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Showing posts with label Three fundamentally different basic economic items. Show all posts
Showing posts with label Three fundamentally different basic economic items. Show all posts

Saturday 7 March 2009

Three fundamentally different basic economic items

The economy is divided in the monetary and non-monetary or real economy. Economic items consist of monetary and non-monetary items. Non-monetary items are sub-divided in variable real value non-monetary items and constant real value non-monetary items. There are thus three fundamentally different basic economic items in the economy: monetary items, variable items and constant items.


Variable real value non-monetary items


The first economic items were variable real value items. Their real values were determined by supply and demand. Their values were not yet expressed in terms of money because money was not yet invented at that time.

The first economies were barter economies. People bartered economic items they possessed or produced in excess of their own personal needs for other products they desired from other people who had an excess of the products they in turn possessed or produced.

There was no inflation because there was no money. There was no monetary medium of exchange. There was no monetary unit of account. There was no monetary store of wealth. There was no money illusion.

There was no double entry accounting model at that time.

There were thus no Historical Cost Accounting model, no stable measuring unit assumption, no historical cost items and no nominal monetary units.

There was also no Consumer Price Index at that time and consequently there were no units of constant purchasing power and no real value maintaining Constant Purchasing Power Accounting model.

There were no financial reports: e.g. no profit and loss accounts and no balance sheets.

There were no monetary items and no constant items. There were only variable real value items not yet expressed in monetary terms.

Examples of variable real value non-monetary items in today’s economy are property, plant, equipment, inventory, shares, raw materials, merchandise, patents, trademarks, etc.


Monetary items


Money was then invented over a long period of time as a response to the limitations imposed by the barter economy. Eventually money came to fulfil the following three functions:

a. Medium of exchange
b. Store of value
c. Unit of account

Non-monetary items were only defined in monetary terms after the invention of money when it came to be used as the basic monetary unit of account in the economy. The economy came to be divided in the monetary economy and the non-monetary or real economy. There were monetary items and non-monetary items.

Monetary items

Monetary items are money held and items with an underlying monetary nature.

Examples of monetary items in today’s economy are bank notes and coins, bank loans, bank account balances, treasury bills, commercial bonds, government bonds, mortgage bonds, student loans, car loans, consumer loans, credit card loans, notes payable, notes receivable, etc.

Non-monetary items

Non-monetary items are all items that are not monetary items.

Non-monetary items in today’s economy are divided into two sub-groups:

a) Variable real value non-monetary items
b) Constant real value non-monetary items


There were still no units of constant purchasing power because there was still no CPI at that time. There was still no Historical Cost Accounting model and still no stable measuring unit assumption. There was still no Constant Purchasing Power Accounting model. There were still no double entry financial reports: still no profit and loss accounts and still no balance sheets.

Inflation

Inflation is always and everywhere a monetary phenomenon: Milton Friedman.

Inflation destroys the real value of money. Deflation creates real value in money.

Inflation reared its ugly head soon after the invention of money. It only destroyed the real value of money and other monetary items at that time as it does today. Inflation did not and can not destroy the real value of variable and constant items. Inflation has no effect on the real value of non-monetary items.

There was only one systemic economy-wide process of real value destruction at that time. The economic process of inflation destroyed the real value of money and other monetary items equally throughout the monetary economy at that time as it does today in economies subject to inflation.

There was no second systemic economy-wide accounting practice destroying the real value of constant real value non-monetary items never or not fully updated as we experience today because the real value destroying Historical Cost Accounting model, which includes the very destructive stable measuring unit assumption, was not yet invented at that time. Today South African accountants unknowingly destroy the real values of constant real value non-monetary items never or not fully updated because they choose to measure financial capital maintenance in SA banks and companies in nominal monetary units when they implement the very destructive stable measuring unit assumption as part of the real value destroying traditional Historical Cost Accounting model.


Constant items


Finally the double entry accounting model was invented. It was first comprehensively codified by the Italian Franciscan monk, Luca Pacioli in his book Summa de arithmetica, geometria, proportioni et proportionalita, published in Venice in 1494.
The invention of the double entry accounting model enables accountants to maintain the real values of both income statement as well as balance sheet constant real value non-monetary items – the third distinct category of economic items. Maintaining the real value of constant items in the SA economy where accountants use the double entry accounting model to account all economic activity is, however, only possible with the real value maintaining Constant Purchasing Power Accounting model during inflation. It is not possible, at present, while SA accountants implement the real value destroying traditional Historical Cost Accounting model because of their application of the very destructive stable measuring unit assumption during inflation. SA accountants unknowingly destroy real value on a massive scale in the real economy when they implement the traditional Historical Cost model.
The specific choice of measuring financial capital maintenance in units of constant purchasing power (the CPPA model) at all levels of inflation and deflation as contained in the Framework for the Preparation and Presentation of Financial Statements, was approved by the International Accounting Standards Board’s predecessor body, the International Accounting Standards Committee Board, in April 1989 for publication in July 1989 and adopted by the IASB in April 2001.
“In the absence of a Standard or an Interpretation that specifically applies to a transaction, management must use its judgement in developing and applying an accounting policy that results in information that is relevant and reliable. In making that judgement, IAS 8.11 requires management to consider the definitions, recognition criteria, and measurement concepts for assets, liabilities, income, and expenses in the Framework. This elevation of the importance of the Framework was added in the 2003 revisions to IAS 8." IAS Plus, Deloitte.


IAS8, 11: “In making the judgement, management shall refer to, and consider the applicability of, the following sources in descending order:
(a) the requirements and guidance in Standards and Interpretations dealing with similar and related issues; and
(b) the definitions, recognition criteria and measurement concepts for assets, liabilities, income and expenses in the Framework.”
There is no applicable International Financial Reporting Standard or Interpretation regarding the valuation of constant real value non-monetary items, e.g. issued share capital, retained earnings, capital reserves, all other items in Shareholders Equity, trade debtors, trade creditors, deferred tax assets and liabilities, taxes payable and receivable, all other non-monetary receivables and payables, Profit and Loss account items such as salaries, wages, rents, etc. The Framework is thus applicable.
The scope of the Framework includes dealing with defining, recognizing and measuring the items in financial statements and dealing with the concepts of capital and capital maintenance.
Framework, Par. 104 (a)

Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power.

The Framework, Par. 110 states that the choice of the measurement bases and the concept of capital maintenance will decide the accounting model applied in the preparation of the financial reports. The Framework applies to different accounting models and is a guide to the preparation and presentation of the financial reports under the chosen accounting model.

The Framework is the IASB approved basis for accountants to choose, in terms of Par. 104 (a), to measure financial capital maintenance in units of constant purchasing power – the CPPA model - instead of in nominal monetary units – the traditional HCA model. They can, in terms of Par. 110, choose the Constant Purchasing Power Accounting model implementing the constant purchasing power financial capital concept, capital maintenance concept and the determination of profit/loss in terms of units of constant purchasing power instead of the Historical Cost capital concept, capital maintenance concept and the determination of profit/loss in terms of nominal monetary units.

The Framework, Par. 102 states that most companies choose a financial concept of capital. Capital is the same as the shareholders´ equity of a company or its net assets when a financial concept of capital is adopted, for example, invested purchasing power or invested money.

The maintenance of capital is as important as its recognition and definition. Capital maintenance is an accounting practice implementing a concept of capital.

The Framework states that the needs of the users of financial reports should be the basis for choosing the correct concept of capital by a company. When the users of financial reports are mainly concerned with the preservation of the purchasing power of the invested capital or its nominal value, then a financial concept of capital should be used.

According to the Framework, the choice of the measurement bases and the concept of capital maintenance will decide the accounting model applied in the preparation of the financial reports. A profit is made under the financial capital maintenance concept only when the period-end financial (or money) net asset value is greater than at the start of the period, after subtracting distributions and contributions to and from shareholders during the accounting period. Financial capital maintenance can be calculated in either units of constant purchasing power or in nominal monetary units.

The real value maintaining Constant Purchasing Power Accounting model is thus an IASB approved alternative to the real value destroying traditional Historical Cost Accounting model.

The Framework states that the capital maintenance concept deals with how companies define the capital they want to preserve. It is the connection between the concepts of capital and the concepts of profit/loss since it gives the point of reference for calculating profit/loss.

Examples of constant real value non-monetary items in today’s economy are Profit and Loss Account items like salaries, wages, rentals, pensions, taxes, duties, fixed interest payments, etc as well as balance sheet items like retained earnings, issued share capital, capital reserves, share issue premiums, share issue discounts, provisions, capital reserves, all other shareholder’s equity items, trade debtors, trade creditors, other non-monetary debtors and creditors, taxes payable and receivable, deferred tax assets and liabilities, dividends payable and receivable, royalties payable and receivable, etc.