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Wednesday, 14 August 2013

Differences in the three capital maintenance concepts

Differences in the three capital maintenance concepts

To form a company, you need capital. 

The company is a new legal entity even if you own 100% of the capital. You are a legal entity. You are not the company. The company is a new, separate legal entity. There are thus two legal entities or legal persons.

The company has to maintain its capital otherwise it will stop existing.

A long time ago in the past everybody believed that the real value of money is perfectly stable. They did not understand that inflation destroys the real value of money over time. 

So they thought that they were maintaining the real value of capital by simply doing their accounting in nominal monetary units. They used Historical Cost Accounting. 

Today the whole world still uses Historical Cost Accounting (except during hyperinflation  when a flawed form of CMUCPP is implemented, namely IAS 29), that is, traditional accounting: doing accounting in nominal monetary units, but, everybody knows that inflation destroys the real value of money over time.

During low inflation accountants know that inflation is destroying the real value of money, but, they assume that changes in the real value (purchasing power) of money are not sufficiently important to implement Capital Maintenance in Units of Constant Purchasing Power in terms of the Daily CPI

Everybody in low inflation economies worldwide thus implements traditional Historical Cost Accounting. That is (1) Financial Capital Maintenance in nominal monetary units. 

As you can see, it is impossible to maintain the real value of your capital in nominal monetary units over time during inflation and deflation. Companies bluff themselves that they overcome this problem by assuming that money is perfectly stable during low inflation and deflation. What they do is they do not declare all their profits in dividends to the owners of the capital. They retain profits hoping to maintain the real value of their capital. No-one knows for sure if the do or not.

Under financial capital maintenance in nominal monetary units (Historical Cost Accounting) a company - in theory - only maintains it capital when its nominal capital at the end of the accounting period is at least equal to its nominal capital at the start  - excluding contributions from and distributions to the shareholders.

You can see that is only true in theory. In reality it is not true. But, all accountants have been doing HCA like that for the last 3000 years, so they think it must be correct. You can see that it is not. However, it is very difficult to change something that all accountants worldwide have been doing for the last 3000 years. I think it will take about another 200 years to stop accountants doing Historical Cost Accounting while we have inflation and deflation. 

(2) Financial Capital Maintenance can also be measured in units of constant purchasing power in terms of a Daily CPI.

There are three basic economic items in the economy. They are all three stated in monetary units: they thus all have monetary values, but, they are not all monetary items. 

The three basic economic items are:

(i) Monetary items. 
(ii) Constant real value non-monetary items 
(iii) Variable real value non-monetary items

Monetary items constitute the money supply. If an item forms part of a country´s money supply as stated by the country´s central bank, then it is a monetary item. 

All items that are not monetary items are non-monetary items. 

Non-monetary items are split in two:

Constant real value non-monetary items  and
Variable real value non-monetary items.

Constant items are non-monetary items with constant real values over time. Examples are salaries, wages, rentals, interest paid, interest received, issued share capital, retained profits, retained losses, capital reserves, all other items in equity, provisions, all items in the income statement, trade debtors, trade creditors, all other non-monetary payables, all other non-monetary receivables, etc.

Constant items are always and everywhere measured in units of constant purchasing power only under Capital Maintenance in Units of Constant Purchasing Power in terms of a Daily CPI. 

Variable items are non-monetary items with variable real values over time. Examples are property, plant, equipment, quoted and unquoted shares, foreign exchange, inventory, raw materials, finished goods, patents, trademarks, etc. 

Under HCA variable items are measured in terms of International Financial Reporting Standards including the stable measuring unit assumption, that is, including nominal Historical Cost.

Under CMUCPP variable items are measured in terms of International Financial Reporting Standards excluding the stable measuring unit assumption, that is, excluding nominal Historical Cost.

How do you solve the problem of (1) the real value of monetary items being destroyed by inflation and (2) the real value of constant items being destroyed by the stable measuring unit assumption.
Inflation is always and everywhere a monetary phenomenon (Milton Friedman). Inflation only destroys the real value of monetary items not inflation-adjusted in terms of a daily index. Inflation has no effect on the real value of non-monetary items. Implementing the stable measuring unit assumption during inflation destroys the real value of constant items never maintained constant in real value. 

You can maintain the real value of monetary items during inflation by inflation-adjusting them in terms of the Daily CPI during low inflation. 

You maintain the real value (constant purchasing power) of constant items by measuring them in units of constant purchasing powe in terms of a daily index: that is, you DO NOT implement the stable measuring unit assumption. 

The stable measuring unit assumption is the assumption that money is perfectly stable. 

You measure, for example, capital in units of constant purchasing power by never implementing the stable measuring unit assumption; that is, you never assume money is perfectly stable. 

You measure capital of 100 in units of constant purchasing power over a year by multiplying it with the increase in inflation during that year. If inflation were 10% during the year, you multiply the 100 by 1.1 and you get 110. Now your capital is stated in units of constant purchasing power: the real value stays the same, but the nominal value changes daily in terms of the Daily CPI. At the end of the year the nominal value would be 110, but, the real value would be the same as the 100 at the BEGINNING of the year. Thus the REAL value remains the same over time (100 in BEGINNING of the year terms), but, the nominal value will change daily with daily inflation.

When this is done with all constant real value non-monetary items in the economy in terms of the Daily CPI, the constant real value non-monetary item economy would be stable.

When all monetary items are inflation-adjusted daily in terms of the Daily CPI during low inflation, then the monetary economy would be stable. There would still be inflation, but no cost of or gain from inflation.


Physical Capital Maintenance is maintaining the physical capital of a company in terms of physical units of output.

For example: if you have a factory that produces 1 million bricks per annum, you have maintained your physical capital (with on-going general maintenance during the year, preventative maintenance, replacement of old machinery, etc.) if the physical factory machines at the end of the year still have the capacity to produce 1 million bricks per annum. Physical capital maintenance is very different from financial capital maintenance. 

1. Financial capital maintenance in nominal monetary units 
2. Financial capital maintenance in units of constant purchasing power
3. Physical capital maintenance in physical units of output. 

Financial capital maintenance in units of constant purchasing power is fundamentally different from financial capital maintenance in nominal monetary units. Financial capital maintenance in nominal monetary units (HCA) implements the stable measuring unit assumption while the stable measuring unit assumption is never implemented under financial capital maintenance in units of constant purchasing power in terms of a daily index. 

Nicolaas Smith Copyright (c) 2005-2013 Nicolaas J Smith. All rights reserved. No reproduction without permission.