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Friday, 24 October 2014

Historical Cost Accounting versus Capital Maintenance in Units of Constant Purchasing Power™

"Double-entry accounting is one of the greatest inventions of the human mind." Wolfgang Goethe 

DOUBLE-ENTRY ACCOUNTING MODELS


I) CAPITAL MAINTENANCE IN UNITS OF CONSTANT PURCHASING POWER


Paradigm: Units of Constant Purchasing Power 

Capital Maintenance

The constant purchasing power of shareholders' equity (capital) and all other constant real value non-monetary items are maintained constant in all entities that at least break even in real value, ceteris paribus at all levels of inflation (low, high and hyperinflation) and deflation. 

General Price Level fact: the general price level changes at least daily. Thus the use of the Daily CPI. The general price level can change more than once per day during hyperinflation.

The stable measuring unit assumption is never implemented.

MEASUREMENT BASES

There are three economic items in the economy.

1. Monetary items

Measurement basis 

(a) During current financial year: Nominal Historical Cost, i.e., in nominal monetary units. These items exist in terms of Historical Cost contracts still being used under the Units of Constant Purchasing Power paradigm.

(b) Prior year monetary items in current year financial reports and all other historical monetary items not part of current year financial reports: daily updated Historical Cost always and everywhere updated till the current (today´s) real value in terms of all (at least daily) changes in the general price level - generally in terms of the Daily CPI. There is no such thing as a nominal historical cost monetary item except for current year items.

2. Variable real value non-monetary items

Measurement basis: Daily updated fair value always and everywhere updated till the current (today´s) real value. There is no such thing as a nominal historical variable real value non-monetary item.

3. Constant real value non-monetary items

Measurement basis

Daily updated units of constant  purchasing power always and everywhere updated till the current (today´s) real value in terms of all (at least daily) changes in the general price level, generally in terms of the Daily CPI. There is no such thing as a nominal historical constant real value non-monetary item.

The Units of Constant Purchasing Power Measurement Basis: in terms of all - at least daily - changes in the general price level under all levels of inflation (low, high and hyperinflation) and deflation always and everywhere updated till the current (today´s) real value. In terms of the US Dollar daily parallel rate when the Daily CPI is not available during hyperinflation.

Summary

MEASUREMENT BASES

1. Units of constant  purchasing power*
2. Fair value*
3. Updated Historical Cost*
4. Nominal Historical Cost
  
*Always and everywhere updated in terms of all (at least daily) changes in the general price level - generally in terms of the Daily CPI - up to the current (today´s) real value under all levels of inflation (low, high and hyperinflation) and deflation. In terms of the US Dollar daily parallel rate when the Daily CPI is not available during hyperinflation. 

Net Monetary Losses and Gains

Net monetary gains and losses are always calculated and accounted.     

Authorization in IFRS: CMUCPP™ was originally authorized 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."

CMUCPP™ was also authorized in US GAAP in 1989 as well as in other country accounting standards at that time.

Measurement time interval: Every change in the general price level, i.e., daily under low, high and hyperinflation and deflation while the general price level can change more than once per day during hyperinflation.

Classification of Economic Items

1. Monetary items

2. Variable real value non-monetary items

3. Constant real value non-monetary items.

CPI: Daily CPI (in general): all changes in the general price level.

Financial Reports

Financial reports are updated daily generally in terms of the Daily CPI to the current (today´s) date. Financial reports are thus preferably kept only in digital form and not printed on hard (paper) copy. 

Effect of inflation/deflation

1. Inflation and deflation only affect the real value of monetary items not inflation- or deflation-adjusted in terms of all (at least daily) changes in the general price level, nothing else.

See Also

Measurement Bases under the IFRS Units of Constant Purchasing Power Paradigm


Three measurement bases in IFRS





II) HISTORICAL COST ACCOUNTING 




Paradigm: Nominal Historical Cost

Capital Maintenance

No entity in the world economy ever knew and today knows whether it maintained or maintains the real value (constant purchasing power) of all contributions to shareholders´equity (capital) over the life of the entity. Generally, the real value of capital was and is eroded in that portion of capital (not known by any entity) not backed by the real value of net assets. The result was and is continual erosion of a portion of the real value of capital (equity) or inadequate capital maintenance over time during inflation and the creation of real value in these items not updated daily during deflation resulting in economic instability. 

Accounting standard setters, HC accounting educators and HC accountants and people in general mistakenly believe nothing can be done about this matter except the lowering of inflation or deflation by central banks. That is not true.

Daily inflation- or deflation-indexing of the entire money supply in terms of all (at least daily) changes in the general price level would remove the complete effect of low, high and hyperinflation and deflation. Chile inflation-indexes at least 25% of its entire money supply on a daily basis with their Unidad de Fomento Daily Index. 

This would do nothing to actual low, high and hyperinflation and deflation. That has to be dealt with by the monetary authorities. Accounting (daily inflation - or deflation-indexing) can only remove the effect of inflation or deflation.

Daily measurement of all constant real value non-monetary items in terms of all (at least daily) changes in the general price level would maintain the constant purchasing power of these items constant in all entities that at least break even in real value, ceteris paribus at all levels of low, high and hyperinflation and deflation. Obviously, this would require the rejection of the HCA model and the adoption of the Capital Maintenance in Units of Constant Purchasing Power model at all levels of inflation and deflation always in terms of the Daily CPI.

General Price Level assumption: Under HCA the general price level is assumed to be perfectly stable at all levels of low and high inflation and deflation. Assumption: the general price level changes once per month during hyperinflation. Thus the incorrect use of the monthly published CPI during hyperinflation under the IAS 29 Financial Reporting in Hyperinflationary Economies. Only updating in terms of all - at least daily - changes in the general price level can result in actual capital maintenance in units of constant purchasing power which has never been achieved under the current version of of the IAS 29 which is mistakenly implemented using the monthly published CPI. 

Basic underlying principle: the stable measuring unit assumption is implemented for the valuation of some, not all items.

IFRS are based on the HCA model with the exception of IAS 29 although HC principles are even used under this standard too.

Measurement bases

(i) Historical Cost

(ii) Current Measurement Bases

       (a) fair value 

       (b) fulfilment value for liabilities and value in use for assets 


(iii) Units of Constant Purchasing Power 


The UCPP measurement basis is used to update  some expenses, for example, salaries and wages, etc. and some prices, e.g., utility prices, mobile phone call rates, etc. on an annual basis, i.e., to measure these items in units of constant purchasing power in terms of the CPI or a Cost of Living Index on an annual basis under HISTORICAL COST ACCOUNTING. It is part of GAAP under IFRS and US GAAP. Its use is so universal that the IASB refuses to recognize it specifically in the Conceptual Framework. This is a fundamental mistake in the CF and adds to IFRS being of low quality.

Net Monetary Losses and Gains

Net monetary gains and losses are never calculated and accounted.  

Authorization in IFRS: Historical Cost Accounting was originally authorized 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."

HCA is the centuries old, traditional, global, generally accepted accounting model used by almost all entities worldwide.

Measurement time interval

(i) Under Nominal Historical Cost measurement: No time interval: it is assumed time does not change. Original date with no change in time after that.

(ii) Under Unupdated Fair Value measurement: The end of the reporting period which can - in general - be the end of (a) the month (b) quarter (c) six months (d) nine months or (e) twelve months.

CPI: Annual CPI used when items like salaries, wages, rents, etc. are updated, normally annually. They are then treated like nominal historical costs for accounting purposes.

Classification of Economic Items

1. Monetary items

2. Non-monetary items

Financial Reports

A HC financial report is generally prepared on hard (paper) copy and in digital format after the end-date of the financial period to which the financial report refers, stated at the balance sheet date and never updated.

HC financial reports are thus always out of date and technically wrong and can be misleading in terms of the, at least, daily changing general price level as indicated by the Daily CPI. HC financial reports are more misleading in terms of real values the higher the rate of cumulative inflation or deflation from the date of the balance sheet to the date that the report is read. 

HC accountants assume they overcome this problem when they simply apply the stable measuring unit assumption, i.e., they simply assume money was, is and will always be perfectly stable over any period of time at any level of low and high inflation and deflation. They abruptly change their minds as soon as hyperinflation is reached at 26% per annum inflation for three years in a row; i.e., 100% cumulative inflation over three years which is the IASB´s definition of hyperinflation used by all accountants worldwide. They then try to implement capital maintenance in units of constant purchasing power during hyperinflation. Unfortunately they do it in terms of IAS 29. They do it in terms of the monthly published CPI. This results in IAS 29 not having any positive effect as it had no positive effect during the 8 years it was implemented in Zimbabwe´s hyperinflationary economy in the recent past. Only applying at least the Daily CPI can result in actual capital maintenance in units of constant purchasing power. IAS 29 was implemented in terms of the monthly published CPI during 8 years in Zimbabwe´s hyperinflationary economy with no positive effect at all. 

When hyperinflation is overcome and the economy returns to a low inflationary level, HC accountants again suddenly start assuming money is perfectly stable. They again implement the stable measuring unit assumption and implement HCA. 

Effect of inflation/deflation

It is mistakenly believed by (taught to) HC accountants, economists, central bankers, bankers, business people and people in general that inflation and deflation affect the real value of both monetary and non-monetary items as mistakenly stated in all HC textbooks ever written and also specifically stated in US GAAP and IFRS.

HC accountants, economists, central bankers, bankers, business people and people in general do not realize that inflation and deflation are monetary phenomena and can only affect monetary items and nothing else. They were and are generally taught incorrectly at all universities that inflation and deflation affect the real value of both monetary and non-monetary items. 

See Also

IASB defines measurement bases under Historical Cost Accounting


Three measurement bases in IFRS


Nicolaas Smith 

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