effect on
the real value of non-monetary items. Capital and invested profits are
non-monetary items. Inflation only affects the real value of money and other
monetary items.
Under
the CIPP paradigm, there is no erosion of companies´ capital and invested
profits because the stable measuring unit assumption is never applied under
this paradigm.
The
CIPP paradigm is obviously a better paradigm than the HC paradigm.
The
possible changeover from the current 3000-year old, globally implemented,
generally accepted, traditional HC paradigm to the IFRS-authorized CIPP
paradigm would take at least another hundred to two hundred years to come about
in the world economy (2012) – or it may also never happen.
‘Relative to most changes in financial reporting, the
changes required by Statement 33 were monumental. 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 1986: Par. 4
Authors
stated about a hundred years ago that HCA is not an appropriate accounting
model, but it is still the only accounting model implemented today (2012). It
appears that the authorization of financial capital maintenance in units of
constant purchasing power in IFRS in 1989 was not meant to be the authorization
of a second paradigm, but simply a technical back up for attempted measurement
in units of constant purchasing power in IAS 29 (totally ineffective: see its
implementation in Zimbabwe) – also authorized in 1989.
The
IASB has now (2012) unanimously voted to submit the replacement of IAS 29 to
research. If the IFRS to replace IAS 29 were to continue with any form of HCA,
then the replacement of the HC paradigm with the CIPP paradigm would suffer a
severe setback.
Any
individual company can immediately implement financial capital maintenance in
units of constant purchasing power because it was authorized in IFRS in the
original Framework (1989), Par. 104 (a) [now the Conceptual Framework (2010),
Par. 4.59 (a)].
No
person understanding the above would start a new company implementing the HC
paradigm.
Nicolaas Smith
Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.
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