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Monday, 17 June 2013

Capital maintenance in units of constant purchasing power is an objective of Accounting / Financial Reporting

The entity concept is only possible together with the capital concept. Capital being independent from the owner(s) of capital is only possible with double-entry accounting and this is not referring to Historical Cost Accounting.

The above concept of capital assumes that the constant purchasing power of capital is being maintained constant over time during inflation and deflation because capital is equal to the real value of net assets. This assumption is not part of HCA because HCA simply assumes money is perfectly stable as far as the measurement of monetary items and constant real value non-monetary items are concerned, i.e., the stable measuring unit assumption is implemented and net monetary losses and gains are not accounted under HCA. Net monetary losses and gains are accounted and the stable measuring unit assumption is never implemented under ideal Capital Maintenance in Units of Constant Purchasing Power.

If the constant purchasing power of capital were not maintained 100 percent constant and if its real value were completely eroded by the stable measuring unit assumption during hyperinflation, it would lead to the end of the existence of the entity - all else being equal - only in the case of entities with net assets made up of only monetary items and constant real value non-monetary items, e.g., trade debtors, other non-monetary receivables, etc. never maintained constant under HCA. Entities with net assets made up of variable real value non-monetary items (e.g., property, plant, equipment, inventory, shares, foreign exchange, etc.) would continue existing even when the real value of the entire local money supply is completely eroded by hyperinflation as in the case of Zimbabwe on 20 November 2008.

Capital maintenance in units of constant purchasing power is thus essential for the entity.

Double-entry accounting is not essential for business, for example in a business with no organised accounting. Double-entry accounting is not essential for the exchange of goods and services. A contract - implied or not - is essential for exchange (business). The measurement bases underlying the contract are generally implied or stated / agreed / assumed in the contract.

Double-entry accounting is essential for the existence of an entity with capital. The economic items constituting the entity need to be valued from time to time. Measurement bases thus need to be adopted by the entity besides the ones used in exchange contracts for variable real value non-monetary items.

The entity has to adopt a measurement basis for the measurement of monetary items and constant real value non-monetary items, e.g., all items in equity, trade debtors, trade creditors, all other non-monetary receivables, all other non-monetary payables, provisions, all items in the income statement, etc. Under HCA the measurement basis adopted for this purpose is the stable measuring unit assumption, i.e., changes in the purchasing power of the monetary unit of account are not considered sufficiently important to implement measurement in units of constant purchasing power in terms of an index that recognises all - normally daily - changes in the general price level. HCA thus simply ignores the fact that money is not stable in real value. HCA also ignores the net monetary losses and gains that result from the choice of financial capital maintenance in nominal monetary units.

The stable measuring units assumption is never implemented under ideal CMUCPP in terms of an index that recognises all - normally daily - changes in the general price level for the purpose of measuring constant real value non-monetary items and net monetary losses and gains in monetary items are accounted.

Measurement bases are adopted by an entity with capital for the valuation of the entity items via the capital maintenance concept adopted. The Conceptual Framework states this in another way, namely that the accounting model is decided by the capital maintenance concept and measurement bases adopted.

One of the objectives of accounting / general purpose financial reporting on a logical or scientific basis is thus the adoption of measurement bases that would ensure capital maintenance in units of constant purchasing power in terms of an index that recognises all - normally daily - changes in the general price level during inflation and deflation. This can only be achieved via the adoption of Capital Maintenance in Units of Constant Purchasing Power in terms of an index that recognises all - normally daily - changes in the general price level for both physical and financial capital maintenance. It is the only possible choice on a logical or scientific basis. HCA, i.e., financial capital maintenance in nominal monetary units being the traditional accounting model only came about because of generally accepted social and economic practice over the last 3000 years.

Maintaining the constant purchasing power of capital constant during inflation and deflation is generally impossible under traditional HCA, i.e., under financial capital maintenance in nominal monetary units - all else being equal. Entities increase their nominal equity under HCA (hoping to maintain the real value of their nominal capital in this way) with increases in capital and with retained earnings which are then again not maintained constant in real value over time which again needs new capital or retained earnings which again are not maintained constant, etc., etc., etc., ... in a never ending process during inflation. In general, no entity in the world knows whether it has in the past maintained or is currently maintaining the real value (constant purchasing power) of its capital constant. This calculation is generally not done or required to be done in entities.

Capital Maintenance in Units of Constant Purchasing Power in terms of an index that recognises all - normally daily - changes in the general price level would automatically maintain the constant purchasing power of capital constant under complete co-ordination  in all entities that at least break even in real value - all else being equal - for an indefinite period of time at all levels of inflation and deflation.

The objectives of accounting / general purpose financial reporting on a logical or scientific basis are thus:

1. Capital Maintenance in Units of Constant Purchasing Power in terms of an index that recognises all - normally daily - changes in the general price level.

2. “The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity.” Conceptual Framework, OB2  

Accounting / general purpose financial reporting is not normally implemented on a logical or scientific basis on the international accounting standard-setting level. International accounting standard-setting is highly politicised. (Bunting 2013)

However, accounting / general purpose financial reporting on a logical or scientific basis is not forbidden or illegal in most of the world economy. CMUCPP is authorised in IFRS on an optional basis at all levels of inflation and deflation [CF 4.59 (a)] for whoever wishes to choose it in terms of an index that recognises all - normally daily - changes in the general price level.

No-one chooses it because it is not prescribed in IFRS: it is optional.

If the IASB were to require a daily index in IFRS, it would stabilise the non-monetary economy in every entity or country or monetary union which implements it at all levels of inflation and deflation under complete co-ordination.

If a daily index had been prescribed in IAS 29 in 1989, the Zimbabwean economy would never have imploded in 2008. Brazil had a relatively stable non-monetary economy during the 30 years of high inflation and hyperinflation of up to 2000 percent per annum from 1964 till 1994 as the result of Capital Maintenance in Units of Constant Purchasing Power in the form of daily indexation or daily monetary correction (daily price-level accounting) in terms of various government supplied daily indices.

Nicolaas Smith

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