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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]

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