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Thursday, 20 November 2014

Stop inflation with an IFRS

That was the headline that got Iran interested in Capital Maintenance in Units of Constant Purchasing Power in terms of a Daily CPI some months ago. Accountants there are already familiar with IFRS. That you could use it to stop their high inflation at the time was really interesting to them. I responded enthusiastically to the request to explain how that can be done.

Yes, it is possible. But, and there is always a but, you have to go all the way as well as accept economic concepts/reality/facts.

First of all: what would normally stop inflation? Various possible actions: an increase in the money supply exactly equal to the required level to guarantee zero inflation. Is that known at the time of the money supply increase? No. Etc, etc, etc.

However, there is an interesting additional fact: daily indexing the entire money supply to all (at least daily) changes in the general price level would remove only the effect of inflation: it does nothing to actual inflation.

This is quite interesting and worth looking into. Imagine: removing the entire effect of inflation. Well, it is being done - in part - right now in Chile, Colombia and the majority of countries in the world economy in government inflation-linked bonds.

How can the entire effect of inflation be removed from the entire money supply?

You have to start off with abandoning traditional Historical Cost Accounting (by the way, that would be the best thing you could ever do for your company or country) and implement the alternative authorized in IFRS, namely Capital Maintenance in Units of Constant Purchasing Power in terms of the Daily CPI. The IASB´s Conceptual Framework (2010), Par. 4.59 (a) states: "Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power." So, it is authorized in IFRS (since 1989). It is also authorized in US GAAP and individual country national accounting standards.

Changing over to CMUCPP in its generally accepted form only solves two of the three problems (there are three fundamentally different economic items: monetary items, variable real value non-monetary items and constant real value non-monetary items): (1) it would maintain the constant purchasing power of all constant real value non-monetary items constant in all entities that at least break even in real value, ceteris paribus, and (2) it would only keep all historical  non-monetary items - variable and constant items - updated till the current (today´s) real value in terms of all (at least daily) changes in the general price level. The stable measuring unit assumption would still be implemented in the case of nominal monetary items during the current financial period. Thus the effect of inflation would still result in the erosion of the real value of these monetary items over time.

It is generally accepted ( a Generally Accepted Accounting Principle) that selecting IFRS-authorized CMUCPP only does what is stated in (1) and (2) above. It is not yet generally accepted that the rejection of the stable measuring unit assumption includes updating all monetary items (the entire money supply) in terms of all (at least) daily changes in the general price level, i.e., in terms of the Daily CPI.

So, implementing CMUCPP - in its generally accepted form - is the same as never implementing the stable measuring unit assumption in any form in the valuation of only variable and constant real value non-monetary items. That does not stop the effect of inflation at all because the stable measuring unit assumption would still be implemented for the valuation of nominal monetary items under CMUCPP in its generally accepted form.

So, to actually stop only the effect of inflation (it would be as if there is no inflation) you have to daily inflation-index all monetary items (the entire money supply) in terms of all (at least daily) changes in the general price level, i.e., in terms of the Daily CPI. This would do nothing to actual inflation. There would, however, be no effect of inflation in the economy.

Implementing CMUCPP is part of GAAP. However, it only solves the valuation problems (created by the implementation of the stable measuring unit assumption under HCA) related to non-monetary items (variable and constant real value non-monetary items).

Actual daily inflation-adjustment of the entire money supply is not yet a GAAP. However, the principle is. The principle of rejecting the stable measuring unit assumption (abandoning HCA) applies to monetary items too, in princle, not yet generally in practice. Although, a 2% inflation target can be seen as 98% inflation-indexing the entire money supply.

Chile has been daily inflation-indexing more than 25% of its entire money supply for a number of years. Colombia daily inflation-adjusts all mortgage bonds, also for a number of years already. The majority of countries in the world economy daily inflation-index their respective sovereign inflation-linked bonds to the global total of more than USD 3 trillion (US TIPS included).

So, you can actually use an IFRS to stop the entire effect of inflation (or deflation) in the entire economy. It is authorized in IFRS, in principle. The above application of IFRS is generally accepted  in Chile, Colombia and most countries in the world economy that daily inflation-index government inflation-linked bonds in terms of the Daily CPI.

Consequently, the question can be asked: is the IASB potentially more powerful than the Fed? Has the IASB the power to require daily inflation-indexing of all monetary items? That would stop the effect of inflation and deflation worldwide.

Don´t worry. The IASB would never do that. They are too irresponsible/incompetent/inefficient/hard headed/ stubborn /resistant to new ideas/clueless about CMUCPP/openly hostile to CMUCPP and the units of constant purchasing power in terms of the Daily CPI measurement basis/stuck in HCA, to even discuss publicly the possibility of requiring daily indexing in IAS 29 Financial Reporting in Hyperinflationary Economies - a requirement that would assure the stabilization of at least the non-monetary economy over a short period of time in any hyperinflationary economy.

Nicolaas Smith 

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