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Tuesday, 4 September 2012

IFRS apply to two paradigms



IFRS apply to two paradigms

 

IFRS apply to the following two paradigms:

 

  1. Historical Cost (HC) paradigm
  2. 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

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