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Friday, 21 November 2008

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