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Sunday 28 December 2008

Difference between deflation and disinflation


Updated on 23 July 2013

Deflation is a sustained decrease in the general price level resulting in a sustained increase in the real value of money and other monetary items not deflation-adjusted daily as well as constant real value non-monetary items treated as monetary items (e.g. trade debtors, trade creditors, all other non-monetary receivables, all other non-monetary payables, etc.), i.e., not measured in units of constant purchasing power in terms of a daily index, under Historical Cost Accounting. These items are worth more in real value all the time during deflation as opposed to being worth less in real value all the time during inflation. Deflation is negative inflation. The above only applies to monetary items not deflation-adjusted daily under Capital Maintenance in Units of Constant Purchasing Power. Constant items are always and everywhere measured in units of constant purchasing power in terms of a daily index under CMUCPP.

Disinflation is lower inflation. Prices are still rising during disinflation, but at a lower rate. The general price level still rises, but, at a slower rate resulting in a continued, but, lower rate of real value destruction in money and other monetary items as well as constant real value non-monetary items treated as monetary items. A lowering of inflation is not deflation but disinflation.

Under Accounting Capital Maintenance in Units of Constant Purchasing Power under which all constant real value non-monetary items are always measured in units of constant purchasing power in terms of a daily index only money and monetary items not inflation-adjusted daily lose real value all the time during inflation and disinflation and gain in real value all the time during deflation.

Under Economic Capital Maintenance in Units of Constant Purchasing Power under which

(1) all constant real value non-monetary items are always and everywhere measured in units of constant purchasing power in terms of a daily index and

(2) all monetary items (except local currency bank notes and coins outside the banking system) are inflation-adjusted or deflation-adjusted daily

only local currency bank notes and coins outside the banking system lose real value all the time during inflation and disinflation and gain in real value all the time during deflation.

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Deflation means the general price level is not increasing at all, but, actually decreasing continuously and the internal functional currency – money - and other monetary items as well as constant items treated as monetary items under HCA not deflation-adjusted daily in terms of a daily index are worth more all the time. Deflation causes an increase in the real value of money and other monetary items as well as constant items treated as monetary items under HCA not deflation-adjusted daily in terms of a daily index.

Inflation destroys real value in money and monetary items not inflation-adjusted daily as well as constant items treated as monetary items under HCA, i.e., not measured in units of constant purchasing power in terms of daily index. Disinflation destroys real value in money, etc. more slowly. Deflation creates real value in money, etc.

Inflation is a sustained increase in the general price level. Disinflation is a slower sustained increase in the general price level. Deflation is a sustained decrease in the general price level.

Disinflation happens after a period of higher inflation in what are normally considered low inflation economies and is sometimes initially popularly confused with deflation. During disinflation many prominent prices, for example, oil, fuel, commodity, property and food prices are falling, but, the general price level is still actually rising, albeit at a much slower rate than during normal low inflation. When the slowing annual inflation rate moves lower and lower it eventually gets to a zero percent annual rate for maybe a month or two. When the general price level then continues to decline even further - below zero percent per annum - the economy flips over (a very big change) from inflation to deflation: not just a slower increase in the general increasing price level as during disinflation but actually a sustained decrease in the general price level below zero percent per annum which causes an increase in the real value of money, etc.: the opposite of inflation or negative inflation.

Countries (excluding Japan) have little recent experience of deflation. Deflation is generally regarded as a very serious economic problem that everyone is trying to avoid at all costs especially after what happened during the Great Depression.


Copyright © 2008 Nicolaas Smith

Thursday 4 December 2008

Inflation has no effect on the real value of non-monetary items



Geoffrey Whittington, one of the world’s leading experts in inflation accounting and International Financial Reporting Standards stated:

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“Constant Purchasing Power Accounting (CPP) is a consistent method of indexing accounts by means of a general index which reflects changes in the purchasing power of money.” Inflation Accounting, Geoffrey Whittington. P. 73.

It is clear from Whittington’s benchmark book that CPPA can be applied in periods of high and hyperinflation to index or inflation-adjust non-monetary accounts by means of a general index, normally the CPI, which reflects changes in the purchasing power of the functional currency. Accountants in this manner determine the values of non-monetary items when

(1) they account them during the reporting period
(2) calculate the period-end profit or loss and
(3) measure financial capital maintenance in units of constant purchasing power

during high and hyperinflation.

Whittington signed off the preface to his book in 1983. The IASB´s Framework was authorized in 1989.

This book, contrary to Whittington’s book, is not about SA accountants implementing 1970-style inflation accounting in the SA economy during low inflation.

This book is about SA accountants maintaining the real values of constant real value non-monetary items during low inflation in the SA economy by implementing the Constant Purchasing Power Accounting model as authorized in the IASB´s Framework, Par. 104 (a) which forms part of International Financial Reporting Standards.

This book is about SA accountants indexing or inflation-adjusting constant items never or not fully updated in the low inflationary SA economy by means of the CPI which reflects changes in the purchasing power of the Rand, as authorized in the IASB´s Framework which forms part of IFRS.

This book is about SA accountants choosing to measure financial capital maintenance in SA companies in units of constant purchasing power during low inflation as authorized in the IASB´s Framework which forms part of IFRS.

This book is about SA accountants rejecting the stable measuring unit assumption during low inflation as authorized in the IASB´s Framework which forms part of IFRS.

This book is about stopping SA accountants unknowingly destroying about R200 billion of real value in the SA real economy each and every year when they choose to implement the traditional Historical Cost Accounting model instead of the CPPA model as authorized in the IASB´s Framework which forms part of IFRS: because they unknowingly make the Historical Cost Mistake.

This book is about SA accountants being able to maintain about R200 billion of real value in the SA real economy for an unlimited period of time instead of unknowingly destroying it year in year out as they do at the moment.

This book is about SA accountants abandoning the Historical Cost Accounting model and adopting the Constant Purchasing Power Accounting model in SA´s low inflationary economy – as authorized in the IASB´s Framework which forms part of IFRS.

Current reporting period monetary item accounts cannot be indexed or inflation-adjusted under any circumstance because the real value of money cannot be maintained during inflation or deflation under any circumstance.

This book does not propose that the historical costs of variable real value non-monetary items, e.g. property, plant, equipment, shares, stock, raw materials, patents, trademarks, etc, are to be consistently indexed or inflation-adjusted by SA accountants by means of the CPI for the purpose of valuation during the current accounting period, for calculating the period-end profit or loss and for financial capital maintenance during low inflation. Variable items are valued by SA accountants in terms of IFRS or SA Generally Accepted Accounting Practice excluding during hyperinflation when the implementation of International Accounting Standard IAS 29 Financial Reporting in Hyperinflationary Economies is specifically required by the IASB. SA has never experienced hyperinflation which may explain a possible lack of profound analysis of value accounting in SA.

This book is about SA accountants rejecting the stable measuring unit assumption in the SA economy at all levels of inflation and deflation as authorized in the IASB´s Framework which forms part of IFRS.

It is very clear from the IASB´s Framework, Par. 104 (a) that measuring financial capital maintenance in units of constant purchasing power is authorized by the IASB as the basis for a CPPA model at any level of inflation and deflation. The IASB does not state that financial capital maintenance can be measured in nominal monetary units (the traditional HC model) only during low inflation and that it can be measured in units of constant purchasing power (the CPP model) only during high and hyperinflation. It states simply that either the one or the other can be used. That means at all levels of inflation and deflation. It does, however, specifically require IAS 29 during hyperinflation.

In the Framework, Par. 101 the IASB states that companies most commonly use the traditional HC measurement basis to prepare their financial reports and that other measurement bases are used in combination with HC. The IASB does, however, specifically require entities only in hyperinflationary economies – being exceptional circumstances - to implement IAS 29. IAS 29 is based on CPPA. No-where is it stated by the IASB that the basic CPPA model can only be used during high inflation and hyperinflation or that it can not be used during low inflation.

The IASB - as far as measurement bases are concerned - specifically mentions historical cost, current cost, realizable (settlement) value, present value, market value, recoverable value and fair value which SA accountants, in fact, use to value variable items like property, plant, equipment, stock, shares, raw materials, patents, trademarks, etc in terms of IFRS or SA GAAP.

In Par. 104 (a) the IASB authorizes SA accountants to measure financial capital maintenance in units of constant purchasing power which would determine that they use the CPPA model instead of the traditional HC that they use at the moment. Although SA accountants choose to measure financial capital maintenance in nominal monetary units, that is, they choose the HC model, they do, however, use units of constant purchasing power to index or inflation-adjust constant items like salaries, wages, rentals, etc. SA accountants can also use units of constant purchasing power, in terms of Par. 104 (a), to value constant items like retained earnings, issued share capital, other shareholder equity items, trade debtors and creditors, etc to implement a CPP concept of capital maintenance. The IASB notes that entities use various different measurement bases in varying combinations and to different degrees in their financial reports.

We commonly find that SA companies state in their opening notes to their balance sheet that their financial reports have been prepared based on the traditional HC model. We normally find that they use different measurement bases to different degrees and in different combinations including items that are indexed or inflation-adjusted by means of the CPI in SA´s low inflationary economy; e.g. salaries, wages, rentals, utility prices, transport fees, etc. CPP indexing or inflation-adjustment is thus currently a generally accepted accounting practice in SA´s low inflationary economy only for the above-mentioned items.

In the case of salaries and wages the annual CPP indexation or inflation-adjustment normally involves labour union negotiations with employer bodies. To maintain the constant purchasing power of salaries and wages – which are expressed in nominal Rand monetary terms - they normally agree on an annual increase in the nominal Rand payment values of salaries and wages that covers – or compensates for or inflation-adjusts for - at least the expected rate of destruction in the real value of the Rand – which is the monetary medium of exchange in SA for the payment of constant purchasing power salaries and wages - for the period in question – normally the year ahead - plus an additional percentage increase for increases in productivity or for political or social reasons by government employment-contract negotiators.

CPP indexation or inflation-adjustment is thus part of IFRS and it is also a SA generally accepted accounting practice and well understood in SA´s low inflationary economy for constant real value non-monetary items like salaries, wages, rents, etc.

Despite the fact that CPPA is authorized in the IASB´s Framework, Par. 104 (a) as it forms part of IFRS since April 1989 as an alternative choice to the traditional HC model at any level of inflation and deflation, it is, unfortunately, not chosen by a single SA accountant in SA to measure financial capital maintenance in units of constant purchasing power and to value constant items in the balance sheet like retained earnings, issued share capital, other shareholder equity items, taxes payable and receivable, trade debtors and trade creditors, etc. SA accountants value these items at HC. Where CPPA is not applied and these constant items are never or not fully updated SA accountants unknowingly destroy their real values at the rate of inflation because they choose to measure financial capital maintenance in nominal monetary units; that is, they choose the traditional HC model which includes the stable measuring unit assumption.

The real values of these constant real value non-monetary items are not being destroyed by inflation since inflation is a monetary phenomenon and can only destroy the real value of money and other monetary items; namely, in SA, the real value of the monetary medium of exchange, the Rand; that is, the SA functional currency. Milton Friedman, the American economist and Noble Laureate, correctly stated that: Inflation is always and everywhere a monetary phenomenon. Inflation has no effect on the real value of non-monetary items. Inflation cannot erode or destroy the real value of non-monetary items. Erode is, in fact, the same as destroy – there is no difference. SA accountants´ choice of implementing the stable measuring unit assumption as part of the HC model – instead of the CPP option - means that they unknowingly destroy the real values of constant items never or not fully updated in the SA real economy on a massive scale. The erosion or destruction stops the moment they choose to implement the CPPA model no matter what the level of inflation or deflation. The choice is theirs as authorized in the IASB´s Framework which is part of IFRS. It is thus SA accountants´ choice of accounting model and not inflation that is doing the destroying. The real values of these constant items are unknowingly being destroyed by SA accountants because they, unfortunately, implement the stable measuring unit assumption only for the purpose of valuing the above specified constant items. When they value and account constant items like retained earnings, issued share capital, capital reserves, provisions, other shareholder equity items, trade debtors and creditors, taxes payable and receivable, deferred tax assets and liabilities, etc, they assume that changes in the Rand´s general purchasing power are not sufficiently important to require adjustments to the nominal values of these constant items in order to maintain their real values constant over time. They value and account them at their historical costs and unknowingly destroy their real values at the rate of inflation each and every year – as long as they carry on implementing the HC model and the stable measuring unit assumption.

In the same breath, they do exactly the opposite: they now suddenly acknowledge that inflation is destroying the real value of the Rand as a monetary medium of exchange and they index or inflation adjust by means of the CPI constant real value non-monetary items like salaries, wages, rents, pensions, etc by increasing their nominal values at the rate of inflation thus keeping their real values constant over the time period in question.

SA accountants of listed JSE companies comply with IFRS. If SA should enter into hyperinflation they would implement IAS 29. They would then apply the CPPA model and index or inflation-adjust items like retained earnings, issued share capital, capital reserves, provisions, other shareholder equity items, trade debtors and creditors, taxes payable and receivable, deferred tax assets and liabilities, etc by means of the CPI. They would update issued share capital for all JSE listed companies from the date it was contributed, etc and maintain their real values constant under hyperinflation.

When SA is not in a hyperinflationary economy any more they would stop the CPPA model and go back to the real-value-destroying HC model and again destroy all these items´ real values at the rate of inflation or they can choose to carry on with the CPPA model and maintain their real values constant or they can choose to change now to the CPPA model in terms of Par. 104 (a). The choice is theirs since CPPA has already been authorized in the IASB´s Framework since 1989.

Inflation accounting is generally only used in periods of very high inflation, for example in the 1970´s and during hyperinflation, e.g. in the current hyperinflationary economy in Zimbabwe. The IASB´s IAS 29 is only required during hyperinflation. Hyperinflation is defined by the IASB as a cumulative inflation rate of 100% over three years; that is, 26% per annum inflation for three years in a row.

The principal objective of this book is to demonstrate with actual values that SA accountants unknowingly destroy the real value of constant items never or not fully updated in the SA real economy on a massive scale because they choose to measure financial capital maintenance in nominal monetary units in terms of Par. 104 (a); that is, they choose to implement the stable measuring unit assumption as it forms part of the traditional Historical Cost Accounting model only for this purpose.

It is an objective of this book to show that measuring financial capital maintenance in units of constant purchasing power - as authorized in the IASB´s Framework, Par. 104 (a) - is the only way to maintain the real values of constant real value non-monetary items at all levels of inflation and deflation in the SA economy; namely, with a Constant Purchasing Power Accounting model. It is the only way to stop SA accountants unknowingly destroying the real value of constant items on a massive scale in the SA real economy during inflation.

Another objective is to show that there are three distinct economic items in the economy, namely, variable real value non-monetary items, monetary items and constant real value non-monetary items and that they are valued in distinctly different ways during the reporting period when SA accountants choose to measure financial capital maintenance in units of constant purchasing power in terms of Par. 104 (a).

It is an objective of this book to start a process to stop SA accountants unknowingly destroying the real values of constant items at the rate of inflation where they are never or not fully updated in the real economy because they choose to measure financial capital maintenance in nominal monetary units. The objective is thus to get SA accountant to choose the other official option in Par. 104 (a); namely, to measure financial capital maintenance in units of constant purchasing power during low inflation as authorized in IFRS.

Measuring financial capital maintenance in units of constant purchasing power means rejecting the stable measuring unit assumption and with it the traditional Historical Cost Accounting model; that is, it means indexing all constant real value non-monetary items by means of the CPI at all levels of inflation and deflation in the SA economy, except during hyperinflation when indexing of not only constant items but all non-monetary items are to be done, not at the CPI, but, at the parallel rate. See Hyperinflation. Indexing by means of the CPI during hyperinflation as required in IAS 29 is one of the main reasons for its failure as an accounting standard.

The IASB does not state anything in Par 104 (a) about measuring financial capital maintenance in units of constant purchasing power being an option only or specifically for the purpose of inflation accounting in high inflationary and hyperinflationary economies. It is an IASB authorized alternative to the traditional HC model at any level of inflation or deflation as clearly evident from the wording of Par. 104 (a). This book is mainly about that. Obviously, CPPA is also applicable in high inflationary and hyperinflationary periods when inflation accounting per se is normally used. This book is, however, mainly about measuring financial capital maintenance in units of constant purchasing power as an alternative to HCA during low inflation in the SA economy in order to stop SA accountants unknowingly destroying massive amounts of real value in the real economy.

Any accounting practice that adjusts monetary values to compensate for or to correct the effect of the destruction of the monetary medium of exchange’s real value can be seen as inflation accounting since inflation destroys the real value of the monetary unit of account which is used as the monetary medium of exchange in the internal economy. All updating of salaries, minimum wages, rentals, utility prices, etc is currently maintaining the real values of those items in units of constant purchasing power – where it is exactly the same as the inflation rate during the relevant period - even when the main accounting model is stated to be the traditional HCA model.

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.

The IASB authorizes two concepts of capital maintenance in Par. 104 (a): in nominal monetary units; i.e. the HCA model - and in units of constant purchasing power; i.e. the CPPA model. The IASB does not exclude the CPPA model during low inflation. It authorizes it as an alternative to the traditional HCA model at all levels of inflation and deflation. It only mandates that it specifically requires IAS 29, which is based on CPPA, during hyperinflation.

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Copyright © 2008 Nicolaas Smith