The Historical Cost Mistake

Updated on 31 May 2014

The Historical Cost Mistake is the implementation of the stable measuring unit assumption under Historical Cost Accounting during inflation and deflation. Stopping the stable measuring unit assumption, i.e., implementing Capital Maintenance in Units of Constant Purchasing Power in terms of the Daily Index fixes the Historical Cost Mistake.

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• Constant Item Purchasing Power Accounting per IFRS

Historical Cost accountants are unknowingly and unintentionally responsible for the destruction of the real value of constant real value non-monetary items never or not fully updated daily /maintained constant in real value daily over time when they choose to measure financial capital maintenance in nominal monetary units in terms of the IASB´s Conceptual Framework (2010), Par. 4.59 (a) as it forms part of IFRSs. Almost all accountants choose the Historical Cost Accounting model which includes the stable measuring unit assumption.

Inflation can be any value, for example 2000 % per annum in the case of Brazil during phases in their 30 years of hyperinflation. When accountants choose to measure financial capital maintenance in terms of units of constant purchasing power in terms of the Daily CPI instead of in terms of nominal monetary units as per Par. 4.59 (a) - all constant real value non-monetary items are maintained constant at their constant real values – at any level of inflation/lhyperinflation as happened in Brazil - or deflation. It is thus clearly not inflation but accountants choosing the HCA model - under which they implement the stable measuring unit assumption who are unknowingly and unintentionally responsible for the destruction of the real value of constant real value non-monetary items never or not fully updated daily/maintained constant in real value daily over time.

Brazil in effect implemented Capital Maintenance in Units of Constant Purchasing Power (CMUCPP)  in terms of a Daily Index (their Unidade Real de Valor in 1994) when various different governments implemented various different Daily indexes to Daily index all non-monetary items as well as many monetary items (money loans/deposits) in the Brazilian economy for 30 years from 1964 to 1994 as stated to me by the Brazilian Central Bank.

Inflation also does not destroy the real values of fixed nominal payments of constant real value non-monetary items like salaries, wages, rents, pensions, etc. Inflation can only erode the real value of money and other  monetary items over time, nothing else. Accountants choosing the HCA model, under which they implement the stable measuring unit assumption, are unintentionally and unknowingly responsible for the destruction of the real values of fixed nominal payments of constant real value non-monetary items. When CMUCPP in terms of a Daily CPI is implemented the real value of payments of constant real value non-monetary items are maintained constant at any level of inflation or deflation. See Brazil from 1964 to 1994.

It is thus accountants choosing the HCA model that do the destroying with the stable measuring unit assumption (in the case of constant real value non-monetary items never or not fully maintained) and not inflation. Inflation only erodes the real value of monetary items, nothing else. Accountants freely choose to implement the HCA model instead of the CMUCPP model. No-one forces them to implement HCA during low and high inflation or deflation.

The level of inflation simply indicates the level of daily constant purchasing power adjustments in terms of the Daily CPI necessary to maintain the real value of constant real value non-monetary items over time. It is accountants choosing the HCA model – in fact, their choice to implement the stable measuring unit assumption - that is destroying the real value of constant real value non-monetary items never or not fully updated over time and not inflation. Inflation only erodes the real value of money and other monetary items over time.

IFRS / US GAAP authorized solution to the Historical Cost Mistake: Daily Indexing

Financial capital maintenance in units of constant purchasing power is authorized in both IFRS and US GAAP as the alternative to Historical Cost Accounting, i.e., financial capital maintenance in nominal monetary units (or the Historical Cost Mistake).

The Historical Cost Mistake is, obviously, fixed with Daily Indexing: Capital Maintenance in Units of  Constant Purchasing Power in terms of the Daily CPI during low inflation and high inflation and deflation and in terms of the US Dollar parallel rate during hyperinflation.

Daily Indexing

1. Accounting Daily Indexing
2. Comprehensive Daily Indexing

1. Accounting Daily Indexing is implementing CMUCPP in terms of the Daily CPI instead of HCA. That only eliminates the destruction of the real value of constant real value non-monetary items never or not fully maintained constant in real value by HCA. Accounting Daily Indexing keeps the constant real value non-monetary economy perfectly stable my stopping the stable measuring unit assumption in accounting, i.e. stopping HCA.

2. Under Comprehensive Daily Indexing, Accounting Daily Indexing is combined with daily indexing of the entire money supply in terms of the Daily CPI. This only eliminates the effect of inflation and deflation from only monetary items. Nothing else. It does not stop inflation or deflation. It stops the destruction of the real value of monetary items over time by inflation and it stops the increase in the real value of monetary items over time during deflation. It only eliminates the effect of inflation and deflation on only monetary items. It would be as if there is no inflation or deflation - while actual inflation or deflation continues.

For example, Daily Inflation Indexing the $3 trillion in global government inflation-indexed bonds maintains the real value of this USD 3 trillion perfectly stable over time on a daily basis, but it does not stop the inflation or deflation in the countries concerned. The inflation or deflation continues, but it is as if there is not inflation or deflation for the holders of the $3 trillion sovereign capital inflation-adjusted bonds inflation-indexed daily.

Daily indexing only removes the effect of inflation and deflation. It does not stop the inflation or deflation. It is as if there is no inflation or deflation.

This is free, authorized under IFRs and US GAAP and available to all countries and economies.

Daily Indexing is free. It kills the need for very costly Dollarization or a currency board at no cost while the countries'  central banks maintain their full monetary creation and monetary policy powers (what they lose under Dollarization and a currency board).

Copyright © 2008 Nicolaas Smith

Accountants unknowingly destroy banks´ and companies´ capital

No double entry accounting model creates value.

Not all double entry accounting models maintain value.

Not all double entry accounting models destroy value.

No double entry accounting model can create real economic value out of nothing. Deflation creates real value in monetary items as a result of a decrease in the general price level below 0% inflation with all models of double entry accounting.

The fundamental double entry accounting model, per se, does not destroy real value. Accountants are unknowingly responsible for the destruction of real value in constant items never or not fully updated when they choose the HC model and implement the stable measuring unit assumption.

An attribute of the double entry accounting model is that it maintains the real value of constant items during inflation and deflation only when a CPP model is used as authorized by the IASB in the Framework, Par. 104 (a).

Monetary items

The double entry accounting model is incapable of maintaining the real value of monetary items in an inflationary or deflationary economy. Nothing can be done about the fact that above zero percent inflation destroys the real value of monetary items in any accounting model or even without an accounting model. The accounting model has nothing to do with the valuation of monetary items. Real value is always destroyed in monetary items in an inflationary economy with the implementation of whatever accounting model.

Since the double entry accounting model always requires all debit balances to equal all credit balances, a net monetary asset balance will require a one-sided net monetary loss entry while a net monetary liability balance will require a one-sided net monetary gain entry.

The double entry accounting model is also incapable of preventing the creation of value in monetary items in a deflationary economy.

The Historical Cost and Current Cost Accounting models do not account the net monetary loss or gain of inflation or deflation; that is, there are no one-sided net monetary loss or one-sided net monetary gain entries.

Only CPPA models including the RVA model account one-sided net monetary gain and one-sided net monetary loss entries.

Variable items

SA accountants value variable items in terms of IFRSs or SA GAAPs under all accounting models with appropriate entries to the P+L and shareholders equity accounts to maintain the double entry balance. Inflation does not affect the real values of variable real value non-monetary items.

Constant items

The Historical Cost and Current Cost models are specific double entry accounting models but they do not maintain the real value of constant items. When accountants choose these models they destroy the real value of constant items under inflation and create real value in constant items under deflation like inflation in monetary items. The CPP and Real Value Accounting models are constant purchasing power models that maintain the real value of constant items under both inflation and deflation.

The reason that it appears that inflation has a non-monetary effect is the fact that there is no value destruction at 0% inflation in constant items. The reason for that is that at 0% inflation the HC, CC, CPP and RVA models all maintain the real values of constant items. When inflation keeps on declining and gets to 0% and further general price level declines result in an increase in the real value of money when the economy enters into deflation, then the HCA model creates value in constant items while the CPP and RVA models maintain constant items´ real values by reducing constant items´ nominal values at the rate of deflation. Deflation creates real value in money while accountants would unknowingly create value in constant items during deflation when they implement either the HC or CC accounting models instead of CPP or RV accounting.

It does not make any difference which accounting model is used. No accounting model can reduce or stop inflation’s monetary effect. Only a reduction in inflation can reduce and only 0% can stop inflation’s monetary effect.

Inflation does not erode - which is exactly the same as destroy- the real value of historical cost non-monetary items. Accountants choosing HCA unknowingly do that.

Inflation does not destroy the real value of non-monetary items that do not hold their purchasing power. Accountants choosing HCA do that unknowingly.

Inflation does not destroy the real value of fixed nominal payments.

Inflation does not destroy the real value of constant real value non-monetary items never or not fully updated over time.

When accountants choose to measure financial capital maintenance in units of constant purchasing power instead of in nominal monetary units in terms of the IASB´s Framework Par. 104 (a) as it forms part of IFRSs - all constant real value non-monetary items are maintained at their constant real values – at any level of inflation or deflation.

Copyright © 2008 Nicolaas Smith

Inflation does not affect the real value of non-monetary items

Inflation affects the fundamental value of all monetary items. Inflation destroys the real value of all monetary items directly and equally.

“Inflation is always and everywhere a monetary phenomenon.” Milton Friedman

Inflation does not affect the real values of non-monetary items. The accounting model accountants choose affects the real values of constant real value non-monetary items.

The following three paragraphs are not true and correct - they are simply generally accepted, but still completely wrong:

*Inflation erodes the real value of nominally fixed payments. The real value of fixed nominal payments (like rents, pensions, wages, interest, and taxes) are eroded by inflation.

*Inflation erodes the real value of historical cost accounting items. Inflation erodes the real values of non-monetary assets and liabilities stated at historical cost; e.g., retained earnings, issued share capital, capital reserves, provisions, taxes, dividends, trade payables and receivables, etc. Two percent inflation - the European Central Bank's definition of price stability – will erode by 51 percent the real value of historical cost non-monetary items over 35 years.

*Inflation destroys the real value of non-monetary items which do not hold their value in terms of purchasing power.

Erode is exactly the same as destroy in the above cases.

It is not inflation, but, accountants implementing the stable measuring unit assumption (the traditional HC model) who unknowingly destroy the real values of nominally fixed payments and constant items stated at historical cost. The rate of inflation simply indicates the rate of real value destruction over the time period involved.

There are no fixed nominal payments and there are no constant real value non-monetary income, expenses, assets and liabilities stated at historical cost when accountants choose a CPP model. In this case the rate of inflation simply indicates the rate of adjustment required to maintain the real value of constant items expressed in the functional currency in the internal economy.

No real value is destroyed in constant items over any period of time when accountants choose to implement a CPP model at any level of inflation. It is thus accountants choosing the HC model who unintentionally destroy the real value of constant items and not inflation.

Inflation does not affect the fundamental value of constant real value non-monetary items, e.g. salaries and retained earnings.

It is accountants choosing the HC model - instead of the IASB-suggested CPP model - and implementing the stable measuring unit assumption who unwittingly destroy the real value of nominally fixed payments and the real values of constant items stated at historical cost when they choose to measure financial capital maintenance in nominal monetary units.

Copyright © 2008 Nicolaas Smith

Only Constant Item Purchasing Power Accounting maintains constant items´ real values

There are no constant real value non-monetary items without double entry accounting.

A fundamental attribute of the Constant Item Purchasing Power Accounting model is that it maintains the real values of constant items during inflation (increasing nominal values) and deflation (decreasing nominal values) as a result of the measurement of financial capital maintenance in units of constant purchasing power. A fundamental attribute of the traditional Historical Cost Accounting model is that it destroys the real values of constant items never or not fully updated (increased) during inflation and creates real value in constant items never or not fully updated (decreased) during deflation as a result of the stable measuring unit assumption.

CPPA maintains constant items´ real values while HCA destroys constant items´ real values. SA accountants unknowingly are responsible for maintaining or destroying constant items´ real values in the SA real economy depending on the choice they make in terms of the IASB´s Framework, Par. 104 (a) which forms part of IFRSs.

The fact that SA accountants value economic activity does not mean that they can create value out of nothing simply by accounting economic items using the double entry accounting model. They cannot and do not use the basic accounting model to create wealth out of thin air. It is not part of the wealth creating process. No accounting model can create real value out of nothing.

SA accountants can maintain the real value of constant items in the real economy, but, only when they choose to measure financial capital maintenance in units of constant purchasing power as provided for in the Framework, Par. 104 (a). They can not do that when they choose to measure financial capital maintenance in nominal monetary units; that is, when they choose the traditional HCA model, unfortunately also provided for in Par. 104 (a). In fact, accountants do exactly the opposite when they choose to measure financial capital maintenance in nominal monetary units: they unknowingly destroy the real values of constant items never or not fully updated under the HC model at the rate of inflation.

Framework, Par. 110:

“The selection of the measurement bases and concept of capital maintenance will determine the accounting model used in the preparation of the financial statements”

Not a single SA Chartered Accountant chooses to measure financial capital maintenance in units of constant purchasing power in terms of the IASB´s Framework Par. 104 (a) for any SA company listed on the Johannesburg Stock Exchange. Not one CA chooses the Constant Purchasing Power Accounting model under which she or he would maintain the real values of all constant items in a JSE listed company.

All CAs in JSE listed companies choose to measure financial capital maintenance in nominal monetary units. All Financial Directors and Chief Financial Officers of JSE listed companies state in their notes to the balance sheet that their companies´ accounts have been prepared based on the Historical Cost model; that is, that they implement the stable measuring unit assumption. In so doing, they, as well as all other accountants in all unlisted SA companies, are unknowingly responsible for the destruction of the real value of all constant items never or not fully updated in their companies in the SA real economy at the current 13% rate of inflation. This amount to about R200 billion per annum in current values compounded into the future for as long as SA accountants choose to implement the stable measuring unit assumption as it forms part of the HCA model; that is, for as long as they make the Historical Cost Mistake.

The accountants in these companies are unknowingly and unintentionally responsible – because they choose to measure financial capital maintenance in nominal monetary units in terms of Par. 104 (a) - for the destruction of the real values of salaries, wages, rents, pensions, taxes, duties, fixed interest payments, all other Profit and Loss Account items, retained earnings, issued share capital, capital reserves, share issue premiums, share issue discounts, all other shareholder’s equity items, provisions, 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 never or not fully updated at the rate of inflation in SA.

Only Constant Purchasing Power Accounting models can maintain the real value of constant items over time in inflationary and deflationary economies. Real Value Accounting is a CPPA model presenting all items at today’s real value. The valuation of economic items, the measurement of financial capital maintenance in constant purchasing power units and the determination of profit are the same under CPPA models and the RVA model. Generally CPPA models present results calculated in units of constant purchasing power at the CPI rate prevailing at the period end date. Those results or real values are not updated every month in the future when the CPI changes. Historical CPP values are thus presented as HC values in the future when the CPI changes. They are thus calculated in units of CPP and then presented in the future at their HC values at the period end date. The RVA model measures financial capital maintenance in units of constant purchasing power – it is a CPPA model - and always presents all CPP calculated items updated at the latest CPI value in the future.

Copyright © 2008 Nicolaas Smith

Accountants value economic activity

The three distinct economic items in the economy:

1. variable items
2. monetary items and
3. constant items
are all three economic values. Each economic item has an economic value expressed in terms of money. The accounting model deals with these three economic items in an organized manner: journal entries, trial balances, general ledger accounts, cash flow statements, items in the Profit and Loss Account, assets and liabilities in the balance sheet plus other financial, management and costing reports.

South African accountants value economic items when they account economic activity in the accounting records and prepare financial reports of SA economic entities based on the double entry accounting model. Every accounting entry is a valuation of the economic items (the debit item and the credit item) being accounted.

SA accountants do not simply record economic activity. Accounting is not just a scorekeeping of economic events. Accountants value economic items when they account them. Subsequent accounting entries are part of continuous generally accepted accounting practices of valuation of the economic items originally valued and accounted over time as required by SA Generally Accepted Accounting Practices, International Accounting Standards and IFRSs applied in conjunction with the IASB´s Framework.

Variable Items

SA accountants value variable items in terms of IASs and IFRSs or SA GAAPs. No real value is unknowingly destroyed in the value of variable items by accountants choosing the traditional HCA model as long as the International Standards or GAAPs are implemented. “Listed companies use IFRS and the unlisted companies could use either IFRS or Statements of GAAP.”

Monetary items

SA accountants value monetary items at their original nominal monetary values; that is, at their original HC values since monetary items cannot be updated in current period accounts and financial reports published during the current period. Inflation – not accountants - destroys the real value of monetary items over time – currently at the high rate of 13% per annum. The real value of a monetary item is determined by the rate of inflation as indicated by the change in the CPI. Inflation destroys the value of monetary items under any accounting model and also when no accounting model is implemented; that is, when a business does not account its economic activities; for example, street vendors.

Constant items

SA accountants choose to value constant items in either nominal monetary units or in units of constant purchasing power in terms of the Framework, Par. 104 (a):

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

How they value constant items does make a difference to the fundamental values of constant items. The accounting model accountants choose in terms of Par. 104 (a) is of critical importance. When SA accountants choose to measure financial capital maintenance in units of constant purchasing power they choose to value constant items in units of constant purchasing power, as provided for by IFRSs in the Framework, Par. 104 (a) and they maintain their real values over time. The only way SA accountants can maintain the real value of constant items during inflation or deflation is by choosing the Constant Purchasing Power Accounting model. Not a single SA accountant in SA chooses to measure financial capital maintenance in units of constant purchasing power as per Par. 104 (a). All SA accountants, unfortunately, choose to value constant items in nominal monetary units and thus, unknowingly, destroy their real values at the rate of inflation. In so doing, SA accountants are, for example, unknowingly destroying the real value of all retained earnings balances in all SA companies at the rate of inflation and unknowingly destroying the real value of issued share capital balances of companies with no Fixed Assets to revalue at least equal to the original real value of their issued share capital. SA accountants are unintentionally killing the real economy.

© 2005-2010 by Nicolaas J Smith. All rights reserved

No reproduction without permission.

The Historical Cost Mistake

There are three distinct economic items in the economy:

1. Variable real value non-monetary items
2. Monetary items
3. Constant real value non-monetary items


Variable real value 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 has not yet been invented at that time.

The first economies functioned without money. They 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 money and no double entry accounting model at that time. There was no stable measuring unit assumption. There were no historical cost items. There was no inflation because there was no money. There was no medium of exchange. There was no monetary unit of account. There were no financial reports: no profit and loss accounts and no balance sheets. There was no Consumer Price Index. There were no nominal monetary units since there was no money and there were no units of constant purchasing power because there was no CPI.

There were no monetary items and no constant items. There were only variable items.


Money


Money was then invented over a long period of time. Eventually money came to fulfil the following three functions:

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

At that stage there were two distinct economic items in the economy: variable items and monetary items.

Variable items were defined in monetary terms after the invention of money, since money came to be used as the basic unit of account in the economy. The economy was 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.

Non-monetary items

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

Non-monetary items were made up of only variable items at that time. There were no constant items because double entry accounting was still not invented yet.

There were still no units of constant purchasing power because there was still no CPI. There was still no HCA model, no stable measuring unit assumption and no HC items. There were still no double entry financial reports: still no profit and loss accounts and still no balance sheets.

Inflation

When inflation reared its ugly head soon after the invention of money it destroyed the real value of money and other monetary items as it does today. Inflation caused the only systemic economy-wide real value destruction in monetary items at that time and as it continues today in inflationary economies.

There was no second systemic economy wide real value destruction in constant real value non-monetary items as a result of accountants unknowingly destroying the real value of constant items never or not fully updated because they choose to measure financial capital maintenance in nominal monetary units when they implement the stable measuring unit assumption as part of the HC model.


Constant items


Finally the double entry accounting model was invented. It was first comprehensively codified by 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 established the accounting framework for maintaining the real values of constant real value non-monetary items – the third distinct category of economic items. The double entry accounting model’s fundamental function of maintaining the real value of constant items is only possible with a Constant Purchasing Power Accounting model as provided for in International Financial Reporting Standards by the International Accounting Standards Board in the Framework for the Preparation and Presentation of Financial Statements, Paragraph 104 (a) in an inflationary or deflationary economy. South African accountants unknowingly destroy the real value of constant items never or not fully updated in the SA real economy on a massive scale when they implement the stable measuring unit assumption as part of the traditional Historical Cost Accounting model. This mistake costs South Africa about R200 billion per annum compounded into the future if SA accountants keep on selecting the traditional Historical Cost model as they all do today instead of the CIPPA model as provided for by IFRSs.

Examples of constant items in today’s economy are salaries, wages, rents, pensions, taxes, duties, fixed interest payments, all other Profit and Loss Account items, retained earnings, issued share capital, capital reserves, share issue premiums, share issue discounts, all other shareholder’s equity items, provisions, 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.

Copyright © 2008 Nicolaas Smith

DOUBLE ENTRY ACCOUNTING - per se – neither creates nor destroys value

DOUBLE ENTRY ACCOUNTING - per se – neither creates nor destroys value.

Double entry accounting - per se - maintains value.

Historical Cost Accounting destroys real value during low inflation when entities do not own sufficient revaluable fixed assets.

Only Constant ITEM Purchasing Power Accounting which rejects the stable measuring unit assumption maintains the real value of constant real value non-monetary items over time in low inflationary economies.

The IASB´s Framework:

Par 104 (a):

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

INFLATION destroys value in monetary items with and without an accounting model.

Inflation or hyperinflation can not destroy the real value of constant real value non-monetary items never or not fully updated over time. Put in another way: inflation and hyperinflation do not destroy the real value of non-monetary items which do not hold their value in terms of purchasing power.

Real value is only destroyed in constant items never or not fully updated over time when accountants freely choose to implement the stable measuring unit assumption instead of units of constant purchasing power as they can do in terms of IFRSs.

SA Chartered Accountants unknowingly destroy real value on a massive scale in the SA real economy when they choose – without anyone forcing them to make that choice - to measure financial capital maintenance in nominal monetary units in terms of Paragraph 104 (a) of the IASB´s Framework.

CAs freely choose the Historical Cost Accounting model under which they implement the stable measuring unit assumption. In so doing, they unintentionally destroy about R200 billion in the real value of constant items never or not fully updated in the real economy each and every year.

Only when accountants choose to implement the stable measuring unit assumption is value destroyed in constant items never or not fully updated. Both the Historical and the Current Cost Accounting models destroy value in an inflationary economy because accountants choose to implemnt the stable measuring unit assumption in the valuation and accounting of constant real value non-monetary items.

When CA´s choose to measure financial capital maintenance in units of constant purchasing power they will stop destroying about R200 billion in real value annually in the real economy.

Inflation-adjusting accounts in a low inflation environment is part of International Financial Reporting See the Framework (1989), par 104 (a). Salaries, wages, rents, interest, pensions, utilities, etc are inflation-adjusted in most economies.
When CAs choose to measure financial capital maintenance in units of constant purchasing power they will reject the stable measuring unit assumption in terms of IFRSs.
Simply choosing to measure financial capital maintenance in units of constant purchasing power, as per Par 104 (a), SA accountants will stop unknowingly destroying about R200 billion in real value in the SA real economy each and every year, they will follow IFRSs, they will reject the stable measuring unit assumption and they will inflation-adjust all constant items in the SA economy.

© 2005-2010 by Nicolaas J Smith. All rights reserved
No reproduction without permission.