The debate of how to account for value has been around for decades.
Robert Kemp, CPA Professor, University of Virginia
The three fundamentally different basic economic items in the economy
1. variable items
2. monetary items and
3. constant items
are economic values. Each economic item is an economic value expressed in terms of money, i.e. the functional currency. SA accountants account economic transactions involving these three economic items in an organized manner when they implement a double entry accounting model: journal entries, general ledger accounts, trial balances, cash flow statements, income and expenses in the Profit and Loss Account, assets and liabilities in the Balance Sheet plus other financial, management and costing reports.
SA accountants value economic items when they account economic activity in the accounting records and prepare financial reports of SA economic entities based on the double entry accounting model. Accounting entries are valuations of the economic items (the debit items and the credit items) being accounted.
SA accountants do not simply record economic activity. Accounting is not just a scorekeeping or recordkeeping of economic events. That concept of financial reporting has no substance. SA accountants value economic items when they account them. Subsequent accounting entries are part of generally accepted accounting practice of continuous valuation of the economic items originally valued and accounted over time as required by SA Generally Accepted Accounting Practice and IFRS implemented in conjunction with the IASB´s Framework.
The measurement basis and concept of financial capital maintenance SA accountants choose - either real value destroying traditional Historical Cost nominal monetary units (their current choice) or real value maintaining units of constant purchasing power (the CPPA model) - to value constant real value non-monetary items determine whether they unknowingly destroy or maintain their real values during low, high and hyperinflation. SA accountants are required by the IASB to implement IAS 29 Financial Reporting in Hyperinflationary Economies during hyperinflation. IAS 29 is based on the Constant Purchasing Power Accounting model. Inflation, being a uniquely monetary phenomenon, can not, by definition, destroy the real value of constant real value non-monetary items or variable real value non-monetary items. It is SA accountants’ choice of capital maintenance concept (accounting model) that determines whether they carry on currently unintentionally destroying real value in constant items never or not fully updated or maintain those values for an unlimited period of time – all else being equal.
When SA accountants apply the very destructive stable measuring unit assumption as part of the real value destroying traditional HCA model and value constant items at their HC nominal monetary values and these items are never or not fully updated or inflation-adjusted by means of the CPI over time in SA´s non-hyperinflationary environment, they unknowingly destroy their constant real non-monetary values at a rate equal to the rate of inflation. This is the case with all constant items never or not fully inflation-adjusted including the unintentional destruction by SA accountants of the real value of issued share capital in SA banks and companies which do not have variable real value non-monetary fixed property, plant and equipment that can be revalued at least equal to the updated original real value of all capital contributions under the HC paradigm.
When SA accountants choose to measure financial capital maintenance in real value maintaining units of constant purchasing power (the CPPA model) – as they can freely do in terms of the IASB´s Framework, Par. 104 (a) - they will maintain all constant item real values over time including issued share capital, whether entities have fixed property, plant and equipment to revalue or not.
When SA accountants value constant items in HC nominal monetary units – as they all currently do – they unknowingly destroy their real values at a rate equal to the inflation rate when they are never updated under the HC paradigm.
Variable Items
SA accountants value variable real value non-monetary items in terms of IFRS or SA GAAP. “Listed companies use IFRS and the unlisted companies could use either IFRS or Statements of GAAP.”
IAS 16 deals with Property Plant & Equipment. It allows two methods of valuation or measurement; either historical cost or revaluation based on fair value. The charge for depreciation relates to the carrying value, whether historical cost or fair value. It is not acceptable under HCA to index up the original cost of an asset by reference to subsequent inflation or to base the depreciation charge on that indexed amount.
There are similar requirements in respect of intangible assets (IAS 38) and inventories (IAS 2).
IAS 39 requires fair values to be applied in valuing investments and derivative financial instruments. A historical cost basis of accounting is not acceptable for these items.
The real values of variable real value non-monetary items, e.g. property, are not destroyed when accountants value them at Historical Cost in terms of IFRS or GAAP. These items will be valued at their market prices when they are eventually sold.
Monetary items
Low inflation is what long term sustainable economic growth is built on. Alan Greenspan.
SA accountants value monetary items at their original nominal monetary values; that is, at their original HC values since monetary items can not be updated or indexed during the current financial period for the purpose of
1. accounting their values during the reporting period,
2. determining the profit or loss for the reporting period, and
3. measuring financial capital maintenance in either nominal monetary units or constant purchasing power units
during inflation or deflation.
Inflation – not SA accountants - destroys the real value of SA monetary items over time. The internal real value of the Rand is automatically adjusted downwards as it is being destroyed by the economic process of inflation in SA´s inflationary economy as indicated by the rate of change in the CPI. Inflation destroys the real value of monetary items under any accounting model and also when no accounting model is implemented; that is, when a business does not account its economic activities; for example, street vendors. The accounting model has no affect on the real value of monetary items during the reporting period.
Double entry accounting cannot maintain the real value of monetary items during the reporting period. It is not an attribute of double entry accounting to maintain the real value of monetary items during the reporting period. Inflation destroys the real value of monetary items no matter which accounting model is used. That is why low inflation is so critical for long term sustainable economic growth.
Constant items
SA accountants can choose to measure financial capital maintenance in either nominal monetary units (the HCA model) or in real value maintaining units of constant purchasing power (the CPPA model) as authorized by the IASB in the Framework, Par. 104 (a).
It is very obvious that how SA accountants choose to measure financial capital maintenance does make a big difference to the real value of constant items. There is absolutely no substance in the statement that the choices accountants make won't affect the economy.
The accounting model SA accountants choose in terms of the Framework, Par. 104 (a) is of critical importance. When they choose to measure financial capital maintenance in real value maintaining units of constant purchasing power they will maintain the real values of, for example, all SA banks´ and companies´ retained income values constant over time, all else being equal, instead of unknowingly destroying them, as the currently do. The ONLY way SA accountants can maintain the real value of constant real value non-monetary items during inflation and deflation is by choosing a Constant Purchasing Power Accounting model as per the IASB´s Framework, Par. 104 (a).
Not a single SA accountant in SA chooses to measure financial capital maintenance in real value maintaining units of constant purchasing power as authorized by the IASB in the Framework, Par. 104 (a). SA accountants, unfortunately, choose to measure financial capital maintenance in nominal monetary units and thereby, unknowingly, destroy the real values of constant items at a rate equal to the rate of inflation when they are never or not fully updated over time when they implement the very destructive stable measuring unit assumption as part of the real value destroying HCA model. SA accountants are unknowingly killing the real economy at the rate of about R200 billion per annum – each and every year - as long as they carry on choosing to measure financial capital maintenance in nominal monetary units.
© 2005-2010 by Nicolaas J Smith. All rights reserved
No reproduction without permission
Sunday, 15 March 2009
Sunday, 8 March 2009
Constant Item Purchasing Power Accounting
Constant Purchasing Power Accounting as defined in International Accounting Standard IAS 29 Financial Reporting in Hyperinflationary Economies is the IASB´s inflation accounting model required to be implemented during hyperinflation.
Constant Item Purchasing Power Accounting is an International Accounting Standards Board approved basic accounting model alternative to traditional Historical cost accounting during low inflation. IAS 29 requires the updating of all non-monetary items (both variable and constant real value non-monetary items) by means of the Consumer Price Index during hyperinflation. Constant Item Purchasing Power Accounting as approved by the IASB in the Framework, Par. 104 (a) only requires the updating of constant real value non-monetary items during non-hyperinflationary periods. In terms of the Framework, Par. 104 (a), accountants can choose CIPPA to implement a financial capital concept of invested purchasing power instead of the traditional Historical Cost concept of invested money. They will thus implement a constant purchasing power financial capital maintenance concept by measuring financial capital maintenance in units of constant purchasing power instead of the traditional Historical Cost nominal monetary units and they will implement a constant purchasing power profit/loss determination concept. It simply means inflation-adjusting only constant real value non-monetary items, e.g. issued share capital, retained income, shareholders´ equity, trade debtors, trade creditors, deferred tax assets and liabilities, salaries, wages, rentals, etc, by means of the Consumer Price Index while valuing variable real value non-monetary items, e.g. property, plant, equipment, shares, inventory, etc in terms of International Financial Reporting Standards or Generally accepted accounting practice during non-hyperinflationary periods. Monetary items are valued at their original nominal values during the accounting period under all accounting models.
Monetary items, variable items and constant items are the three fundamentally different basic economic items in the economy.
Constant Item Purchasing Power Accounting will automatically maintain instead of continually erode - as the Historical Cost Accounting model is currently doing - the real value of all constant items never or not fully updated, including banks´ and companies´ capital base, for an unlimited period of time - all else being equal. Constant Item Purhcasing Power Accounting was authorized by the IASB in 1989 as an alternative to the traditional historical cost accounting model at all levels of inflation and deflation in the Framework for the Preparation and Presentation of Financial Statements and forms part of International Financial Reporting Standards. [http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=CELEX:32003R1725:EN:NOT]
The Framework, Par. 104 (a)
"Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power."
Discredited 1970-style CPPA was a form of inflation accounting which tried unsuccessfully - by updating all non-monetary items (variable as well as constant real value non-monetary items) equally by means of the Consumer Price Index during high inflation - to allow for the effect of inflation in an attempt to make corporate accounts more informative when comparing current transactions with previous transactions.
Nevertheless, almost all accountants and accounting authorities - excluding the IASB - still regard Constant item purchasing power accounting as a discredited and failed 1970-style CPPA inflation accounting model. They ignore the Constant Item Purchasing Power Accounting model´s substantial benefits, for example, automatically maintaining banks´ and companies´ capital base, when accountants choose to inflation-adjust only constant items by means of the CPI thus maintaining their real values while they value variable items in terms of IFRS. Monetary items cannot be inflation-adjusted or updated and accountants value them at their original nominal values during the accounting period.
Certain income statement constant real value non-monetary items, most notably salaries, wages and rentals, are inflation-adjusted by means of the CPI, that is, valued or measured in units of constant purchasing power, in most economies.
The IASB specifically requires the CPPA inflation accounting model to be used during hyperinflation as per International Accounting Standard IAS 29 Financial Reporting in Hyperinflationary Economies. [http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=CELEX:32003R1725:EN:NOT][http://www.pwc.com/gx/eng/about/svcs/corporatereporting/IAS29Publication06.pdf]PricewaterhouseCoopers, Financial Reporting in Hyperinflationary Economies, Understanding IAS 29
1970-style CPPA was a failed inflation accounting model
International Accounting Standard 29, Par. 6:
"In most countries, primary financial statements are prepared on the historical cost basis of accounting without regard either to changes in the general level of prices or to increases in specific prices of assets held, except to the extent that property, plant and equipment and investments may be revalued. Some entities, however, present financial statements that are based on a current cost approach that reflects the effects of changes in the specific prices of assets held.
The following quote from Geoffrey Whittington's book Inflation Accounting - An Introduction to the Debate, published in 1983, reflects the above position:
Constant Purchasing Power Accounting (CPP) is a consistent method of indexing accounts by means of a general index which reflects changes in the purchasing power of money. It therefore attempts to deal with the inflation problem in the sense in which this is popularly understood, as a decline in the value of the currency. It attempts to deal with this problem by converting all of the currency unit measurement in accounts into units at a common date by means of the index.
Inflation Accounting: An Introduction to the Debate, Geoffrey Whittington, Cambridge University Press, 1983, ISBN 0521270553, ISBN 9780521270557, P. 73.[http://books.google.com/books?hl=en&id=-5Dz0JtXM9sC&dq=inflation+accounting+by+geoffrey+whittington&printsec=frontcover&source=web&ots=vrKex7Mpzp&sig=b6JGICF8YHoHzzAXESioFwOieBc&sa=X&oi=book_result&resnum=1&ct=result#PPA73,M1]
Constant Item Purchasing Power Accounting as a financial capital maintenance concept
The specific choice of measuring financial capital maintenance in units of constant purchasing power (the CIPPA model) at all levels of inflation and deflation as contained in the Framework, was approved by the International Accounting Standards Board’s predecessor body, the International Accounting Standards Committee Board, in April 1989 for publication in July 1989 and adopted by the IASB in April 2001.
“In the absence of a Standard or an Interpretation that specifically applies to a transaction, management must use its judgement in developing and applying an accounting policy that results in information that is relevant and reliable. In making that judgement, IAS 8.11 requires management to consider the definitions, recognition criteria, and measurement concepts for assets, liabilities, income, and expenses in the Framework. This elevation of the importance of the Framework was added in the 2003 revisions to IAS 8."
IAS Plus, Deloitte [http://www.iasplus.com/standard/framewk.htm]
IAS8. 11:
“In making the judgement, management shall refer to, and consider the applicability of, the following sources in descending order:
(a) the requirements and guidance in Standards and Interpretations dealing with similar and related issues; and
(b) the definitions, recognition criteria and measurement concepts for assets, liabilities, income and expenses in the Framework.”
[http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=CELEX:32003R1725:EN:NOT]
There is no applicable International Financial Reporting Standard or Interpretation regarding the valuation of constant real value non-monetary items, e.g. issued share capital, retained earnings, capital reserves, all other items in Shareholders Equity, trade debtors, trade creditors, deferred tax assets and liabilities, taxes payable and receivable, all other non-monetary receivables and payables, Profit and Loss account items such as salaries, wages, rents, etc. The Framework is thus applicable.
Despite being part of IFRS Constant Item Purchasing Power Accounting is almost completely ignored by accountants in non-hyperinflationary economies even though it would maintain instead of diminish the real values of not only all income statement constant items but also all balance sheet constant real value non-monetary items for an unlimited period of time. This is because the CIPPA model is generally viewed by almost all accountants and accounting authorities, excluding the IASB, as a 1970-style failed CPPA inflation accounting model that requires all non-monetary items - variable real value non-monetary items and constant real value non-monetary items - to be inflation-adjusted by means of the Consumer Price Index. They - including the IASB - fail to introduce the substantial real value maintaining benefits, which last for an unlimited period of time (all else being equal), of measuring financial capital maintenance in units of constant purchasing power in companies and the economy in general.
The IASB did not approve Constant Item Purchasing Power Accounting in 1989 as an inflation accounting model. CIPPA by measuring financial capital maintenance in units of constant purchasing power incorporates an alternative capital concept, financial capital maintenance concept and profit determination concept to the Historical Cost capital concept, financial capital maintenance concept and profit determination concept. CIPPA only requires all constant real value non-monetary items, e.g. issued share capital, retained income, all other items in Shareholders Equity, trade debtors, trade creditors, deferred tax assets and liabilities, taxes payable and receivable, all items in the profit and loss account, etc to be valued in units of constant purchasing power. Variable real value non-monetary items, e.g. property, plant, equipment, listed and unlisted shares, inventory, etc are valued in terms of IFRS and are not required in terms of the Framework, Par. 104 (a) to be valued in units of constant purchasing power.
CIPPA is authorized by the IASB during low inflation
The statement "Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power," in the IASB´s Framework, Paragraph 104 (a), means that Constant Item Purchasing Power Accounting has been authorized by the International Accounting Standards Board since 1989 as an alternative to the traditional Historical Cost Accounting model, including during periods of low inflation. This means that the international accounting profession has been in agreement regarding the use of Constant Purchase Power Accounting for financial capital maintenance in units of constant purchasing power during low inflation since 1989. It also means that Constant Item Purchasing Power Accounting and the inflation-adjustment of constant real value non-monetary items to maintain their real values in a low inflationary environment are authorized by International Financial Reporting Standards since the Framework is part of IFRS.
Constant real value non-monetary items like salaries, wages, rents, pensions, utilities, transport fees, etc are normally valued by accountants in terms of Constant Purchasing Power units during low inflation in most economies. Payments in money for these items are normally inflation-adjusted by means of the Consumer Price Index to compensate for the erosion of the real value of the monetary medium of exchange by inflation. Inflation is always and everywhere a monetary phenomenon and can only erode the real value of money (the functional currency inside an economy) and other monetary items. Inflation can not erode the real value of non-monetary items. Constant real value non-monetary items´ real values can be maintained by accountants choosing the Constant Item Purchasing Power Accounting model as per the Framework during low inflation as authorized in IFRS since 1989 instead of currently being eroded by the implementation by accountants of the traditional Historical Cost Model when they apply the stable measuring unit assumption. It is thus accountants´ choice of accounting model and not inflation that maintains or erodes the real value of constant real value non-monetary items like retained earnings, issued share capital (banks´ and companies´ capital base), capital reserves, other shareholder equity items, trade debtors, trade creditors, deferred tax assets and liabilities, other taxes payable and receivable, etc.
Implementing the CIPPA model means accountants choose to reject the stable measuring unit assumption which they implement when they choose to measure financial capital maintenance in nominal monetary units. Accountants world wide currently choose the traditional Historical Cost Accounting model except during hyperinflation when they are required by IFRS to implement IAS 29 which is based on the CPPA model.
Net monetary gain or loss
Accountants have to calculate the net monetary loss or gain from holding monetary items when they choose the CIPPA model and measure financial capital maintenance in units of constant purchasing power.
CIPPA as per the IASB's Framework
Framework for the Preparation and Presentation of Financial Statements
Concepts of Capital and Capital Maintenance
Concepts of Capital
Par. 102
A financial concept of capital is adopted by most entities in preparing their financial statements. Under a financial concept of capital, such as invested money or invested purchasing power, capital is synonymous with the net assets or equity of the entity. Under a physical concept of capital, such as operating capability, capital is regarded as the productive capacity of the entity based on, for example, units of output per day.
Par. 103
The selection of the appropriate concept of capital by an entity should be based on the needs of the users of its financial statements. Thus, a financial concept of capital should be adopted if the users of financial statements are primarily concerned with the maintenance of nominal invested capital '''or the purchasing power of invested capital'''. If, however, the main concern of users is with the operating capability of the entity, a physical concept of capital should be used. The concept chosen indicates the goal to be attained in determining profit, even though there may be some measurement difficulties in making the concept operational.
Concepts of Capital Maintenance and the Determination of Profit
The concepts of capital give rise to the following concepts of capital maintenance:
Par. 104
(a) Financial capital maintenance. Under this concept a profit is earned only if the financial (or money) amount of the net assets at the end of the period exceeds the financial (or money) amount of net assets at the beginning of the period, after excluding any distributions to, and contributions from, owners during the period. Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power.
(b) Physical capital maintenance. Under this concept a profit is earned only if the physical productive capacity (or operating capability) of the entity (or the resources or funds needed to achieve that capacity) at the end of the period exceeds the physical productive capacity at the beginning of the period, after excluding any distributions to, and contributions from, owners during the period.
Par. 105
The concept of capital maintenance is concerned with how an entity defines the capital that it seeks to maintain. It provides the linkage between the concepts of capital and the concepts of profit because it provides the point of reference by which profit is measured; it is a prerequisite for distinguishing between an entity’s return on capital and its return of capital; only inflows of assets in excess of amounts needed to maintain capital may be regarded as profit and therefore as a return on capital. Hence, profit is the residual amount that remains after expenses (including capital maintenance adjustments, where appropriate) have been deducted from income. If expenses exceed income the residual amount is a loss.
Par. 106
The physical capital maintenance concept requires the adoption of the current cost basis of measurement. The financial capital maintenance concept, however, does not require the use of a particular basis of measurement. Selection of the basis under this concept is dependent on the type of financial capital that the entity is seeking to maintain.
Par. 107
The principal difference between the two concepts of capital maintenance is the treatment of the effects of changes in the prices of assets and liabilities of the entity. In general terms, an entity has maintained its capital if it has as much capital at the end of the period as it had at the beginning of the period. Any amount over and above that required to maintain the capital at the beginning of the period is profit.
Par. 108
Under the concept of financial capital maintenance where capital is defined in terms of nominal monetary units, profit represents the increase in nominal money capital over the period. Thus, increases in the prices of assets held over the period, conventionally referred to as holding gains, are, conceptually, profits. They may not be recognised as such, however, until the assets are disposed of in an exchange transaction. When the concept of financial capital maintenance is defined in terms of constant purchasing power units, profit represents the increase in invested purchasing power over the period. Thus, only that part of the increase in the prices of assets that exceeds the increase in the general level of prices is regarded as profit. The rest of the increase is treated as a capital maintenance adjustment and, hence, as part of equity.
Par. 109
Under the concept of physical capital maintenance when capital is defined in terms of the physical productive capacity, profit represents the increase in that capital over the period. All price changes affecting the assets and liabilities of the entity are viewed as changes in the measurement of the physical productive capacity of the entity; hence, they are treated as capital maintenance adjustments that are part of equity and not as profit.
Par. 110
The selection of the measurement bases and concept of capital maintenance will determine the accounting model used in the preparation of the financial statements. Different accounting models exhibit different degrees of relevance and reliability and, as in other areas, management must seek a balance between relevance and reliability. The Framework is applicable to a range of accounting models and provides guidance on preparing and presenting the financial statements constructed under the chosen model. At the present time, it is not the intention of the Board of IASC to prescribe a particular model other than in exceptional circumstances, such as for those entities reporting in the currency of a hyperinflationary economy. This intention will, however, be reviewed in the light of world developments.
The IASB Framework was approved by the IASC Board in April 1989 for publication in July 1989, and adopted by the IASB in April 2001.
CPPA inflation accounting is required by the IASB during hyperinflation
The IASB authorized the CIPPA model during low inflation in the Framework, Par. 104 (a) as an alternative to the Historical Cost Accounting model. The IASB, however, specifically requires the implementation of the CPPA inflation accounting model during hyperinflation as per IAS 29 Financial Reporting in Hyperinflationary Economies which is based on the CPPA model. [http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=CELEX:32003R1725:EN:NOT]
© 2005-2010 by Nicolaas J Smith. All rights reserved
No reproduction without permission.
Constant Item Purchasing Power Accounting is an International Accounting Standards Board approved basic accounting model alternative to traditional Historical cost accounting during low inflation. IAS 29 requires the updating of all non-monetary items (both variable and constant real value non-monetary items) by means of the Consumer Price Index during hyperinflation. Constant Item Purchasing Power Accounting as approved by the IASB in the Framework, Par. 104 (a) only requires the updating of constant real value non-monetary items during non-hyperinflationary periods. In terms of the Framework, Par. 104 (a), accountants can choose CIPPA to implement a financial capital concept of invested purchasing power instead of the traditional Historical Cost concept of invested money. They will thus implement a constant purchasing power financial capital maintenance concept by measuring financial capital maintenance in units of constant purchasing power instead of the traditional Historical Cost nominal monetary units and they will implement a constant purchasing power profit/loss determination concept. It simply means inflation-adjusting only constant real value non-monetary items, e.g. issued share capital, retained income, shareholders´ equity, trade debtors, trade creditors, deferred tax assets and liabilities, salaries, wages, rentals, etc, by means of the Consumer Price Index while valuing variable real value non-monetary items, e.g. property, plant, equipment, shares, inventory, etc in terms of International Financial Reporting Standards or Generally accepted accounting practice during non-hyperinflationary periods. Monetary items are valued at their original nominal values during the accounting period under all accounting models.
Monetary items, variable items and constant items are the three fundamentally different basic economic items in the economy.
Constant Item Purchasing Power Accounting will automatically maintain instead of continually erode - as the Historical Cost Accounting model is currently doing - the real value of all constant items never or not fully updated, including banks´ and companies´ capital base, for an unlimited period of time - all else being equal. Constant Item Purhcasing Power Accounting was authorized by the IASB in 1989 as an alternative to the traditional historical cost accounting model at all levels of inflation and deflation in the Framework for the Preparation and Presentation of Financial Statements and forms part of International Financial Reporting Standards. [http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=CELEX:32003R1725:EN:NOT]
The Framework, Par. 104 (a)
"Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power."
Discredited 1970-style CPPA was a form of inflation accounting which tried unsuccessfully - by updating all non-monetary items (variable as well as constant real value non-monetary items) equally by means of the Consumer Price Index during high inflation - to allow for the effect of inflation in an attempt to make corporate accounts more informative when comparing current transactions with previous transactions.
Nevertheless, almost all accountants and accounting authorities - excluding the IASB - still regard Constant item purchasing power accounting as a discredited and failed 1970-style CPPA inflation accounting model. They ignore the Constant Item Purchasing Power Accounting model´s substantial benefits, for example, automatically maintaining banks´ and companies´ capital base, when accountants choose to inflation-adjust only constant items by means of the CPI thus maintaining their real values while they value variable items in terms of IFRS. Monetary items cannot be inflation-adjusted or updated and accountants value them at their original nominal values during the accounting period.
Certain income statement constant real value non-monetary items, most notably salaries, wages and rentals, are inflation-adjusted by means of the CPI, that is, valued or measured in units of constant purchasing power, in most economies.
The IASB specifically requires the CPPA inflation accounting model to be used during hyperinflation as per International Accounting Standard IAS 29 Financial Reporting in Hyperinflationary Economies. [http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=CELEX:32003R1725:EN:NOT][http://www.pwc.com/gx/eng/about/svcs/corporatereporting/IAS29Publication06.pdf]PricewaterhouseCoopers, Financial Reporting in Hyperinflationary Economies, Understanding IAS 29
1970-style CPPA was a failed inflation accounting model
International Accounting Standard 29, Par. 6:
"In most countries, primary financial statements are prepared on the historical cost basis of accounting without regard either to changes in the general level of prices or to increases in specific prices of assets held, except to the extent that property, plant and equipment and investments may be revalued. Some entities, however, present financial statements that are based on a current cost approach that reflects the effects of changes in the specific prices of assets held.
The following quote from Geoffrey Whittington's book Inflation Accounting - An Introduction to the Debate, published in 1983, reflects the above position:
Constant Purchasing Power Accounting (CPP) is a consistent method of indexing accounts by means of a general index which reflects changes in the purchasing power of money. It therefore attempts to deal with the inflation problem in the sense in which this is popularly understood, as a decline in the value of the currency. It attempts to deal with this problem by converting all of the currency unit measurement in accounts into units at a common date by means of the index.
Inflation Accounting: An Introduction to the Debate, Geoffrey Whittington, Cambridge University Press, 1983, ISBN 0521270553, ISBN 9780521270557, P. 73.[http://books.google.com/books?hl=en&id=-5Dz0JtXM9sC&dq=inflation+accounting+by+geoffrey+whittington&printsec=frontcover&source=web&ots=vrKex7Mpzp&sig=b6JGICF8YHoHzzAXESioFwOieBc&sa=X&oi=book_result&resnum=1&ct=result#PPA73,M1]
Constant Item Purchasing Power Accounting as a financial capital maintenance concept
The specific choice of measuring financial capital maintenance in units of constant purchasing power (the CIPPA model) at all levels of inflation and deflation as contained in the Framework, was approved by the International Accounting Standards Board’s predecessor body, the International Accounting Standards Committee Board, in April 1989 for publication in July 1989 and adopted by the IASB in April 2001.
“In the absence of a Standard or an Interpretation that specifically applies to a transaction, management must use its judgement in developing and applying an accounting policy that results in information that is relevant and reliable. In making that judgement, IAS 8.11 requires management to consider the definitions, recognition criteria, and measurement concepts for assets, liabilities, income, and expenses in the Framework. This elevation of the importance of the Framework was added in the 2003 revisions to IAS 8."
IAS Plus, Deloitte [http://www.iasplus.com/standard/framewk.htm]
IAS8. 11:
“In making the judgement, management shall refer to, and consider the applicability of, the following sources in descending order:
(a) the requirements and guidance in Standards and Interpretations dealing with similar and related issues; and
(b) the definitions, recognition criteria and measurement concepts for assets, liabilities, income and expenses in the Framework.”
[http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=CELEX:32003R1725:EN:NOT]
There is no applicable International Financial Reporting Standard or Interpretation regarding the valuation of constant real value non-monetary items, e.g. issued share capital, retained earnings, capital reserves, all other items in Shareholders Equity, trade debtors, trade creditors, deferred tax assets and liabilities, taxes payable and receivable, all other non-monetary receivables and payables, Profit and Loss account items such as salaries, wages, rents, etc. The Framework is thus applicable.
Despite being part of IFRS Constant Item Purchasing Power Accounting is almost completely ignored by accountants in non-hyperinflationary economies even though it would maintain instead of diminish the real values of not only all income statement constant items but also all balance sheet constant real value non-monetary items for an unlimited period of time. This is because the CIPPA model is generally viewed by almost all accountants and accounting authorities, excluding the IASB, as a 1970-style failed CPPA inflation accounting model that requires all non-monetary items - variable real value non-monetary items and constant real value non-monetary items - to be inflation-adjusted by means of the Consumer Price Index. They - including the IASB - fail to introduce the substantial real value maintaining benefits, which last for an unlimited period of time (all else being equal), of measuring financial capital maintenance in units of constant purchasing power in companies and the economy in general.
The IASB did not approve Constant Item Purchasing Power Accounting in 1989 as an inflation accounting model. CIPPA by measuring financial capital maintenance in units of constant purchasing power incorporates an alternative capital concept, financial capital maintenance concept and profit determination concept to the Historical Cost capital concept, financial capital maintenance concept and profit determination concept. CIPPA only requires all constant real value non-monetary items, e.g. issued share capital, retained income, all other items in Shareholders Equity, trade debtors, trade creditors, deferred tax assets and liabilities, taxes payable and receivable, all items in the profit and loss account, etc to be valued in units of constant purchasing power. Variable real value non-monetary items, e.g. property, plant, equipment, listed and unlisted shares, inventory, etc are valued in terms of IFRS and are not required in terms of the Framework, Par. 104 (a) to be valued in units of constant purchasing power.
CIPPA is authorized by the IASB during low inflation
The statement "Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power," in the IASB´s Framework, Paragraph 104 (a), means that Constant Item Purchasing Power Accounting has been authorized by the International Accounting Standards Board since 1989 as an alternative to the traditional Historical Cost Accounting model, including during periods of low inflation. This means that the international accounting profession has been in agreement regarding the use of Constant Purchase Power Accounting for financial capital maintenance in units of constant purchasing power during low inflation since 1989. It also means that Constant Item Purchasing Power Accounting and the inflation-adjustment of constant real value non-monetary items to maintain their real values in a low inflationary environment are authorized by International Financial Reporting Standards since the Framework is part of IFRS.
Constant real value non-monetary items like salaries, wages, rents, pensions, utilities, transport fees, etc are normally valued by accountants in terms of Constant Purchasing Power units during low inflation in most economies. Payments in money for these items are normally inflation-adjusted by means of the Consumer Price Index to compensate for the erosion of the real value of the monetary medium of exchange by inflation. Inflation is always and everywhere a monetary phenomenon and can only erode the real value of money (the functional currency inside an economy) and other monetary items. Inflation can not erode the real value of non-monetary items. Constant real value non-monetary items´ real values can be maintained by accountants choosing the Constant Item Purchasing Power Accounting model as per the Framework during low inflation as authorized in IFRS since 1989 instead of currently being eroded by the implementation by accountants of the traditional Historical Cost Model when they apply the stable measuring unit assumption. It is thus accountants´ choice of accounting model and not inflation that maintains or erodes the real value of constant real value non-monetary items like retained earnings, issued share capital (banks´ and companies´ capital base), capital reserves, other shareholder equity items, trade debtors, trade creditors, deferred tax assets and liabilities, other taxes payable and receivable, etc.
Implementing the CIPPA model means accountants choose to reject the stable measuring unit assumption which they implement when they choose to measure financial capital maintenance in nominal monetary units. Accountants world wide currently choose the traditional Historical Cost Accounting model except during hyperinflation when they are required by IFRS to implement IAS 29 which is based on the CPPA model.
Net monetary gain or loss
Accountants have to calculate the net monetary loss or gain from holding monetary items when they choose the CIPPA model and measure financial capital maintenance in units of constant purchasing power.
CIPPA as per the IASB's Framework
Framework for the Preparation and Presentation of Financial Statements
Concepts of Capital and Capital Maintenance
Concepts of Capital
Par. 102
A financial concept of capital is adopted by most entities in preparing their financial statements. Under a financial concept of capital, such as invested money or invested purchasing power, capital is synonymous with the net assets or equity of the entity. Under a physical concept of capital, such as operating capability, capital is regarded as the productive capacity of the entity based on, for example, units of output per day.
Par. 103
The selection of the appropriate concept of capital by an entity should be based on the needs of the users of its financial statements. Thus, a financial concept of capital should be adopted if the users of financial statements are primarily concerned with the maintenance of nominal invested capital '''or the purchasing power of invested capital'''. If, however, the main concern of users is with the operating capability of the entity, a physical concept of capital should be used. The concept chosen indicates the goal to be attained in determining profit, even though there may be some measurement difficulties in making the concept operational.
Concepts of Capital Maintenance and the Determination of Profit
The concepts of capital give rise to the following concepts of capital maintenance:
Par. 104
(a) Financial capital maintenance. Under this concept a profit is earned only if the financial (or money) amount of the net assets at the end of the period exceeds the financial (or money) amount of net assets at the beginning of the period, after excluding any distributions to, and contributions from, owners during the period. Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power.
(b) Physical capital maintenance. Under this concept a profit is earned only if the physical productive capacity (or operating capability) of the entity (or the resources or funds needed to achieve that capacity) at the end of the period exceeds the physical productive capacity at the beginning of the period, after excluding any distributions to, and contributions from, owners during the period.
Par. 105
The concept of capital maintenance is concerned with how an entity defines the capital that it seeks to maintain. It provides the linkage between the concepts of capital and the concepts of profit because it provides the point of reference by which profit is measured; it is a prerequisite for distinguishing between an entity’s return on capital and its return of capital; only inflows of assets in excess of amounts needed to maintain capital may be regarded as profit and therefore as a return on capital. Hence, profit is the residual amount that remains after expenses (including capital maintenance adjustments, where appropriate) have been deducted from income. If expenses exceed income the residual amount is a loss.
Par. 106
The physical capital maintenance concept requires the adoption of the current cost basis of measurement. The financial capital maintenance concept, however, does not require the use of a particular basis of measurement. Selection of the basis under this concept is dependent on the type of financial capital that the entity is seeking to maintain.
Par. 107
The principal difference between the two concepts of capital maintenance is the treatment of the effects of changes in the prices of assets and liabilities of the entity. In general terms, an entity has maintained its capital if it has as much capital at the end of the period as it had at the beginning of the period. Any amount over and above that required to maintain the capital at the beginning of the period is profit.
Par. 108
Under the concept of financial capital maintenance where capital is defined in terms of nominal monetary units, profit represents the increase in nominal money capital over the period. Thus, increases in the prices of assets held over the period, conventionally referred to as holding gains, are, conceptually, profits. They may not be recognised as such, however, until the assets are disposed of in an exchange transaction. When the concept of financial capital maintenance is defined in terms of constant purchasing power units, profit represents the increase in invested purchasing power over the period. Thus, only that part of the increase in the prices of assets that exceeds the increase in the general level of prices is regarded as profit. The rest of the increase is treated as a capital maintenance adjustment and, hence, as part of equity.
Par. 109
Under the concept of physical capital maintenance when capital is defined in terms of the physical productive capacity, profit represents the increase in that capital over the period. All price changes affecting the assets and liabilities of the entity are viewed as changes in the measurement of the physical productive capacity of the entity; hence, they are treated as capital maintenance adjustments that are part of equity and not as profit.
Par. 110
The selection of the measurement bases and concept of capital maintenance will determine the accounting model used in the preparation of the financial statements. Different accounting models exhibit different degrees of relevance and reliability and, as in other areas, management must seek a balance between relevance and reliability. The Framework is applicable to a range of accounting models and provides guidance on preparing and presenting the financial statements constructed under the chosen model. At the present time, it is not the intention of the Board of IASC to prescribe a particular model other than in exceptional circumstances, such as for those entities reporting in the currency of a hyperinflationary economy. This intention will, however, be reviewed in the light of world developments.
The IASB Framework was approved by the IASC Board in April 1989 for publication in July 1989, and adopted by the IASB in April 2001.
CPPA inflation accounting is required by the IASB during hyperinflation
The IASB authorized the CIPPA model during low inflation in the Framework, Par. 104 (a) as an alternative to the Historical Cost Accounting model. The IASB, however, specifically requires the implementation of the CPPA inflation accounting model during hyperinflation as per IAS 29 Financial Reporting in Hyperinflationary Economies which is based on the CPPA model. [http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=CELEX:32003R1725:EN:NOT]
© 2005-2010 by Nicolaas J Smith. All rights reserved
No reproduction without permission.
Saturday, 7 March 2009
Accountants value economic activity
The debate of how to account for value has been around for decades.
Robert Kemp, CPA Professor, University of Virginia – CC http://www.glgroup.com/News/Fair-Value-Accounting---The-Good-And-Bad-Of-It-In-The-Real-World-27848.html
The three distinct economic items in the economy
1. variable items
2. monetary items and
3. constant items
are economic values. Each economic item is an economic value expressed in terms of money. SA accountants account economic transactions involving these three economic items in an organized manner when they implement a double entry accounting model: journal entries, general ledger accounts, trial balances, cash flow statements, items in the Profit and Loss Account, assets and liabilities in the Balance Sheet plus other financial, management and costing reports.
SA accountants value economic items when they account economic activity in the accounting records and prepare financial reports of SA economic entities based on the double entry accounting model. Accounting entries are valuations of the economic items (the debit items and the credit items) being accounted.
SA accountants do not simply record economic activity. Accounting is not just a scorekeeping or recordkeeping of economic events. Accountants value economic items when they account them. Subsequent accounting entries are part of continuous generally accepted accounting practice of valuation of the economic items originally valued and accounted over time as required by SA Generally Accepted Accounting Practice and IFRS implemented in conjunction with the IASB´s Framework.
The measurement basis SA accountants choose to value constant real value non-monetary items determines whether they maintain or destroy their real values. Inflation being a monetary phenomenon cannot destroy the real value of constant real value non-monetary items. When accountants value constant items at their HC nominal monetary values they unknowingly destroy their constant real non-monetary values at a rate equal to the rate of inflation because the depreciating monetary unit of account is the same as the depreciating monetary medium of exchange and inflation destroys the real value of the depreciating monetary medium of exchange. Only when they choose to measure financial capital maintenance in real value maintaining units of constant purchasing power – as they can freely do in terms of the IASB´s Framework, Par. 104 (a) - do they maintain their real values over time.
Variable Items
SA accountants value variable real value non-monetary items in terms of IFRS or SA GAAP. “Listed companies use IFRS and the unlisted companies could use either IFRS or Statements of GAAP.”
Monetary items
SA accountants value monetary items at their original nominal monetary values; that is, at their original HC values since monetary items can not be updated or indexed during the current financial period for the purpose of
1. accounting their values during the reporting period,
2. determining the profit or loss for the reporting period, and
3. measuring financial capital maintenance in either nominal monetary units or constant purchasing power units
during inflation or deflation.
Inflation – not SA accountants - destroys the real value of SA monetary items over time. The internal real value of the Rand is automatically adjusted downwards as it is being destroyed by the economic process of inflation in SA´s inflationary economy as indicated by the rate of change in the CPI. Inflation destroys the real value of monetary items under any accounting model and also when no accounting model is implemented; that is, when a business does not account its economic activities; for example, street vendors. The accounting model has no affect on the real value of monetary items during the reporting period.
Double entry accounting cannot maintain the real value of monetary items during the reporting period. It is not an attribute of double entry accounting to maintain the real value of monetary items during the reporting period. Inflation destroys the real value of monetary items no matter which accounting model is used. That is why low inflation is so critical for long term sustainable economic growth.
Low inflation is what long term sustainable economic growth is built on. Alan Greenspan.
Constant items
SA accountants can choose to measure financial capital maintenance in either nominal monetary units or in real value maintaining units of constant purchasing power as authorized by the IASB in the Framework, Par. 104 (a).
It is very obvious that how SA accountants choose to measure financial capital maintenance does make a big difference to the real value of constant items. There is no substance in the statement that economic resources´ values – per se - are independent of the way in which we value them – no matter how well respected and how important that person is in the SA accounting and academic circles. The accounting model SA accountants choose in terms of the Framework, Par. 104 (a) is of critical importance. When they choose to measure financial capital maintenance in real value maintaining units of constant purchasing power they will maintain the real values of, for example, all SA banks´ and companies´ retained income values constant over time, all else being equal, instead of unknowingly destroying them as the currently do. The only way they can maintain the real value of constant real value non-monetary items during inflation and deflation is by choosing a Constant Purchasing Power Accounting model as per the IASB´s Framework, Par. 104 (a).
Not a single SA accountant in SA chooses to measure financial capital maintenance in real value maintaining units of constant purchasing power as authorized by the IASB in the Framework, Par. 104 (a). SA accountants, unfortunately, choose to measure financial capital maintenance in nominal monetary units and thereby, unknowingly, destroy the real values of constant items at a rate equal to the rate of inflation when they are never or not fully updated over time when they implement the very destructive stable measuring unit assumption as part of the HCA model. SA accountants are unknowingly killing the real economy at the rate of about R200 billion per annum – each and every year - as long as they carry on implementing the very destructive stable measuring unit assumption.
© 2005-2010 by Nicolaas J Smith. All rights reserved
No reproduction without permission.
Robert Kemp, CPA Professor, University of Virginia – CC http://www.glgroup.com/News/Fair-Value-Accounting---The-Good-And-Bad-Of-It-In-The-Real-World-27848.html
The three distinct economic items in the economy
1. variable items
2. monetary items and
3. constant items
are economic values. Each economic item is an economic value expressed in terms of money. SA accountants account economic transactions involving these three economic items in an organized manner when they implement a double entry accounting model: journal entries, general ledger accounts, trial balances, cash flow statements, items in the Profit and Loss Account, assets and liabilities in the Balance Sheet plus other financial, management and costing reports.
SA accountants value economic items when they account economic activity in the accounting records and prepare financial reports of SA economic entities based on the double entry accounting model. Accounting entries are valuations of the economic items (the debit items and the credit items) being accounted.
SA accountants do not simply record economic activity. Accounting is not just a scorekeeping or recordkeeping of economic events. Accountants value economic items when they account them. Subsequent accounting entries are part of continuous generally accepted accounting practice of valuation of the economic items originally valued and accounted over time as required by SA Generally Accepted Accounting Practice and IFRS implemented in conjunction with the IASB´s Framework.
The measurement basis SA accountants choose to value constant real value non-monetary items determines whether they maintain or destroy their real values. Inflation being a monetary phenomenon cannot destroy the real value of constant real value non-monetary items. When accountants value constant items at their HC nominal monetary values they unknowingly destroy their constant real non-monetary values at a rate equal to the rate of inflation because the depreciating monetary unit of account is the same as the depreciating monetary medium of exchange and inflation destroys the real value of the depreciating monetary medium of exchange. Only when they choose to measure financial capital maintenance in real value maintaining units of constant purchasing power – as they can freely do in terms of the IASB´s Framework, Par. 104 (a) - do they maintain their real values over time.
Variable Items
SA accountants value variable real value non-monetary items in terms of IFRS or SA GAAP. “Listed companies use IFRS and the unlisted companies could use either IFRS or Statements of GAAP.”
Monetary items
SA accountants value monetary items at their original nominal monetary values; that is, at their original HC values since monetary items can not be updated or indexed during the current financial period for the purpose of
1. accounting their values during the reporting period,
2. determining the profit or loss for the reporting period, and
3. measuring financial capital maintenance in either nominal monetary units or constant purchasing power units
during inflation or deflation.
Inflation – not SA accountants - destroys the real value of SA monetary items over time. The internal real value of the Rand is automatically adjusted downwards as it is being destroyed by the economic process of inflation in SA´s inflationary economy as indicated by the rate of change in the CPI. Inflation destroys the real value of monetary items under any accounting model and also when no accounting model is implemented; that is, when a business does not account its economic activities; for example, street vendors. The accounting model has no affect on the real value of monetary items during the reporting period.
Double entry accounting cannot maintain the real value of monetary items during the reporting period. It is not an attribute of double entry accounting to maintain the real value of monetary items during the reporting period. Inflation destroys the real value of monetary items no matter which accounting model is used. That is why low inflation is so critical for long term sustainable economic growth.
Low inflation is what long term sustainable economic growth is built on. Alan Greenspan.
Constant items
SA accountants can choose to measure financial capital maintenance in either nominal monetary units or in real value maintaining units of constant purchasing power as authorized by the IASB in the Framework, Par. 104 (a).
It is very obvious that how SA accountants choose to measure financial capital maintenance does make a big difference to the real value of constant items. There is no substance in the statement that economic resources´ values – per se - are independent of the way in which we value them – no matter how well respected and how important that person is in the SA accounting and academic circles. The accounting model SA accountants choose in terms of the Framework, Par. 104 (a) is of critical importance. When they choose to measure financial capital maintenance in real value maintaining units of constant purchasing power they will maintain the real values of, for example, all SA banks´ and companies´ retained income values constant over time, all else being equal, instead of unknowingly destroying them as the currently do. The only way they can maintain the real value of constant real value non-monetary items during inflation and deflation is by choosing a Constant Purchasing Power Accounting model as per the IASB´s Framework, Par. 104 (a).
Not a single SA accountant in SA chooses to measure financial capital maintenance in real value maintaining units of constant purchasing power as authorized by the IASB in the Framework, Par. 104 (a). SA accountants, unfortunately, choose to measure financial capital maintenance in nominal monetary units and thereby, unknowingly, destroy the real values of constant items at a rate equal to the rate of inflation when they are never or not fully updated over time when they implement the very destructive stable measuring unit assumption as part of the HCA model. SA accountants are unknowingly killing the real economy at the rate of about R200 billion per annum – each and every year - as long as they carry on implementing the very destructive stable measuring unit assumption.
© 2005-2010 by Nicolaas J Smith. All rights reserved
No reproduction without permission.
Three fundamentally different basic economic items
The economy is divided in the monetary and non-monetary or real economy. Economic items consist of monetary and non-monetary items. Non-monetary items are sub-divided in variable real value non-monetary items and constant real value non-monetary items. There are thus three fundamentally different basic economic items in the economy: monetary items, variable items and constant items.
Variable real value non-monetary items
The first economic items were variable real value items. Their real values were determined by supply and demand. Their values were not yet expressed in terms of money because money was not yet invented at that time.
The first economies were barter economies. People bartered economic items they possessed or produced in excess of their own personal needs for other products they desired from other people who had an excess of the products they in turn possessed or produced.
There was no inflation because there was no money. There was no monetary medium of exchange. There was no monetary unit of account. There was no monetary store of wealth. There was no money illusion.
There was no double entry accounting model at that time.
There were thus no Historical Cost Accounting model, no stable measuring unit assumption, no historical cost items and no nominal monetary units.
There was also no Consumer Price Index at that time and consequently there were no units of constant purchasing power and no real value maintaining Constant Purchasing Power Accounting model.
There were no financial reports: e.g. no profit and loss accounts and no balance sheets.
There were no monetary items and no constant items. There were only variable real value items not yet expressed in monetary terms.
Examples of variable real value non-monetary items in today’s economy are property, plant, equipment, inventory, shares, raw materials, merchandise, patents, trademarks, etc.
Monetary items
Money was then invented over a long period of time as a response to the limitations imposed by the barter economy. Eventually money came to fulfil the following three functions:
a. Medium of exchange
b. Store of value
c. Unit of account
Non-monetary items were only defined in monetary terms after the invention of money when it came to be used as the basic monetary unit of account in the economy. The economy came to be divided in the monetary economy and the non-monetary or real economy. There were monetary items and non-monetary items.
Monetary items
Monetary items are money held and items with an underlying monetary nature.
Examples of monetary items in today’s economy are bank notes and coins, bank loans, bank account balances, treasury bills, commercial bonds, government bonds, mortgage bonds, student loans, car loans, consumer loans, credit card loans, notes payable, notes receivable, etc.
Non-monetary items
Non-monetary items are all items that are not monetary items.
Non-monetary items in today’s economy are divided into two sub-groups:
a) Variable real value non-monetary items
b) Constant real value non-monetary items
There were still no units of constant purchasing power because there was still no CPI at that time. There was still no Historical Cost Accounting model and still no stable measuring unit assumption. There was still no Constant Purchasing Power Accounting model. There were still no double entry financial reports: still no profit and loss accounts and still no balance sheets.
Inflation
Inflation is always and everywhere a monetary phenomenon: Milton Friedman.
Inflation destroys the real value of money. Deflation creates real value in money.
Inflation reared its ugly head soon after the invention of money. It only destroyed the real value of money and other monetary items at that time as it does today. Inflation did not and can not destroy the real value of variable and constant items. Inflation has no effect on the real value of non-monetary items.
There was only one systemic economy-wide process of real value destruction at that time. The economic process of inflation destroyed the real value of money and other monetary items equally throughout the monetary economy at that time as it does today in economies subject to inflation.
There was no second systemic economy-wide accounting practice destroying the real value of constant real value non-monetary items never or not fully updated as we experience today because the real value destroying Historical Cost Accounting model, which includes the very destructive stable measuring unit assumption, was not yet invented at that time. Today South African accountants unknowingly destroy the real values of constant real value non-monetary items never or not fully updated because they choose to measure financial capital maintenance in SA banks and companies in nominal monetary units when they implement the very destructive stable measuring unit assumption as part of the real value destroying traditional Historical Cost Accounting model.
Constant items
Finally the double entry accounting model was invented. It was first comprehensively codified by the Italian Franciscan monk, Luca Pacioli in his book Summa de arithmetica, geometria, proportioni et proportionalita, published in Venice in 1494.
The invention of the double entry accounting model enables accountants to maintain the real values of both income statement as well as balance sheet constant real value non-monetary items – the third distinct category of economic items. Maintaining the real value of constant items in the SA economy where accountants use the double entry accounting model to account all economic activity is, however, only possible with the real value maintaining Constant Purchasing Power Accounting model during inflation. It is not possible, at present, while SA accountants implement the real value destroying traditional Historical Cost Accounting model because of their application of the very destructive stable measuring unit assumption during inflation. SA accountants unknowingly destroy real value on a massive scale in the real economy when they implement the traditional Historical Cost model.
The specific choice of measuring financial capital maintenance in units of constant purchasing power (the CPPA model) at all levels of inflation and deflation as contained in the Framework for the Preparation and Presentation of Financial Statements, was approved by the International Accounting Standards Board’s predecessor body, the International Accounting Standards Committee Board, in April 1989 for publication in July 1989 and adopted by the IASB in April 2001.
“In the absence of a Standard or an Interpretation that specifically applies to a transaction, management must use its judgement in developing and applying an accounting policy that results in information that is relevant and reliable. In making that judgement, IAS 8.11 requires management to consider the definitions, recognition criteria, and measurement concepts for assets, liabilities, income, and expenses in the Framework. This elevation of the importance of the Framework was added in the 2003 revisions to IAS 8." IAS Plus, Deloitte.
IAS8, 11: “In making the judgement, management shall refer to, and consider the applicability of, the following sources in descending order:
(a) the requirements and guidance in Standards and Interpretations dealing with similar and related issues; and
(b) the definitions, recognition criteria and measurement concepts for assets, liabilities, income and expenses in the Framework.”
There is no applicable International Financial Reporting Standard or Interpretation regarding the valuation of constant real value non-monetary items, e.g. issued share capital, retained earnings, capital reserves, all other items in Shareholders Equity, trade debtors, trade creditors, deferred tax assets and liabilities, taxes payable and receivable, all other non-monetary receivables and payables, Profit and Loss account items such as salaries, wages, rents, etc. The Framework is thus applicable.
The scope of the Framework includes dealing with defining, recognizing and measuring the items in financial statements and dealing with the concepts of capital and capital maintenance.
Framework, Par. 104 (a)
Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power.
The Framework, Par. 110 states that the choice of the measurement bases and the concept of capital maintenance will decide the accounting model applied in the preparation of the financial reports. The Framework applies to different accounting models and is a guide to the preparation and presentation of the financial reports under the chosen accounting model.
The Framework is the IASB approved basis for accountants to choose, in terms of Par. 104 (a), to measure financial capital maintenance in units of constant purchasing power – the CPPA model - instead of in nominal monetary units – the traditional HCA model. They can, in terms of Par. 110, choose the Constant Purchasing Power Accounting model implementing the constant purchasing power financial capital concept, capital maintenance concept and the determination of profit/loss in terms of units of constant purchasing power instead of the Historical Cost capital concept, capital maintenance concept and the determination of profit/loss in terms of nominal monetary units.
The Framework, Par. 102 states that most companies choose a financial concept of capital. Capital is the same as the shareholders´ equity of a company or its net assets when a financial concept of capital is adopted, for example, invested purchasing power or invested money.
The maintenance of capital is as important as its recognition and definition. Capital maintenance is an accounting practice implementing a concept of capital.
The Framework states that the needs of the users of financial reports should be the basis for choosing the correct concept of capital by a company. When the users of financial reports are mainly concerned with the preservation of the purchasing power of the invested capital or its nominal value, then a financial concept of capital should be used.
According to the Framework, the choice of the measurement bases and the concept of capital maintenance will decide the accounting model applied in the preparation of the financial reports. A profit is made under the financial capital maintenance concept only when the period-end financial (or money) net asset value is greater than at the start of the period, after subtracting distributions and contributions to and from shareholders during the accounting period. Financial capital maintenance can be calculated in either units of constant purchasing power or in nominal monetary units.
The real value maintaining Constant Purchasing Power Accounting model is thus an IASB approved alternative to the real value destroying traditional Historical Cost Accounting model.
The Framework states that the capital maintenance concept deals with how companies define the capital they want to preserve. It is the connection between the concepts of capital and the concepts of profit/loss since it gives the point of reference for calculating profit/loss.
Examples of constant real value non-monetary items in today’s economy are Profit and Loss Account items like salaries, wages, rentals, pensions, taxes, duties, fixed interest payments, etc as well as balance sheet items like retained earnings, issued share capital, capital reserves, share issue premiums, share issue discounts, provisions, capital reserves, all other shareholder’s equity items, trade debtors, trade creditors, other non-monetary debtors and creditors, taxes payable and receivable, deferred tax assets and liabilities, dividends payable and receivable, royalties payable and receivable, etc.
Variable real value non-monetary items
The first economic items were variable real value items. Their real values were determined by supply and demand. Their values were not yet expressed in terms of money because money was not yet invented at that time.
The first economies were barter economies. People bartered economic items they possessed or produced in excess of their own personal needs for other products they desired from other people who had an excess of the products they in turn possessed or produced.
There was no inflation because there was no money. There was no monetary medium of exchange. There was no monetary unit of account. There was no monetary store of wealth. There was no money illusion.
There was no double entry accounting model at that time.
There were thus no Historical Cost Accounting model, no stable measuring unit assumption, no historical cost items and no nominal monetary units.
There was also no Consumer Price Index at that time and consequently there were no units of constant purchasing power and no real value maintaining Constant Purchasing Power Accounting model.
There were no financial reports: e.g. no profit and loss accounts and no balance sheets.
There were no monetary items and no constant items. There were only variable real value items not yet expressed in monetary terms.
Examples of variable real value non-monetary items in today’s economy are property, plant, equipment, inventory, shares, raw materials, merchandise, patents, trademarks, etc.
Monetary items
Money was then invented over a long period of time as a response to the limitations imposed by the barter economy. Eventually money came to fulfil the following three functions:
a. Medium of exchange
b. Store of value
c. Unit of account
Non-monetary items were only defined in monetary terms after the invention of money when it came to be used as the basic monetary unit of account in the economy. The economy came to be divided in the monetary economy and the non-monetary or real economy. There were monetary items and non-monetary items.
Monetary items
Monetary items are money held and items with an underlying monetary nature.
Examples of monetary items in today’s economy are bank notes and coins, bank loans, bank account balances, treasury bills, commercial bonds, government bonds, mortgage bonds, student loans, car loans, consumer loans, credit card loans, notes payable, notes receivable, etc.
Non-monetary items
Non-monetary items are all items that are not monetary items.
Non-monetary items in today’s economy are divided into two sub-groups:
a) Variable real value non-monetary items
b) Constant real value non-monetary items
There were still no units of constant purchasing power because there was still no CPI at that time. There was still no Historical Cost Accounting model and still no stable measuring unit assumption. There was still no Constant Purchasing Power Accounting model. There were still no double entry financial reports: still no profit and loss accounts and still no balance sheets.
Inflation
Inflation is always and everywhere a monetary phenomenon: Milton Friedman.
Inflation destroys the real value of money. Deflation creates real value in money.
Inflation reared its ugly head soon after the invention of money. It only destroyed the real value of money and other monetary items at that time as it does today. Inflation did not and can not destroy the real value of variable and constant items. Inflation has no effect on the real value of non-monetary items.
There was only one systemic economy-wide process of real value destruction at that time. The economic process of inflation destroyed the real value of money and other monetary items equally throughout the monetary economy at that time as it does today in economies subject to inflation.
There was no second systemic economy-wide accounting practice destroying the real value of constant real value non-monetary items never or not fully updated as we experience today because the real value destroying Historical Cost Accounting model, which includes the very destructive stable measuring unit assumption, was not yet invented at that time. Today South African accountants unknowingly destroy the real values of constant real value non-monetary items never or not fully updated because they choose to measure financial capital maintenance in SA banks and companies in nominal monetary units when they implement the very destructive stable measuring unit assumption as part of the real value destroying traditional Historical Cost Accounting model.
Constant items
Finally the double entry accounting model was invented. It was first comprehensively codified by the Italian Franciscan monk, Luca Pacioli in his book Summa de arithmetica, geometria, proportioni et proportionalita, published in Venice in 1494.
The invention of the double entry accounting model enables accountants to maintain the real values of both income statement as well as balance sheet constant real value non-monetary items – the third distinct category of economic items. Maintaining the real value of constant items in the SA economy where accountants use the double entry accounting model to account all economic activity is, however, only possible with the real value maintaining Constant Purchasing Power Accounting model during inflation. It is not possible, at present, while SA accountants implement the real value destroying traditional Historical Cost Accounting model because of their application of the very destructive stable measuring unit assumption during inflation. SA accountants unknowingly destroy real value on a massive scale in the real economy when they implement the traditional Historical Cost model.
The specific choice of measuring financial capital maintenance in units of constant purchasing power (the CPPA model) at all levels of inflation and deflation as contained in the Framework for the Preparation and Presentation of Financial Statements, was approved by the International Accounting Standards Board’s predecessor body, the International Accounting Standards Committee Board, in April 1989 for publication in July 1989 and adopted by the IASB in April 2001.
“In the absence of a Standard or an Interpretation that specifically applies to a transaction, management must use its judgement in developing and applying an accounting policy that results in information that is relevant and reliable. In making that judgement, IAS 8.11 requires management to consider the definitions, recognition criteria, and measurement concepts for assets, liabilities, income, and expenses in the Framework. This elevation of the importance of the Framework was added in the 2003 revisions to IAS 8." IAS Plus, Deloitte.
IAS8, 11: “In making the judgement, management shall refer to, and consider the applicability of, the following sources in descending order:
(a) the requirements and guidance in Standards and Interpretations dealing with similar and related issues; and
(b) the definitions, recognition criteria and measurement concepts for assets, liabilities, income and expenses in the Framework.”
There is no applicable International Financial Reporting Standard or Interpretation regarding the valuation of constant real value non-monetary items, e.g. issued share capital, retained earnings, capital reserves, all other items in Shareholders Equity, trade debtors, trade creditors, deferred tax assets and liabilities, taxes payable and receivable, all other non-monetary receivables and payables, Profit and Loss account items such as salaries, wages, rents, etc. The Framework is thus applicable.
The scope of the Framework includes dealing with defining, recognizing and measuring the items in financial statements and dealing with the concepts of capital and capital maintenance.
Framework, Par. 104 (a)
Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power.
The Framework, Par. 110 states that the choice of the measurement bases and the concept of capital maintenance will decide the accounting model applied in the preparation of the financial reports. The Framework applies to different accounting models and is a guide to the preparation and presentation of the financial reports under the chosen accounting model.
The Framework is the IASB approved basis for accountants to choose, in terms of Par. 104 (a), to measure financial capital maintenance in units of constant purchasing power – the CPPA model - instead of in nominal monetary units – the traditional HCA model. They can, in terms of Par. 110, choose the Constant Purchasing Power Accounting model implementing the constant purchasing power financial capital concept, capital maintenance concept and the determination of profit/loss in terms of units of constant purchasing power instead of the Historical Cost capital concept, capital maintenance concept and the determination of profit/loss in terms of nominal monetary units.
The Framework, Par. 102 states that most companies choose a financial concept of capital. Capital is the same as the shareholders´ equity of a company or its net assets when a financial concept of capital is adopted, for example, invested purchasing power or invested money.
The maintenance of capital is as important as its recognition and definition. Capital maintenance is an accounting practice implementing a concept of capital.
The Framework states that the needs of the users of financial reports should be the basis for choosing the correct concept of capital by a company. When the users of financial reports are mainly concerned with the preservation of the purchasing power of the invested capital or its nominal value, then a financial concept of capital should be used.
According to the Framework, the choice of the measurement bases and the concept of capital maintenance will decide the accounting model applied in the preparation of the financial reports. A profit is made under the financial capital maintenance concept only when the period-end financial (or money) net asset value is greater than at the start of the period, after subtracting distributions and contributions to and from shareholders during the accounting period. Financial capital maintenance can be calculated in either units of constant purchasing power or in nominal monetary units.
The real value maintaining Constant Purchasing Power Accounting model is thus an IASB approved alternative to the real value destroying traditional Historical Cost Accounting model.
The Framework states that the capital maintenance concept deals with how companies define the capital they want to preserve. It is the connection between the concepts of capital and the concepts of profit/loss since it gives the point of reference for calculating profit/loss.
Examples of constant real value non-monetary items in today’s economy are Profit and Loss Account items like salaries, wages, rentals, pensions, taxes, duties, fixed interest payments, etc as well as balance sheet items like retained earnings, issued share capital, capital reserves, share issue premiums, share issue discounts, provisions, capital reserves, all other shareholder’s equity items, trade debtors, trade creditors, other non-monetary debtors and creditors, taxes payable and receivable, deferred tax assets and liabilities, dividends payable and receivable, royalties payable and receivable, etc.
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