Objective of general purpose financial reporting

The objectives of general purpose financial reporting are:

1) Automatic maintenance of the constant purchasing power of capital in all entities that at least break even - ceteris paribus.¹ ²


2) Provision of continuously updated decision-useful financial information about the reporting entity to capital providers and other users.

The objectives try to answer the question: what is accounting suppose to do?

Continuous financial capital maintenance to continuously maintain the real value of capital stable can only be measured in units of constant purchasing power during inflation, hyperinflation and deflation.

Financial capital maintenance in nominal monetary units per se is a complete fallacy, even though it is a very popular accounting fallacy, it is authorized by the IASB in the Framework, Par 104 (a) in 1989 and even though it is 700 years old, a SA Generally Accepted Accounting Practice and forms part of real value destroying generally accepted traditional Historical Cost Accounting used by everyone. It still is a fallacy that costs SA about R200 billion per annum in real value unknowingly, unnecessarily and unintentionally destroyed by SA accountants implementing their very destructive stable measuring unit assumption - the second of the three very popular accounting fallacies - two of which are authorized by the IASB in the exact same Framework, Par 104 (a).

A company has continuously maintained the real value of its capital stable if it has as much capital - expressed in units of constant purchasing power - at the end of the reporting period as it had at the beginning of the period, after excluding any distributions to, and contributions from, owners during the period. Consequently: a profit is earned only if the constant purchasing power of the net assets at the end of the period exceeds the constant purchasing power of net assets at the beginning of the period, after excluding any distributions to, and contributions from, owners during the period.

Continuous financial capital maintenance implies maintaining the constant purchasing power of constant items by continuously applying the monthly CPI during low inflation and deflation. The daily parallel rate is continuously applied during hyperinflation.

Variable items are continuously valued in terms of IFRS excluding the stable measuring unit assumption during low inflation and deflation. Variable items are continuously valued in units of constant purchasing power during hyperinflation by applying the daily parallel rate.

Monetary items are money held and items with an underlying monetary nature valued in nominal monetary units during the reporting period. The net monetary loss or gain from holding monetary items is included in net income.

¹ “It is the overall objective of reporting for price changes to ensure the maintenance of the business as an entity.”

Accounting for Price Changes: An Analysis of Current Developments in Germany, Adolf G Coenenberg and Klaus Macharzina, Journal of Business Finance & Accounting, 3.1 (1976), P 53.

² The Framework, Par 104 (a): "Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power."

Kindest regards,

Nicolaas Smith

Three popular accounting fallacies: two IFRS approved

SA accountants preparing their companies’ financial reports in compliance with IFRS are required, in terms of the IASB´s Framework, Par 104 (a), to choose between measuring financial capital maintenance in nominal monetary units or in units of constant purchasing power. They actually have to choose the one or the other measurement basis. The choice is not made for them like under GAAP where Historical Cost Accounting is the generally accepted accounting model.

The Framework, Par 104 states that the financial and physical concepts of capital stated in Par 102 give origin to the financial and physical capital maintenance concepts.

The Framework, Par 104 (a) states:

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

Consequently, it does not simply state that the economic item financial capital can be measured in nominal monetary units, but, financial capital maintenance can be measured in nominal monetary units. Generally stated financial capital maintenance implies maintaining the real value of financial capital stable – all else being equal. However, under the Historical Cost model it is assumed that the monetary unit of account is stable: the very destructive stable measuring unit assumption. Under the HC model it is thus assumed that the real value of financial capital is maintained stable with measurement in nominal monetary units. The statement that financial capital maintenance can be measured in nominal monetary units which implies that financial capital is maintained stable in real value is a very popular fallacy amongst accountants. It is mostly a deceptive, misleading and false statement. It is only true per se in theory at sustainable zero inflation. It is always false per se during inflation and deflation in real terms. It is only true during low inflation when qualified to the effect that it is required that a company invests 100% of its Issued Share Capital, Share Premium Account and Non-distributable Reserves in revaluable fixed assets which always have a revalued or not revalued total real value equal to the updated real value of the original real values of those items.

The IFRS statement “Financial capital maintenance can be measured … in nominal monetary units” would only be true – per se – in nominal and real value terms in one single theoretical instance: it would only be possible to maintain the nominal and real value of financial capital stable in nominal monetary units per se – all else being equal – at sustainable zero inflation: an economic environment that has never been achieved in monetary history and is not very likely to be achieved any time soon or in the distant future. The above IASB statement is not a fallacy at zero inflation. It is, however, a purely theoretical statement: we have never had, we do not have and we most probably will never have sustainable zero inflation anywhere in the monetary economy.

It is impossible to maintain the real value of financial capital stable with measurement in nominal monetary units per se during low inflation and deflation. The above IFRS statement is thus false in terms of real value during low inflation and deflation. The real value of financial capital measured in nominal monetary units is being destroyed at a rate equal to the inflation rate during low inflation when a SA company has no revaluable fixed assets by its accountant’s choice of the HCA model during low inflation. The nominal value of financial capital is maintained in nominal value by measuring it in nominal monetary units during low inflation and deflation. This is, however, a popular fallacy: a false, misleading, unsound, inappropriate and deceptive notion in real value terms. HCA is an inappropriate accounting model authorized by the IASB which adds to general economic instability in SA´s low inflationary economy. It causes massive destruction of reported constant items´ real values, e.g. the real value of all existing reported Retained Earnings, during low inflation in the SA economy. It causes economic instability in the real economy as the real value of companies´ profits and capital is destroyed in this manner. This is mistakenly blamed on inflation by accounting standard setters, accounting authorities, accounting professors and lecturers as well as accountants.

The above IFRS statement is true in nominal value, false in real value and a fallacy during deflation. It results in economic instability during deflation by creating real value in constant items valued in nominal monetary units.

The IASB approved fallacy of financial capital maintenance in nominal monetary units during low inflation leads to SA accountants unnecessarily, unknowingly and unintentionally destroying about R200 billion per year in the real value of SA companies´ existing reported constant items because of their implementation of the stable measuring unit assumption in SA´s low inflationary environment.

The above is one of the three popular accounting fallacies. They are the following:

1. The stable measuring unit assumption: IFRS approved
2. Inflation erodes companies´ profits and capital (The FASB loves this one)
3. Financial capital maintenance in nominal monetary units: IFRS approved (The IASB loves this one)

These three fallacies constitute the very destructive basis of the traditional generally accepted IFRS authorized Historical Cost Accounting model fully approved in most probably all SA companies.

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

No reproduction without permission.

IFRS statement mainly a destructive fallacy

SA accountants doing their companies’ accounting in compliance with IFRS are required, in terms of the IASB´s Framework, Par 104 (a), to choose between measuring financial capital maintenance in nominal monetary units or in units of constant purchasing power.

The IFRS statement “Financial capital maintenance can be measured … in nominal monetary units” in the Framework, Par 104 (a) is mainly a destructive fallacy.

It would only be true – per se – in nominal and real value terms in one single theoretical instance: It would only be possible to maintain the nominal and real value of financial capital constant in nominal monetary units per se at sustainable zero inflation – an economic environment that has never been achieved in all of monetary history and is not very likely to be achieved any time soon or even in the distant future.

The IASB statement is not a fallacy at zero inflation. It is, however, a purely theoretical statement at zero inflation: We have never had, we do not have and we most probably will never have sustainable zero inflation anywhere in the monetary economy.

Kindest regards,

Nicolaas Smith

Destructive GAAP

SA accountants consider their unknowing destruction of the real value of existing reported constant items in SA companies by their free choice of implementing the stable measuring unit assumption as part of the traditional Historical Cost Accounting model to be similar to the cost of inflation which is not accounted under HCA during low inflation. They are consequently satisfied when it is also not accounted. They do not see the destruction of real value in companies´ profits and capital as a separate item from inflation. To them it is all part of the “erosion” caused by inflation. They are dead wrong. Inflation has no effect on the real value of non-monetary items. Inflation can only destroy the real value of money and other non-monetary items which are items with an underlying monetary nature.

The IASB authorized an alternative basic accounting model, financial capital maintenance in units of constant purchasing power in the Framework, Par 104 (a) which SA accountants are free to choose which would allow them to stop their unknowing destruction caused by their choice of the stable measuring unit assumption during low inflation.

SA accountants do not know they are destroying about R200 billion in real value each and every year when they freely choose, in terms of the Framework, Par 104 (a), an IASB authorized 700 year old traditional, generally accepted accounting model complaint with IFRS; consequently, they do not look for a solution: they ignore the other option in Par 104 (a), namely, financial capital maintenance in units of constant purchasing power.

The cost of inflation, i.e., the net monetary loss from holding monetary items is not accounted under HCA during low inflation. This is not the same as the cost of the stable measuring unit assumption: the unknowing destruction of constant items´ real values by SA accountants´ choice of measuring them in nominal monetary units implementing the stable measuring unit assumption during low inflation, when inflation can only destroy the real value of the Rand, the monetary unit of account. This is the cost of a destructive Generally Accepted Accounting Practice (GAAP) by SA accountants. This cost is also not accounted under HCA during low inflation. It thus appears to be the same as the net monetary loss - the cost of inflation. However, it is not the same, even though the IASB, FASB and most people think it is.

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

No reproduction without permission.

Blind leading the blind

In 2008 I agreed with the statement that inflation destroys the value of non-monetary items which do not maintain their real values. I agreed at the time but later I realized that it is wrong. Inflation has no effect on the real value on non-monetary items. It was stated that SA accountants are not doing the destroying, but inflation. That is dead wrong. They unknowingly destroy about R200 billion per year in the real values of SA banks´ and companies´ reported constant items, e.g. reported Retained Profits, never maintained, either under SA GAAP or implementing the stable measuring unit assumption.

SA accountants, it was stated, simply do not record this destruction. So, SA accountants know and admit that there is real value being destroyed. It is dead right when it is stated that they do not record this destruction. Why? Because SA accountants also mistakenly think it is caused by inflation. They maintain that it is the monetary authorities´ task to contain inflation which would reduce this cost. They mistakenly regard the destruction caused by their choice to implement the stable measuring unit assumption as “the erosion of business profits and invested capital caused by inflation” (FASB). They consider it to be similar to the cost of inflation which is not accounted under HCA during low inflation. They are consequently satisfied when it is also not accounted. They do not see it as a separate item. To them it is all part of the “erosion” caused by inflation.

Inflation is the well known enemy number one. SA accountants´ choice of the stable measuring unit assumption is the unknown but real enemy number two camouflaged by the fact that it has been authorized by the International Accounting Standard Board in International Financial Reporting Standards with its statement in the Framework, Par 104 (a) in 1989 that financial capital maintenance can be measured in nominal monetary units. That statement is only theoretically true as an accounting principle. It is impossible to maintain capital in nominal monetary units - per se - in our low inflationary economies.


IFRS are principles-based standards. That statement is only, in fact, true at sustainable zero inflation, an economic environment that has never been achieved in the past and is not likely to be achieved any time soon in the future - if ever. The IASB´s statment is generally false: it is false for all of economic history as well as the current state of the world and SA economy: it is thus generally false and can even be considered a fantasy. It´s result is the destruction by SA accountants - who freely choose the stable measuring unit assumption - of about R200 billion in the real value of SA banks´ and companies´ constant items never maintained in SA´s low inflation environment each and every year.
Almost like the blind leading the blind. Everybody blinded by an IFRS fantasy principle which is part of SA GAAP and the basis of the 700 year old traditional Historical Cost Accounting model.

All this can be stopped when SA accountants freely choose the other option also authorized by the IASB twenty years ago in the Framework, Par 104 (a):

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

Copyright © 2005 - 2010 Nicolaas J Smith

SA´s second enemy camouflaged by IFRS approval

It was stated that inflation destroys the value of non-monetary items which do not maintain their real values. I agreed at the time but later understood that this is wrong. Inflation has no effect on the real value on non-monetary items. To that way of thinking SA accountants are not doing the destroying, but inflation. That is dead wrong. SA accountants unnecessarily and unknowingly destroy about R200 billion per year in the real values of SA banks´ and companies´ reported constant items, e.g. reported Retained Profits, never maintained either under SA GAAP or with their free choice of measuring financial capital maintenance in nominal monetary units implementing the stable measuring unit assumption in terms of the IASB´s Framework, Par. 104 (a) which states that financial capital maintenance can be calculated in either units of constant purchasing power or in nominal monetary units.

According to that view, SA accountants simply do not record this destruction. That is dead right: they do not record it because they also mistakenly think it is caused by inflation and they can do nothing about it as their actions do not affect inflation. They mistakenly think the cost of the stable measuring unit assumption is similar to the cost of inflation: the net monetary loss from holding monetary items, the only harm caused - and able to be caused - by inflation, which is not accounted under HCA during low inflation. It is not the same.

What SA accountants ignore is the fact that the IASB authorized an alternative basic accounting model, financial capital maintenance in units of constant purchasing power in the Framework, Par. 104 (a) twenty years ago which they are free to choose which will allow them to stop their unknowing destruction of about R200 billion in the real value of SA banks´ and companies´ constant items which they unknowingly destroy each and every year by measuring them in nominal monetary units implementing their very destructive stable measuring unit assumption under HCA in SA´s low inflationary economy.

The cost of inflation, i.e., the net monetary loss from holding monetary items is not accounted under HCA during low inflation. This is not the same as the cost of the stable measuring unit assumption: the unknowing destruction of constant items´ real values by SA accountants´ choice of measuring them in nominal monetary units implementing the stable measuring unit assumption during low inflation, when inflation can only destroy the real value of the Rand, the monetary unit of account. The latter is the cost of a destructive Generally Accepted Accounting Practice (GAAP) by SA accountants, namely, valuing constant items in nominal monetary units implementing the stable measuring unit assumption during low inflation. This cost is also not accounted under HCA during low inflation. It thus appears to be exactly the same as the net monetary loss - the cost of inflation. However, it is not the same, even though most people think it is.

The indisputable proof - from an accounting standards point of view - that inflation does not destroy the value of non-monetary items which do not maintain their real values is the fact that the cost of this destruction is not calculated as part of the net monetary loss in FAS 33: US Statement of Financial Accounting Standards No. 33 Financial Reporting and Changing Prices. It is thus a mistaken view. FAS 33 required the purchasing power gain or loss on net monetary items to be presented as supplementary information in published annual reports in companies using HCA during inflation.

IAS 29 also requires the calculation of the net monetary gain or loss from holding monetary items, but, during hyperinflation rejecting the stable measuring unit assumption; i.e. measuring all non-monetary items in units of constant purchasing power. There is no cost from the stable measuring unit assumption when it is not applied. In practice, it is normally exactly the opposite in hyperinflationary economies which do not follow the Brazilian example by indexing all non-monetary items. In practice, it is the stable measuring unit assumption that is applied even under hyperinflation which hyper-destroys the non-monetary or real economy together with hyperinflation in monetary items which hyper-destroys the monetary economy. The two enemies in the economy: the one seen as a monster, the other – wreaking maybe even more damage – a stealth enemy camouflaged by IFRS approval.

Copyright © 2005 - 2010 Nicolaas J Smith

Capital is a variable item or monetary item in SA

Capital is a constant real value non-monetary item.

However, there is no constant real value non-monetary item capital in South Africa under the Historical Cost Accounting model during low inflation.

Issued Share Capital and Share Premium Account values are, in fact, treated as variable items under HCA when a SA company owns revaluable fixed assets.

Issued Share Capital and Share Premium Account real values depend on the variable real non-monetary values of the fixed assets over time determined at fair value in terms of IFRS during low inflation.

When SA companies have no revaluable fixed assets under HCA, capital is, in principle, treated the same as a monetary item (money or cash) and SA accountants unknowingly destroy its real value at a rate equal to the rate of inflation because of their choice of the HCA model which include their very destructive stable measuring unit assumption in SA´s low inflationary environment.

Capital will only become a constant real value non-monetary item in the SA economy when SA accountants freely choose financial capital maintenance in units of constant purchasing power as authorized by the IASB in the Framework, Par. 104 (a) twenty years ago. This is compliant with IFRS.

SA accountants are told that it is not them but inflation doing the destroying. That statement is dead wrong.  Most people think it is inflation doing the destroying. The US FASB sums up this view very well in its statement: “ the erosive impact of inflation on profits and capital ".

Copyright © 2005-2010 Nicolaas J Smith

Sticky salaries and wages

The constant real value non-monetary items salaries and wages are generally sticky downwards: it is not easy for firms to reduce them in nominal value.

It is, of course, very easy to reduce their real values during inflation: just keep them the same or increase them at a rate lower than the inflation rate.

It may happen that it could be some time before the concept of enhanced economic stability during deflation via financial capital maintenance in units of constant purchasing power is generally accepted.

Salaries and wages would then be automatically decreased in nominal value by means of measurement in units of constant purchasing power while their real values would stay the same during deflation. This would improve economic stability substantially and help central banks in their task of getting the economy into a low inflationary mode again. It would also reduce the level of the monetary effect of lower prices during deflation.

Salaries and wages are already being decreased in nominal value in the labour market during deflation, but, not yet by measuring them in units of constant purchasing power in terms of the negative change in the CPI.

There is a lot to be learned about how financial capital maintenance in units of constant purchasing power as authorized by the IASB in the Framework, Par. 104 (a) as an alternative to the real value destroying traditional Historical Cost Accounting model would enhance general economic stability substantially during both low inflation and deflation. It would remove a great part of the distortion in the economy caused by SA accountants´ choice to implement their very destructive stable measuring unit assumption.

This is besides maintaining about R200 billion per annum in the SA constant item economy unnecessarily, unknowingly and unintentionally currently being destroyed by SA accountants´ choice of the stable measuring unit assumption during low inflation.

SA accountants mistakenly blame their unnecessary, unknowing and unintentional destruction of the real value of companies´ capital and profits on inflation since they do not value and account it the same way they do not value and account the net monetary gain or loss from holding monetary items during low inflation and deflation although this can be done according to Kapnick.

SA accountants can not stop the destruction of real value of monetary items in the SA monetary economy. The SARB with its monetary policy and the government with its economic policies have to reduce inflation which would reduce the amount of real value destruction in the monetary economy. The late Milton Friedman so famously stated "Inflation is always and everywhere a monetary phenomenon." Inflation can only destroy the real value of the Rand and other monetary items in the SA monetary economy - nothing else. Inflation has no effect on the real value of non-monetary items

“Purchasing power of non monetary items does not change in spite of variation in national currency value.”

Prof Dr. Ümit GUCENME, Dr. Aylin Poroy ARSOY, Changes in financial reporting in Turkey, Historical Development of Inflation Accounting 1960 - 2005, Page 9.

SA accountants can easily stop their about R200 billion annual destruction of the profits and capital of SA banks and companies and its negative effect on economic growth and employment during low inflation.

When SA accountants freely choose to measure financial capital maintenance in units of constant purchasing power as the IASB authorized them 20 years ago, they would value and account the cost of inflation during low inflation as they are already required (forced) to do during hyperinflation in terms of IAS 29 Financial Reporting in Hyperinflationary Economies. They would also maintain about R200 billion in SA banks´ and companies´ existing profits and capital by not unknowingly destroying that amount each and every year as they are unknowingly doing right now in existing reported constant items, e.g. all reported Retained Profits in all SA banks and companies, never maintained in the SA non-monetary or real economy with their very destructive stable measuring unit assumption during low inflation. This would have a positive impact on economic growth and employment for an unlimited period of time.

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

No reproduction without permission.

IASB got it wrong: there are 3 not just 2

"One can say that capital, as a category, did not exist before double-entry bookkeeping". Werner Sombart

Professor William Paton noted in 1922, "the value of the dollar — its general purchasing power — is subject to serious change over a period of years... Accountants... deal with an unstable, variable unit; and comparisons of unadjusted accounting statements prepared at intervals are accordingly always more or less unsatisfactory and are often positively misleading.”

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

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

Non-monetary items are subdivided in

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

Constant items are non-monetary items with constant real non-monetary values measured in units of constant purchasing power in terms of the CPI over time normally expressed in terms of money in a non-hyperinflationary economy.

Hyperinflation is defined as an exceptional circumstance by the IASB and all non-monetary items – variable and constant items - are required to be valued in units of constant purchasing power in terms of IAS 29 Financial Reporting in Hyperinflationary Economies.

IAS 29 defines monetary items incorrectly as “money held and items to be received or paid in money”. Most items, monetary and non-monetary items are generally received or paid in money as the monetary medium of exchange. The fact that the IASB defines non-monetary items as all items in the income statement and all other assets and liabilities in the balance sheet that are not monetary items, after having defined monetary items incorrectly, leads to the wrong classification of some non-monetary items, notably trade debtors and trade creditors, as monetary items by the Board. This results in the net monetary gain or loss being calculated incorrectly by companies implementing IAS 29 in hyperinflationary economies.

The above definition of non-monetary items describes them generically. It is thus defined by the IASB that there are only two fundamentally distinct items in the economy: monetary and non-monetary items and that the economy is divided into two parts: the monetary economy and the non-monetary or real economy. IAS 29 and other IFRS are based on this premise.

It is not true that there are only two basic economic items as defined by the IASB. There are three fundamentally different basic economic items in the economy:

1. Monetary items
2. Variable items
3. Constant items

The above definition of constant items is confirmed by the IASB in the Framework by implication. The fact that certain non-monetary items have constant real non-monetary values is implied by the IASB in the Framework for the Preparation and Presentation of Financial Statements.

“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." Deloitte, IAS Plus

IAS 8.11
“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 are no applicable IFRS or Interpretations regarding the capital concept, the capital maintenance concept and the valuation of constant items. The explicit and implied definitions of these items in the Framework are thus applicable.

The Framework, Par. 102 states that most companies choose a financial concept of capital to prepare their financial reports. An entity’s capital is the same as its shareholders´ equity or net assets when it adopts a financial concept of capital, for example, invested purchasing power or invested money.

Par. 103 states that the needs of financial report users should determine the choice of the correct concept of capital by a company. If the users of financial reports are mainly concerned with the maintenance of nominal invested capital or the maintenance of the purchasing power of invested capital then a financial concept of capital should be chosen.

Par. 104 states that the concepts of capital stated in Par. 102 give origin to the financial capital maintenance concept. Par. 104 (a) states:

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

Constant items are non-monetary items with constant purchasing power non-monetary values measured in units of constant purchasing power in terms of the CPI over time normally expressed in terms of money in a non-hyperinflationary economy.

Kindest regards,

Nicolaas Smith

SA´s second economic enemy

There are two processes of systemic real value destruction in the SA economy, although it is generally accepted that there is only one economic enemy. This is a mistake. The first process is by the well known enemy inflation. This economic enemy manifests itself in the Rand´s store of value function and only destroys real value in the SA monetary economy. Inflation can only destroy the real value of the Rand and other monetary items in the SA monetary economy - nothing else. Inflation has no effect on the real value of non-monetary items.

The second economic enemy is SA accountants´ choice of traditional HCA which includes their very destructive stable measuring unit assumption. This second process of systemic real value destruction manifests itself in accountants´ stable measuring unit assumption only in the constant item part of the SA non-monetary or real economy when they freely choose to measure financial capital maintenance in nominal monetary units when they implement the traditional HCA model in most SA companies during low inflation.

Accountants (and everyone else) make the mistake of blaming the destruction of companies´ profits and capital by their choice of traditional HCA - which includes the stable measuring unit assumption - on inflation.

Accountants identify the problem, namely, that the real value of companies´ profits and capital are being destroyed over time during inflation when implementing HCA. They blame inflation.

The US Financial Accounting Standards Board blames inflation:

“In Mr. Mosso's view, conventional accounting measurements fail to capture the erosion of business profits and invested capital caused by inflation.”

Statement of Financial Accounting Standard No. 33, P. 24


They blame the wrong enemy. They blame inflation when it is in fact their free choice of traditional HCA; specifically the stable measuring unit assumption. When they freely choose financial capital maintenance in units of constant purchasing power, as the IASB authorized them 20 years ago, they would stop their unknowing and unintentional destruction forever. It is thus completely unnecessary and easily avoidable destruction by SA accountants´ choice of traditional HCA of the investment base and long term capital of SA banks and companies and their corollaries: sustainable economic growth and employment.

Everyone only sees one enemy in the economy being responsible for all of the invisible and untouchable systemic real value destruction in the economy. They think inflation is responsible for all real value destruction in the economy.

SA accountant feel that the SARB with its monetary policies and the SA government with its economic policies should lower inflation which would lower the destruction of companies´ profits and capital.

They are under inflation illusion: the mistaken belief that inflation destroys companies´ profits and capital when it is accountants´ choice of HCA - which includes the stable measuring unit assumption.

This second enemy is a stealth enemy since the way it operates is not understood by SA accountants and accounting lecturers at SA universities. If they understood it, they would have stopped it by now as they have been authorized by the IASB in the Framework, Par. 104 (a) in 1989.

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

No reproduction without permission.

SA accountants blame inflation but admit it´s the stable measuring unit assumption

SA accountants unknowingly destroy the real value of reported Retained Profits in companies over time during low inflation implementing their very destructive stable measuring unit assumption as part of the real value destroying traditional HCA model in exactly the same way as the real value of your salary is destroyed over time during low inflation when your salary is measured in nominal monetary units, i.e. when it is not updated during low inflation.

The real value of your salary is also not destroyed by inflation because inflation can not destroy the real value of any non-monetary item and never has in the past. Your salary is a non-monetary item as defined by the IASB in IAS 29 where it is stated that all income statement items are non-monetary items, in fact, they are all constant real value non-monetary items. Inflation can only destroy the real value of money and other monetary items - nothing else.

It is SA accountants´ choice of measuring unit that destroys the real value of your salary when your salary is measured in nominal monetary units (actually SA accountants´ stable measuring unit assumption) because your salary can be measured in units of constant purchasing power, i.e. it can be inflation-adjusted. Then it will not matter what the rate of inflation is, the real value of your salary will always be maintained: 2% or 2000% like in the case of Brazil which during 30 years of hyperinflation of up to 2000% inflation per annum maintained their real or non-monetary economy stable with indexation (which is, in principle, the same as valuation in units of constant purchasing power) while they had up to 2000% annual inflation in their monetary economy.

It is exactly the same with reported Retained Profits.

SA accountants unnecessarily, unknowingly and unintentionally destroy the real value of all existing reported Retained Profits never maintained in all SA companies, currently at 5.9% per annum, with their very destructive stable measuring unit assumption - all else being equal. They can freely stop their continuous destruction of SA companies´ long term capital and investment base with its negative impact on economic growth and employment, by freely choosing to measure financial capital maintenance in units of constant purchasing power in terms of the IASB´s Framework, Par. 104 (a). SA accountants unknowingly destroy about R200 billion per annum in SA companies´ existing reported constant items never maintained in this manner.

SA accountants blame this on inflation.

SA accountants are very strongly under inflation illusion.


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

No reproduction without permission.

Inflation illusion

Most accountants agree  that "inflation influences reported results". Everybody blames "inflation". Yes, inflation destroys the real value of money and other monetary items - but, nothing else. Inflation has no effect on the real value of non-monetary items.

“Purchasing power of non monetary items does not change in spite of variation in national currency value.”

Prof Dr. Ümit GUCENME, Dr. Aylin Poroy ARSOY, Changes in financial reporting in Turkey, Historical Development of Inflation Accounting 1960 - 2005, Page 9.

Because the net montary gain or loss from holding monetary items is not accounted under HCA, the monetary item cost of inflation is not accounted in low inflationary economies. Everybody, and I mean everybody: IASB, FASB, all accountants, all economists, etc, they all think it is "inflation" "eroding" companies´ capital, as they say. They never say destroy when erode and destroy are exactly the same thing in this case.

However, it is simply accountants with their free choice of the stable measuring unit assumption who are unknowingly and unintentionally destroying the real value of existing reported constant items never maintained, e.g. reported Retained Profits, during low inflation. No-one forces them into HCA. Because "they simply do not record it"  they think the "erosion" of the real value of companies´ profits and captial is also done by "inflation" and this cost or destruction of real value is also "not recorded". So, they are all very blasé about the situation: Gill Marcus and the ANC control inflation according to them.

The central bank with its monetary policy and the government with its economic policies have to bring down inflation and lower the "erosion" of companies´ profits and capital caused by "inflation". Everybody thinks it has absolutely nothing to do with accountants, accounting standard setters and the 700 year old traditional Historical Cost Accounting model.

Meanwhile, the IASB has actually already approved the Framework, Par. 104 (a) twenty years ago stating "Financial capital maintenance can be measured in either nominal monetary units (HCA as the whole world does) or units of constant purchasing power". The units of constant purchasing power option would stop this completely unnecessary and unknowing destruction of real value in existing reported constant items never maintained by SA accountants forever.

Why don´t they do it? It´s been there for 20 years! They are highly educated and very experienced accountants, aren´t they?

Accountants were prisoners of Generally Accepted Accounting Practice till 1989. The IASB set them free from HCA with Par. 104 (a) 20 years ago. Most of them don´t know that. Since they think the rate of inflation equivalent destruction of the real value of companies´ existing reported retained profits and capital, not backed by sufficient revaluable fixed assets, is inflation´s fault, they do not look for a solution in IFRS. They do not know there is an IFRS solution for a national economic problem they do not even know they cause directly. They do not know their choice of HCA is the cause of the problem. They do not even know they make a choice. They think there is no choice - like under GAAP. They can freely change to the IFRS compliant IASB approved option of measuring financial capital maintenance in units of contstant purchasing power during low inflation and deflation any time they want. No-one stops them.

They think it is "inflation" doing the destroying and they state: it is not recorded just like the destruction of the real value of the Rand and other monetary items - the actual and only harm done by inflation - is not recorded under HCA, although it can be done according to Harvey Kapnick, a past president of Arthur Anderson.

I call this inflation illusion: the mistaken belief that inflation destroys companies´ profits and capital when it is accountants´ choice of HCA which includes the stable measuring unit assumption.

It is clear that when you have R40 billion in existing reported Retained Profits, then R2.4 billion of its real value would be destroyed during a year when Retained Profits are valued in nominal monetary units and inflation destroys 6% of the real value of the Rand, the monetary unit of account in SA. Everyone will also agree that when accountants freely choose to measure financial capital maintenance in units of constant purchasing power as approved by the IASB in the Framework, in Par. 104 (a) in 1989, then the real value of that R40 billion at the beginning of the year (stated in beginning of the year CPI value) would be R42.4 billion at the end of the year CPI value. When it is not done which is the current situation in SA, then those accountants are unnecessarily destroying R2.4 billion of the real value of the R40 billion - as all accountants in SA are doing right now in companies with existing reported Retained Profits in their companies. No-one can deny that.

It is not a matter of extra money to maintain capital: it is a capital maintenance concept in a double entry accounting model: it is a matter of measuring financial capital maintenance in units of constant purchasing power by implementing a double entry accounting model in all the company´s assets, liabilities, income and expenses in a low inflationary environment - as approved by the IASB 20 years ago and compliant with IFRS.

So, it is not inflation doing the destroying. It is SA accountants freely choosing to measure financial capital maintenance in nominal monetary units in terms of the IASB´s Framework, Par. 104 (a) whereby they implement the traditional HCA model which includes their very destructive stable measuring unit assumption. They simply assume that the destruction of the real value of the Rand below 26% per annum for 3 years in a row is not sufficiently important for them to change to measuring financial capital maintenance in units of constant purchasing power. They only inflation-adjust some income statement items, e.g. salaries, wages, rentals, etc during inflation below 26% per annum for 3 years in a row.

When inflation increases to 26% per annum for 3 years in a row and above, they immediately change their minds: then they would inflation-adjust not only constant items but also variable items. They would inflation-adjust all non-monetary items as required by IAS29.

But, only as long as annual inflation stays above 26% for three years in a row. When inflation drops below 26% per annum for 3 years in a row, they will again refuse to inflation-adjust capital and retained profits: they will happily go back and unknowingly destroy those real values at, say 20% per annum - as they are doing now at 5.9% and as they were doing not so long ago at 13% annual inflation in SA.

Strange, isn´t it? Well, SA accountants unnecessarily, unknowingly and unintentionally destroy about R200 billion per annum in real value in the long term capital and investment base and its corollaries, economic growth and employment, in SA companies each and every year - all else being equal. They will carry on with their annual unknowing destruction as long as they refuse to abandon their very destructive stable measuring unit assumption while SA experiences low inflation up to 26% per annum for 3 years in a row.

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

The IASB and FASB still get this wrong - but not street vendors.

Money cannot be declared by statute or by institutional definition to be a non-monetary item. Money is either money or it is not money. To be money it has to fulfil the three functions of money in an economy: medium of exchange, store of value and unit of account.

This applies to non-monetary items too. Trade debtors and trade creditors are defined incorrectly by the International Accounting Standards Board and US Financial Accounting Standards Board to be monetary items. They are generally non-monetary items. Defining them as monetary items means the net monetary gain or loss in companies with trade debtors and trade creditors will always be calculated incorrectly under the IASB and FASB definition.

They are generally non-monetary items. All street vendors in hyperinflationary economies know that trade debtors and trade creditors (or their equivalents) are non-monetary items by experience, even if they have never been to school.

The IASB and FASB still get this wrong.

Who else got it right? Brazil got it right for 30 years from 1964 to 1994 as confirmed by the previous head of the Central Bank of Brazil, Dr Gustavo Franco:

When I asked him: "Were trade debtors and trade creditors treated as monetary items under the URV and not updated or were they treated as non-monetary items an updated in terms of the Unidade Real de Valor? What are trade debtors and trade creditors in your opinion? Are they monetary or non-monetary items?"

He responded: "Dear Mr. Smith

I am not sure I understood your question. If I got it right, two observations are in order. First, for spot transactions the existence of the URV is imaterial, sums of means of payment are surrendered in exchange for goods, all delivered and liquidated on spot. Second, the unit of account enteres the picture only when at least one leg of a commercial transaction is defferred. In this case, the URV serves the purpose of defining the price at the day of the contract. The same quantity of URVs are to be paid at the payment day, though this should represent larger quantities of whatever means of payment is used.

It was essentil, in the Brazilian case, and this may be a general case, that the URV was defined as part of the monetary system. It has a lot to do with jurisprudence regarding monetary correction; URV denomiated obligation had to be treated as if they were obligations subject to monetary correction. In the URV law it was defined that the URV would be issued, in the form of notes, and when this would happen, the URV would have its name changed to Real, and the other currency, the old, the Cruzeiro, was demonetized.

Att

GF"

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

No reproduction without permission.

Capital as a variable item and as a constant item

I am not dealing with the value of a business entity´s capital or stock as determined in the market.

As we all know, the term capital has many meanings. As far as it relates to a company it also refers to various different things.

The capital of a business entity has, amongst others, the following two meanings:

(1) The market capitalization of a company; i.e. the market value of one share times the number of shares issued. This "capital" or stock of a company is a variable real value non-monetary item. Its value is determined in the market at market price as per IFRS. I agree 100% with that.

(2) The shareholders´ equity which includes, issued share capital, share premium account, reported retained profits, retained losses, share discount account, capital reserves, revaluation reserve, etc. These items are all constant real value non-monetary items. Currently they are being valued in nominal monetary units by HC accountants world wide during low inflation with the exception of the accounting process of property revaluations via the revaluation reserve account. Only the real value of issued share capital and share premium account can be maintained via sufficient property revaluations via the revaluation reserve account. This real value maintenance can not be applied to other reported items in shareholders´equity, e.g. reported retained profits.

All items in shareholders´ equity are constant real value non-monetary items and - in order to maintain their real values constant during low and hyperinflation - their real values have to be valued in units of constant purchasing power during low inflation and hyperinflation by means of financial capital maintenance in units of constant purchasing power. When this is not done, i.e. when they are currently valued in nominal monetary units, their real values are being destroyed by HC accountants implementing their very destructive stable measuring unit assumption - with the exception of issued share capital and share premium account, the real values of which can be maintained indefinitely with sufficient unreported and hidden revaluable holding gains in fixed property.

I only deal with the valuation of constant real value non-monetary items in companies. I only deal with the "capital" of a company as defined in (2). As far as (1) is concerned, I agree 100% with its valuation in terms of IFRS; i.e., at market value.

Kindest regards,

Nicolaas Smith

Why low inflation is better than no inflation.

1. Low inflation is helpful to economic growth. See previous blog.

2. Maintaining a zero inflation monetary policy can lead to unpredictability and instability in the economy. An inflation targeting policy like the SARB´s 3 to 6 percent target range seeks to maintain a constant rate of inflation. Unfortunately inflation always moves to the top of the target range, thus doubling the cost of inflation in SA´s case. At continuous 3% annual inflation only R60 billion per annum will be destroyed in the real value of the Rand and SA accountants will only unknowingly destroy about R100 billion in the real value of existing constant items (e.g. reported Retained Profits) in the SA real economy with their very destructive stable measuring unit assumption instead of double these values as currently happens. Adherence to a constant low rate allows firms to make reasonable predictions in the future about price and wage levels, but, it causes structural or built-in inflation in the economy. A zero inflation policy would attempt to correct for past deviations. A past period of inflation would have to be corrected by a period of deflation. Past deviations cannot be let go as zero inflation (a set price level) has to be maintained. This need to correct past deviations means that the monetary authority might have to take drastic action to swing the economy in the other direction and so actually increase unpredictability and instability in the economy rather than decrease it.

3. Zero inflation increases the risk of the economy slipping into deflation. The decrease in prices causes nominal wages to fall while their real values increase and fewer goods to be produced, which in turn causes prices to fall further causing further decreases in nominal wages but increases in real wages under the current Historical Cost Paradigm. Production and employment normally decrease too. A low rate of inflation provides a safety barrier against this. Deflation is also very hard for a monetary authority to correct. See Japan’s “ten lost years”. Interest rates typically cannot be used at a negative rate.

4. Downwards stickiness in prices and wages. Wages in particular are very hard to negotiate downwards as workers and trade unions are naturally very reluctant to accept nominal cuts in wages in an inflationary environment. However, if downward adjustments were not possible the disequilibrium in the economy would cause instability and a decrease in economic growth. A low inflation rate allows real wage decreases, while avoiding nominal cuts simply by having no wage increase or a wage increase rate lower than that of inflation. It is in this sense that inflation has been called the grease on the wheels of the economy.

5. Avoiding a possible liquidity trap. If an economy finds itself in a recession with already low, or even zero, nominal interest rates, then the central bank cannot cut these rates further (since negative nominal interest rates are impossible) in order to stimulate the economy.This is known as a liquidity trap. A moderate level of inflation tends to ensure that nominal interest rates stay sufficiently above zero so that if the need arises the bank can cut the nominal interest rate. Some economists assert that even under an occurrence of a liquidity trap, expansive monetary policy could still stimulate the economy via the direct effects of increased money stocks on aggregate demand. This was essentially the hope of both the Bank of Japan in the 1990s, when it embarked upon quantitative easing and of the central banks of the United States and Europe in 2008-9, with their foray into quantitative easing. All these policy initiatives are attempts to stimulate the economy through methods other than the mere reduction of short-term interest rates.

6. The real interest rate is normally still positive at low levels of inflation; thus, inflation provides a savings and investment incentive as it is preferential to save or invest than just have your money on deposit at no return thus losing real value at the rate of inflation.

Kindest regards,

Nicolaas Smith

Inflation and Economic Growth

“The South African Reserve Bank (the SARB) is the central bank of the Republic of South Africa. It regards its primary goal in the South African economic system as "the achievement and maintenance of price stability.

The South African Reserve Bank conducts monetary policy within an inflation targeting framework. The current target is for CPI inflation to be within the target range of 3 to 6 per cent on a continuous basis. The Bank has a floating exchange rate policy and there are no exchange rate targets.

Financial stability is not an end in itself, but, like price stability, is generally regarded as an important precondition for sustainable economic growth and employment creation.”

SARB

The average annual inflation rate in SA has been 6% over the last 10 years while Tito Mboweni was the Governor of the SARB. This is half the 12% average annual inflation rate during the 18 years before Mboweni took over the helm at SA´s central bank.

SA is thus committed to low inflation. This is the correct policy.

“Real economic gain can be achieved by reducing the trend growth of money.”

Money, Inflation and Economic Growth. Keith Carlson, Federal Reserve Bank of St. Luis. 1980

“Monetary policymakers have assumed that faster sustainable growth can only occur in a climate where the inflation monster is tamed.

A reduction in inflation of even a single percentage point leads to an increase in per capita income of 0.5 percent to 2 percent.

As the authors point out, their analysis leaves little room for interpretation. Inflation is not neutral, and in no case does it favor rapid economic growth. Higher inflation never leads to higher levels of income in the medium and long run, which is the time period they analyze. This negative correlation persists even when other factors are added to the analysis, including the investment rate, population growth, schooling rates, and the constant advances in technology. Even when the authors factor in the effects of supply shocks characteristic of a part of the analyzed period, there is still a significant negative correlation between inflation and growth.

Inflation not only reduces the level of business investment, but also the efficiency with which productive factors are put to use. The benefits of lowering inflation are great, according to the authors, but also dependent on the rate of inflation. The lower the inflation rate, the greater are the productive effects of a reduction. For example, reducing inflation by one percentage point when the rate is 20 percent may increase growth by 0.5 percent. But, at a 5 percent inflation rate, output increases may be 1 percent or higher. It is therefore more costly for a low inflation country to concede an additional point of inflation than it is for a country with a higher starting rate. Given their detailed analysis, the authors conclude that "efforts to keep inflation under control will sooner or later pay off in terms of better long-run performance and higher per capita income.”

Does Inflation Harm Economic Growth? Evidence for the OECD: Javier Andres, Ignacio Hernando, The US National Bureau of Economic Research, 1997

“The tests revealed that a weak negative correlation exists between inflation and growth, while the change in output gap bears significant bearing. The causality between the two variables ran one-way from GDP growth to inflation.

Correlation coefficients showed only a weak negative link, while causality was shown to run from economic growth to inflation. With the majority of Fiji’s inflation being imported, the influence of domestic factors (being unit labour costs and to a lesser extent the output gap) is limited. The findings of other empirical studies, however, provide some guidance for Fiji policymakers on the importance of maintaining low inflation, in order to foster higher economic growth. For its part, the Reserve Bank of Fiji will need to maintain monetary policy consistent with low inflation and inflation expectations.”
Relationship between Inflation and Economic Growth: Gokal and Hanif, Reserve Bank of Fiji, 2004

“ There are also significant feedbacks between inflation and economic growth. These results have important policy implications. Moderate inflation is helpful to growth, but faster economic growth feeds back into inflation.

Attempts to achieve faster economic growth may overheat the economy to the extent that the inflation rate becomes unstable. Thus, these economies are on a knife-edge. The challenge for them is to find a growth rate which is consistent with a stable inflation rate. They need inflation for growth, but too fast a growth rate may accelerate the inflation rate and take them downhill as found by Bruno and Easterly (1998).”
INFLATION AND ECONOMIC GROWTH: EVIDENCE FROM FOUR SOUTH ASIAN COUNTRIES, Asia-Pacific Development Journal Vol. 8, No. 1, June 2001, Girijasankar Mallik and Anis Chowdhury

Kindest regards,

Nicolaas Smith

Who drives inflation - Part 1

Who drives inflation, Kalinka asked a day or two ago.

Inflation is always and everywhere the destruction of the real value of money.

Mainstream economists state that inflation is a rise in the general level of prices of goods and services in the economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation destroys the purchasing power of money – the destruction of the real value of the internal medium of exchange and unit of account in the economy. Monetarists believe the most significant factor influencing inflation is the management of money supply through the easing or tightening of credit via the central bank’s interest rate policy.

The Austrian School states that inflation is an excessive increase in the money supply by central banks. They want to ban them and go back to the gold standard.

Economists generally agree that high rates of inflation and hyperinflation are caused by an excessive growth of the money supply. Views on which factors determine low to moderate rates of inflation are more varied.

Rational expectations result in the outcome depending partly on what people expect to happen.

Adaptive expectations means that people form their expectations about what will happen in the future based on what has happened in the past. For example, if inflation has been higher than expected in the past, people would expect the same to happen in the future.

Structural inflation (built-in inflation) is an economic term referring to inflation that results from past events and persists in the present. It then becomes a normal aspect of the economy, via inflationary expectations and the price/wage spiral.

Inflationary expectations play a role because if workers and employers expect inflation to persist in the future, they will increase their (nominal) wages and prices now. This means that inflation happens now simply because of subjective views about what may happen in the future. Of course, following the generally accepted theory of adaptive expectations, such inflationary expectations arise because of persistent past experience with inflation.

The price/wage spiral refers to the adversarial nature of the wage bargain in modern capitalism. Workers and employers usually do not get together to agree on the value of real wages. Instead, workers attempt to protect their real wages (or to attain a target real wage) by pushing for higher money (or nominal) wages. Thus, if they expect price inflation - or have experienced price inflation in the past - they push for higher money wages. If they are successful, this would raise the costs faced by their employers – if they do not inflation-adjust their selling prices – which they do. To protect the real value of their profits (or to attain a target profit rate or rate of return on investment), employers then pass the higher costs on to consumers in the form of higher prices. This encourages workers to push for higher money wages again as the cycle starts all over.
In the end, built-in inflation involves a vicious circle of both subjective and objective elements, so that inflation encourages inflation to persist.

Inertial inflation is a concept coined by structuralist inflation theorists. It refers to a situation where all prices of non-monetary items in an economy are continuously adjusted with relation to a price index by force of contracts as Brazil did for 30 years from 1964 to 1994 and as required by International Accounting Standard IAS 29 Financial Reporting in Hyperinflationary Economies
Changes in price indices trigger changes in prices of all non-monetary items. Contracts are made to accommodate this price-changing scenario by means of indexation. Indexation in a hyperinflationary economy is evident when, for instance, a given price must be recalculated at a later date, incorporating inflation accumulated over the period to correct the nominal price.

In other cases, local currency prices can be expressed in terms of a foreign currency: normally the US Dollar like in Zimbabwe. In some point in the future, prices are converted back from the foreign currency equivalent into local currency. This conversion from a stronger currency equivalent value (ie, the foreign currency) is intended to protect the real value of goods, as the nominal value depreciates.

In the medium-to-long term, economic agents begin to forecast inflation and to use those forecasts as de facto price indexes that can trigger price adjustments before the actual price indices are made known to the public. This cycle of forecast-price adjustment-forecast closes itself in the form of a feedback loop and inflation indices get beyond control since current inflation becomes the basis for future inflation (more formally, economic agents start to adjust prices solely based on their expectations of future inflation).

South Africa does not have inertial inflation. There is no indexation of all non-monetary items by contract.

So, Kalinka who drives inflation in SA?

We will have a look next time.

Kindest regards,

Nicolaas Smith

Inflation - a nebulous subject

Who drives inflation, Kalinka asked a day or two ago. As I said: that is a very sensitive question – especially in South Africa.

Inflation is a huge, hazy, vague, indistinct and confusing subject because of the monetary nature of money and the human nature of consumers and business people. We could have solved the problem very quickly if money was not a store of value (and only a medium of exchange and unit of account) and consumers and business people were not human beings. Remember, central bankers have to guess the collective effects of hundreds of millions of consumers and business people (greedy wall street bankers) exercising their individual self-interests.

I do not like discussing inflation because I question everything, I have already seen many theories disproved, I am not a macroeconomist, nor a central banker, every Tom, Dick and Harrry  are experts in inflation and how it comes about is not that important to me.

It’s correct measurement is. Thank heavens for the people in the past who developed the Consumer Price Index. I could not believe it when I saw that Statistics SA had the calculation wrong in the past. That should never, ever happen.

We know exactly what the problem is in accounting: the stable measuring unit assumption and we know exactly how to get rid of it: financial capital maintenance in units of constant purchasing power as authorized by the IASB in the Framework, Par. 104 (a) twenty years ago. When our accountants stop assuming there is no such thing as inflation and never has been in the past as far as the valuation of the reported Retained Profits and other constant items in the SA economy are concerned, there will be zero real value destruction in the constant item economy.

We will be left with the final problem in real value destruction in the three economic items. IFRS solve the valuation of variable item problems. Abandoning the stable measuring assumption will stop real value destruction in constant items. Then we are left with the destruction of the real value of money and other monetary items by inflation. The last frontier before real value Nirvana: a world where we do not destroy the real value of our medium of exchange simply by the way our economy works as our accountants are currently unknowingly destroying the real value of existing reported Retained Profits of all SA companies simply by the way they do accounting.

Accountants admit it is happening - or something is happening - I don´t think they really know what. The best they can do is to state that "inflation influences reported results". They mistakenly blame inflation as driven by the ANC´s economic policy and the SARB´s monetary policy - in their opinion. They are so wrong.

Kalinka, I still have to answer your question about who drives inflation. As you can see it is very foggy out there.

That will be in the next blog.

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

No reproduction without permission.

Inflation at the micro level

Kalinka, yesterday we saw that no-one gains in SA from inflation at the macro level.

Who gains from inflation at the micro level?

Everyone who pays fixed prices and payments over time for the same real value – all else being equal. He, she or it gains in his or her personal or company capacity. It does not mean the economy gains. It may have the opposite effect in aggregate. See Zimbabwe.

You can see this too in very old lifetime fixed rentals in many cities in Europe. All these areas have been destroyed by these fixed lifetime rentals. The lessee or his or her grand children now pays almost nothing for apartments. This results in these apartments falling apart since the lessor does not get any money to invest in the maintenance of the building. This is however a much larger structural problem. Those lessees´ salaries were also not always inflation adjusted over the decades.

[Financial capital maintenance in units of constant purchasing power will eventually solve all these problems because its ultimate effect is economic stability in the real economy.]

Every month when inflation goes up a little, stays the same or goes down even, the real value of your Rands goes down a little, stays the same or maybe even goes up for one month.

So Kalinka, you gain when you pay the same price for the same products or services any time after a month from the first purchase – as long as your salary is inflation-adjusted with the change in the CPI too. If your salary stays the same and the prices stay the same you, obviously, do not gain.

Companies gain in the very short term by keeping workers´ salaries and wages the same while they put up their selling prices with inflation. This is very bad for economic stability. It is obviously the opposite of economic stability.

They did that in Zimbabwe. Companies adjusted their selling prices to keep up with hyperinflation but kept salaries fixed. They first killed their internal economy – the workers had no money to buy anything - and in the end they killed their money, the ZimDollar. There is no ZimDollar today.

In the case of money you borrow, you will gain if you pay a fixed interest rate and inflation increases, but, your salary has to be inflation-adjusted too.

In the case of your book:

Not to lose any real value you should increase its selling price every time inflation increases, i.e. more or less every month. This obviously depend on the market for your book. If there is bigger demand you may even increase the real price. Lower demand may induce you to lower your real price (by keeping it the same during inflation). The CPI (not inflation) was the same in Oct 2009 as in Sept 2009. You would not change your price when the CPI does not change. The CPI is an internal exchange rate inside the SA economy between the Rand and real value within the SA economy.

The CPI is just an index number at a date. Inflation is indicated by the change in the CPI over a period of time. From 1 Oct 2008 to 30 Sept 2009 annual inflation was 6.1%. From 1 Nov 2008 to 31 Oct 2009 annual inflation was 5.9%. But, from 1 Sept 2009 to 31 Oct 2009 monthly inflation was zero percent: The CPI was the same in Oct 2009 as at was in Sept 2009.

See Statistics SA

I hope this helped a little.

Next I will try and answer your question about who drives inflation. That is a very sensitive question.

As I stated before: inflation is not my forte. I am only really interested in getting rid of the stable measuring unit assumption in SA.

Kindest regards,

Nicolaas Smith

Who gains from inflation?

Kalinka asked me on the previous blog in South Africa: Who gains from inflation?

Kalinka,

Inflation is always and everywhere the destruction of the real value of money and other monetary items, e.g. monetary loans, over time.

As at 31 Oct 2009 SA´s money supply was R 1 939 278 million. Let us assume it was the same for the 12 months to Oct, 2009. Inflation was 5.9% over that period.

That means inflation destroyed 5.9% or R114.4 billion of the real value of that R1.9 trillion over those 12 months.

SA thus lost R114.4 billion in economic real value during that period although all the money is still there in nominal value.

Kalinka, no-one gains from inflation in the Rand at the macro level. But, this is only half the story.

Everybody loses as being part of the SA monetary economy that is the same in nominal value but R114.4 billion smaller in real value over the last year to Oct, 2009.

Everyone in SA is supposedly happy with this destruction in the real value of the Rand because it is within the SARB´s inflation-targeting range of 3% to 6%. Apparently everyone in SA will also be happy when Gill Marcus brings down inflation to 3% and only R58.1 billion in real value is destroyed. SA will gain R56.3 billion per annum. What a nice annual present from Gill and her team at the SARB that would be.

It is very obvious that everyone will be happier at R58.1 billion real value destruction than at R114.4 billion real value destruction per annum. Both are in the target range. Why the lower much happier target is not chosen, I do not know.

Kalinka, now I have some shocking news for you! You think that there is only one economic enemy in SA, namely, inflation. Unfortunately, I must inform you that there is a second one. It is called the stable measuring unit assumption which the accountants at all the companies that your sister audits as well as all other accountants at all other SA companies implement.

Kalinka, as you know Cosatu and Numsa and all the other trade unions see to it that workers´ wages and salaries are valued in units of constant purchasing power, i.e. inflation-adjusted in SA´s low inflationary environment to compensate at least for the annual destruction in the real value of the Rand. SA workers´ salaries and wages are constant real value non-monetary items but they are accounted in the Rand, a depreciating nominal monetary unit of account. They have constant real values but are paid out in a continuously depreciating monetary unit, the SA Rand.

SA accountants agree that inflation of 5.9% destroys the real value of the Rand, which is the depreciating monetary unit of account they use to account all economic activity in SA companies and prepare all financial reports, at 5.9% per annum. They know that if they keep workers´ salaries and wages (which have constant real values over time) the same they would be destroying the constant real values of those salaries and wages because they use the depreciating Rand as depreciating monetary medium of exchange to pay out constant item salaries and wages. They just happily inflation-adjust them at the union agreed values per industry and company.

Where do their companies get the extra money from to pay the inflation-adjusted salaries? In general, they all inflation-adjust all their selling prices too. In fact, the ones who increase their selling prices at levels higher than inflation when there is no actual real increase in real value in the products they sell, actually create this 5.9% inflation that we all have to pay for in the destruction of the real value in the Rand.

Inflation-adjusting or valuing salaries and wages in units of constant purchasing power is of great importance in the SA economy since it maintains internal demand for goods and services and adds greatly to economic, social and political stability in SA. This was not done in Zimbabwe and we all know what happened there.

All those accountants know that inflation was 5.9%. However, when they value all their companies´ reported retained profits and other constant real value non-monetary items never maintained in the companies (which are constant non-monetary items exactly the same as salaries and wages), they suddenly change their collective minds and they all collectively assume that the 5.9% change in the real value of the Rand is not sufficiently important to measure these items in units of constant purchasing power, i.e. they refuse to inflation-adjust them like they did with the salaries and wages.

Kalinka, can you imagine that! Now we are in for big trouble! They collectively implement their very destructive stable measuring unit assumption, the second economic enemy operating only in the constant item part of the SA real economy.

As they would have destroyed the real values of the workers´ salaries and wages if they had not inflation-adjusted them, so they, in fact, unknowingly and unintentionally destroy the real values of all these reported constant items never maintained in their companies; e.g. the reported Retained Profits of all SA companies, including the ones your sister audits.

They unknowingly destroy about R200 billion per annum in SA companies´ like that – each and every year. I am going to calculate this value as accurately as I can.

No-one forces them to do that. They simply do it because it has always been done like that. But, they do not have to do it like that. The International Accounting Standards Board authorized them 20 years ago to stop this destruction in the Framework, Par. 104 (a) which states:

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

This is in agreement with International Financial Reporting Standards.

They can thus freely choose to measure all those constant items in units of constant purchasing power and stop their unknowing destruction of the real value of those items. They do not understand that they are unknowingly doing it with their very destructive stable measuring unit assumption. Neither do  accounting lecturers at universities. They vaguely know that inflation has some effect on financial reports.

They implement their very destructive stable measuring unit assumption at annual inflation rates ranging from 0.1% per annum to 25.99% per annum for three years in a row. At these levels of inflation they assume that the change in the purchasing power of the Rand is not sufficiently important for them to measure financial capital maintenance in units of constant purchasing power.

However, when inflation increases just a little bit more by 0.1% to 26% per annum for 3 years in a row then they all happily would measure all constant items as well as all variable items in units of constant purchasing power. Why? Because 26% annual inflation for 3 years in a row will add up to 100% cumulative inflation over 3 years which is the IASB´s definition of hyperinflation. They have to inflation adjust all non-monetary items during hyperinflation as required by International Accounting Standard IAS 29 Financial Reporting in Hyperinflationary Economies.

But, at 25.99% annual inflation they assume it is not sufficiently important for them to inflation-adjust constant items. They refuse to measure financial capital maintenane in units of constant purchasing power. They insist on unknowingly destroying the real value of reported constant items never maintained in SA companies.

Strange is it not?

Accountants simply blame inflation, the ANC´s economic and growth policy and the SARB´s monetary policy for this at all levels of inflation from 0.1 to 25.99% per annum for 3 years in a row.

It is very clear that accountants and accounting lecturers at do not understand the effects of measuring finacial capital maintenance in units of contstant purchasing power during low inflation as authorized by the IASB in the Framework, Par. 104 (a) although it was published in 1989. If they did, they would have stopped the stable measuring unit assumption in SA by now and they would not make unbelievable statements like

"We do not concur with the suggestion that the standards should reject the stable unit measuring assumption." when the Standards reject it in IAS 29 and its rejection has been approved as an option by the IASB 20 years ago.

Kalinka, your sister audits their accounts and then she or the partner at her audit firm signs the financial reports off as fairly representing the business of the companies when this is in fact happening in all of them. Can you believe that?

Kalinka, as you can see, no-one gains from inflation at the macro level although it is seen as a way to get out of deflation like Japan is trying right this very moment. That is another macro aspect of inflation. As you can see, in SA´s case it is twice as bad as you thought.

But, don´t despair. As soon as SA accountants start measuring financial capital maintenance in units of constant purchasing power they will collectively and knowingly kill the stable measuring unit assumption in SA forever. Then there will only be one economic enemy: inflation and we know Gill Marcus is the enemy of inflation.

Kalinka, I will deal with inflation on a micro level for you in the next blog.

By the way, I am simply an accountant. I am not a macroeconomist or central banker or banker, but, I will try and help with the concepts I do understand. Inflation is a very complex subject especially at the macro level. I am not an expert in inflation at all.

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

No reproduction without permission.

Accountants mistakenly blames inflation

What accountants and accounting lecturers at universities do not understand is that accountants unknowingly destroy massive amounts of real value in  companies doing normal accounting during low inflation. This unknowing and unintentional destruction amounts to about R200 billion per annum in the existing real values of existing constant items in  companies. It is existing real value that is being destroyed. It is not a matter of making more money to update capital.

The IASB authorized them 20 years ago to change that and to stop accountants unknowingly destroying value, but, because they mistakenly think it is inflation doing the destroying, they do nothing about it and say it is up to Gill Marcus and her team at the South African Reserve Bank to bring down inflation.

The crux of the matter is their blind belief that it is inflation doing the destroying and not accountants with normal accounting. They simply cannot contemplate even considering the possibility that measuring financial capital maintenance in units of constant purchasing power during low inflation as the IASB authorized them 20 years ago in the Framework, Par. 104 (a), which states

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

would stop accountants from this unknowing and unintentional destruction during low inflation while they all accept it as absolutely essential during hyperinflation as it is required in IAS 29 Financial Reporting in Hyperinflationary Economies.



It is clear they mistakenly think accountants have absolutely nothing to do with it. They are completely wrong.

Summary

Accountants admit that "inflation influences reported results" doing Historical Cost Accounting during low inflation. They blame inflation resulting from the government´s and the central bank´s economic policy. The Institute apparently does not know that the stable measuring unit assumption is rejected outright in IAS 29 and as an option in the Framework, Par. 104 (a). They refuse to reject the stable measuring unit assumption under any circumstance. They totally disagree that accountants destroy value in any way.

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

No reproduction without permission.

Accountants implement the stable measuring unit assumption

Gill Marcus, the Governor of the SA Reserve Bank is the enemy of inflation.

No-one in SA is the enemy of the stable measuring unit assumption because no-one understands how it operates.

Accountants inexplicably forget that IFRS reject the stable measuring unit assumption in two instances:

(1) In IAS 29 Financial Reporting in Hyperinflationary Economies and

(2) The IASB approved its rejection during low inflation as an option in the Framework, Par. 104 (a) in 1989 which states:

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


Fact: Most countries, including SA, inflation-adjust salaries, wages, rentals, etc. during low inflation.

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

No reproduction without permission.

Two economic enemies

There are two processes of systemic real value destruction in the SA economy. The first process is by the well known enemy inflation. This economic enemy manifests itself in the Rand´s store of value function and only operates in the SA monetary economy since inflation can only destroy the real value of the Rand and other monetary items - nothing else. Inflation has no effect on the real value of variable or constant real value non-monetary items.

The second economic enemy is SA accountants´ very destructive stable measuring unit assumption which they implement as part of the real value destroying traditional Historical Cost Accounting model in most, if not all, SA companies during low inflation. This second process of systemic real value destruction in the SA economy manifests itself in accountants´ stable measuring unit assumption only in the constant item part of the SA non-monetary or real economy when they freely choose to measure financial capital maintenance in nominal monetary units when they implement the HCA model in most SA companies during low inflation.

This second enemy is a stealth enemy since the way it operates is not understood by accountants and accounting lecturers at universities. If they understood it, they would have stopped it by now as they have been authorized by the IASB 20 years ago in the Framework, Par. 104 (a) which states"

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

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

No reproduction without permission.

Sufficient unreported hidden holding gains can maintain un-updated capital

The real value of Issued Share Capital and Share Premium Account can be maintained even if they are not updated over 100´s of years with unreported and hidden holding gains ONLY if 100% of the original updated real values of all contributions to these accounts are invested in sufficient revaluable variable item fixed assets (revalued via the Revaluation Reserve account or not). But, only in the case of these two items. All other reported constant real value non-monetary items´ real values never maintained are unknowingly destroyed by accountants choosing the HCA model during low inflation.

Very, very few companies have 100% of the original real values of Issued Share Capital and Share Premium Account invested in revaluable fixed assets. Only hotel groups and other property companies.

Hidden and unreported holding gains can not and are not applied to maintaining the real values of other items in Shareholders´ Equity. The reported Retained Profits of all companies are thus being unknowingly destroyed by HC accountants at a rate equal to the inflation rate in all low inflationary economies as they always have been in the past and as it is happening right now and as it will carry on as long as they keep choosing the HCA model - or as long as we do not have sustainable zero inflation.

With financial capital maintenance in units of constant purchasing power the real value of companies´ shareholders equity will be maintained for an unlimited period of time even without any fixed assets at all - as long as these companies at least break even for an unlimited period of time - all else being equal.

Kindest regards,

Nicolaas Smith

Accountants destroy value

Inflation destroys the real value of money and other monetary items over time. This fact is generally accepted and appears in Wikipedia stated as "inflation erodes or decreases or reduces the real value of money" and in IFRS as "general forces may result in changes in the general level of prices and therefore in the general purchasing power of money" (IAS29.5).

HC accountants destroy the real value of reported constant real value non-monetary items never maintained, e.g. reported retained profits, when they choose to value them in nominal monetary units during low inflation. This fact is not generally accepted.

This destruction of reported Retained Profit real value is generally attributed to inflation when, in fact, it is the result of accountants´ free choice of the traditional Historical Cost Accounting model whereunder they implement the stable measuring unit assumption, i.e. they simply assume that changes in the real value of the money (inflation) is not sufficiently important during low inflation for them to choose the alternate basic accounting model of financial capital maintenance in units of constant purchasing power as approved by the IASB in the Framework, Par. 104 (a) in 1989 which would stop this destruction.

It is thus HC accountants´ free choice of accounting model and not inflation that is doing the destroying in the real value of reported Retained Profits. HC accountants would stop this destuction when they reject the stable measuring unit assumption and with it traditional Historical Cost Accounting and measure financial capital maintenance in units of constant purchasing power as authorized by the IASB in the Framework, Par. 104 (a) in 1989.

This destruction (by HC accountants) generally incorrectly attributed to inflation is generally accepted by accountants and economists and expressed in Wikipedia in phrases such as:

Inflation results in the overstatement of margins and the overpayment of dividends which results in the erosion of companies´ capital that is paid away in overstated dividends.

Example: R2.4 billion of real value is destroyed by HC accountants in the real value of R40 billion reported Retained Profits during a year in the South African real economy at 6% per annum (a rate equal to the rate of inflation) when inflation is 6% because they value reported Retained Profist in Rand monetary unit terms and the real value of the Rand is being destroyed by inflation at 6% per annum. Inflation can only destroy the real value of money and other monetary items. Inflation has no effect on the real value of non-monetary items.

HC accountants implement their very destructive stable measuring unit assumption at inflation rates ranging from 0.01% per annum to 25.99% per annum continuous inflation for 3 years in a row; i.e. they assume the destruction of 25.99% of the real value of reported Retained Profits and all other existing constant real value non-monetary items never maintained (eg. all items in shareholders equity, provisions, etc) is not sufficiently important for them to freely decide to stop this destruction by implementing financial capital maintenance in units of constant purchasing power as authorized by the IASB in the Framework, Par. 104 (a) in 1989 which is complaint with IFRS.

26% annual inflation for 3 years in a row totalling 100% cumulative inflation over 3 years would define an economy as being an hyperinflationary economy. IAS 29 requires accountants in hyperinflationary economies to value all non-monetary items (variable and constant items) in units of constant purchasing power. Accountants thus agree that 26% annual inflation for 3 years in a row is sufficiently important for them to stop destroying the real values of all reported constant items never maintained, but, not 25.99% annual inflation for 3 years in a row or inflation approaching 26% annual inflation for 3 years in a row.

This is obviously not true and correct. It results in HC accountants unknowingly and unintentionally destroying hunderds of billions of US Dollars of real value annually in existing reported constant items never maintained.

What in reality happens is that accountants do not know that they are doing this because HCA has been the traditional accounting model for the last 700 years.

They unknowingly evade fixing their massive annual destruction in companies´ reported constant real value non-monetary items never maintained by ascribing this destruction in real value to inflation when it is a fact that inflation can only destroy the real value of money and other monetary items - nothing else. It is impossible for inflation to destroy the real value of non-monetary items. Inflation can only destroy the real value of money and monetary items. As Milton Friedman so eloquently stated: inflation is always and everywhere a monetary phenomenon.

Kindest regards,

Nicolaas Smith

Accounting model maintains value - Part 2

Capital - as a variable real value non-monetary item (as traded or untraded shares in a company) - would have emerged even without double-entry accounting.

It is clear, however, that the real value of capital - as a constant real value non-monetary item - i.e. being all the items in shareholders´ equity (issued share capital, reported retained profits, share premium account, capital reserves, etc), can only be maintained constant during inflation with double entry accounting implementing not traditional Historical Cost Accounting (the stable measuring unit assumption) but financial capital maintenance in units of constant purchasing power as authorized by the IASB in the Framework, Par. 104 (a) in 1989 which is compliant with IFRS.

Double entry accounting can maintain the real value of existing constant items (issued share capital, reported retained profits, etc.) even in companies with no fixed assets as long as they at least break even for an unlimited period of time during indefinite inflation, but, only with financial capital maintenance in units of constant purchasing power - not with the traditional 700 year old Historical Cost Accounting model implementing the very destructive stable measuring unit assumption during low inflation.

Thus, instead of saying that the accounting model creates value we can say the accounting model maintains value - qualified as above.

Kindest regards,

Nicolaas Smith

Accounting model maintains value - Part 1

“What advantages does the Merchant derive from Book-keeping by double-entry? It is amongst the finest inventions of the human mind.” Goethe

Capital as we know it today only exists as a result of the double-entry accounting model.

Not the traditional Historical Cost Accounting model, but, simply the double entry accounting model. Measuring financial capital maintenance in units of constant purchasing power is also a double entry accounting model. So are Current Cost Accounting and various others.

Without double-entry accounting there would be no capital which is a constant real value non-monetary item. Without double-entry accounting there would only be monetary items and variable real value non-monetary items.

"The very concept of capital is derived from this way of looking at things; one can say that capital, as a category, did not exist before double-entry bookkeeping.” Sombart 1953, p. 38.

Capitalism is based on double-entry accounting.

"Capitalism develops rationality and adds a new edge to it in two interconnected ways. First it exalts the monetary unit-not itself a creation of capitalism-into a unit of account. That is to say, capitalist practice turns the unit of money into a tool of rational cost-profit calculations, of which the towering monument is double-entry bookkeeping. . . . We will notice that, primarily a product of the evolution of economic rationality, the cost-profit calculus in turn reacts upon that rationality; by crystallizing and defining numerically, it powerfully propels the logic of enterprise." Schumpeter 1950, p. 123.

http://www.dse.unive.it/summerschool/course2007/accounting%20and%20rationality.pdf

Kindest regards,

Nicolaas Smith

SA accountants´ incomprehensible logic

SA accountants value existing reported Retained Profits in SA companies at Historical Cost, i.e. in nominal monetary units. They assume that changes in the real value of the Rand are not sufficiently important for them to stop their destruction of the real value of existing reported Retained Profits as a result of their stable measuring unit assumption.

They make this assumption while inflation ranges from 0.01% to 25.99% per annum for 3 years in a row.

When inflation increases from 25.99% to 26% for three years in a row totalling 100% which would indicate that SA is in hyperinflation, they would immediately change their collective minds and agree that 26% inflation would result in them destroying 26% of all existing reported Retained Profits in SA companies – but not 25.99% inflation for 3 years in a row.

They would inflation-adjust all non-monetary items – variable and constant items – in SA when inflation is 26% per annum for 3 years in a row – but not at 25.99% for 3 years in a row.

They are currently unknowingly destroying 5.9% or about R200 billion of all existing reported Retained Profits and other constant items never maintained in SA companies. When inflation increases to 25.99% they would unknowingly destroy about R866 billion in this way per annum. They would assume the destruction of R866 billion per annum (at current prices) in this manner is not significantly important.

Kindest regards,

Nicolaas Smith