Constant Item Purchasing Power Accounting

1.0 Three basic economic items

The economy consists of economic items and economic entities. Economic items have economic value. Accountants value economic items when they account them. Utility, scarcity and exchangeability are the three basic attributes of an economic item which, in combination, give it economic value. Economic items consist of monetary and non-monetary items. The economy is divided in the monetary and non-monetary or real economy. Non-monetary items are sub-divided in variable real value non-monetary items and constant real value non-monetary items. The three fundamentally different basic economic items in the economy are monetary items, variable items and constant items.


Variable real value non-monetary items


Variable items are non-monetary items with variable real values normally traded in markets.

Examples of variable items in today’s economy are property, plant, equipment, inventory, quoted and unquoted shares, raw materials, finished goods, patents, trademarks, foreign exchange, etc.

There are markets for all the above items. All the above items can be bought or sold in a myriad of different markets world wide.

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 or wished to exchange.

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 no Historical Cost Accounting model, no stable measuring unit assumption, no historical cost items and no nominal monetary units.

There was no value based accounting.

There was also no Consumer Price Index at that time. Consequently there were no units of constant purchasing power and no price-level accounting. There was no inflation accounting. There was no Constant Purchasing Power Accounting model under which all non-monetary items (variable and constant items) are inflation-adjusted by means of the CPI during hyperinflation.

There was also no Constant Item Purchasing Power Accounting under which only constant items are inflation-adjusted by means of the CPI during non-hyperinflationary periods in order to implement a financial capital concept of invested purchasing power by measuring financial capital maintenance in units of constant purchasing power and determining profit/loss in constant purchasing power units while variable items are valued in terms of specific rules at, for example, market value, fair value, present value, recoverable value or net realizable value.

There were no financial reports: e.g. no income statements, no balance sheets, no cash flow statements and no statements of changes in shareholders´ equity.

There were no monetary items. There were variable real value items not yet expressed in monetary terms.



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. 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 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.

Money and other monetary items´ real values are continuously being destroyed by inflation.


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

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

There were still no units of constant purchasing power because there was still no CPI at that time. There were still no HCA model and still no stable measuring unit assumption. There were still no price-level accounting, no CPP inflation accounting model and no Constant Item Purchasing Power Accounting model. There were still no financial reports.

Inflation


Inflation is always and everywhere a monetary phenomenon: Milton Friedman.

Inflation is a rise in the general price level of goods and services in an economy over a period of time. Inflation destroys the real value of money and other monetary items over time. Disinflation is a decrease in inflation’s rate of increase. Inflation still destroys the real value of money and other monetary items during disinflation, just at a slower rate than before. Deflation creates real value in money and other monetary items over time. Deflation is a sustained decrease in the general price level after it has passed below zero per cent inflation.

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 or erode (which is the same as destroy) the real value of non-monetary items – either variable or constant real value non-monetary items. Inflation has no effect on the real value of non-monetary items.

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

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

Changes in financial reporting in Turkey, Historical Development of Inflation Accounting 1960 - 2005

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 HCA 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 traditional HCA 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 generally measure financial capital maintenance in SA banks and companies in nominal monetary units. They generally implement the very destructive stable measuring unit assumption as part of the real value destroying traditional HCA model.

Accountants at Johannesburg Stock Exchange listed companies as well as accountants at unlisted SA companies who prepare financial statements in terms of International Financial Reporting Standards generally choose to measure financial capital maintenance in nominal monetary units in terms of the International Accounting Standard Board’s Framework for the Preparation and Presentation of Financial Statements, Par. 104 (a) which they apply in the absence of Standards relating to the valuation of capital, the maintenance of capital and the determination of profit or loss. The Framework, Par. 104 (a) states that financial capital maintenance can be calculated in either units of constant purchasing power or in nominal monetary units. Accountants at JSE listed companies have to prepare financial reports in terms of IFRS while accountants at unlisted SA companies can prepare financial statements either in terms of IFRS or South African Generally Accepted Accounting Practice.

Accountants preparing financial reports of SA unlisted companies in terms of SA GAAP generally also choose to measure financial capital maintenance in nominal monetary units and implement the HCA model since it is the generally accepted traditional accounting model.


Constant items


Constant items are non-monetary items with constant real values over time normally not traded in a market.


There are markets, namely stock markets, for company shares represented in the form of share certificates which are not constant items but variable real value non-monetary items, but, there is no market for the constant real value non-monetary item Issued Share Capital on a company’s balance sheet. Likewise there is no market for the specific individual constant items retained income, share premium, share discount, capital reserves or revaluation reserves, etc. There is no market for the individual constant items deferred tax assets or deferred tax liabilities. There is no market for taxes payable, taxes receivable, royalties payable, royalties receivable, etc. There is no market for trade creditors.

There is, however, a market for trade debtors when they are treated as monetary items. Trade debtors can be sold to a debt collecting company. Trade debtors are generally treated as monetary items in this case as can be seen from the IASB´s partially incorrect definition of monetary items as money held – which is correct and “items to be received or paid in money” which is incorrect. All items to be paid or received in money are not monetary items. Settlement values for most non-monetary items are to be paid or received in money.

The double entry accounting model 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 Consumer Price Index allows accountants to maintain the real values of certain income statement constant items, e.g., salaries, wages, rents, etc during inflationary periods with the constant purchasing power measurement basis while they implement the overall HCA model during non-hyperinflationary periods and with the inflation accounting CPPA model during hyperinflation. Constant Purchasing Power Accounting as defined in International Accounting Standard IAS 29 Financial Reporting In Hyperinflationary Economies is an inflation accounting model where under both variable and constant real value non-monetary items are inflation-adjusted by means of the CPI during hyperinflation.

Only the Constant Item Purchasing Power Accounting model as approved by the IASB in the Framework, Par. 104 (a), enables accountants to maintain the real values of both income statement and balance sheet constant items during non-hyperinflationary periods. The Framework, Par. 104 (a) states that financial capital maintenance can be calculated in either units of constant purchasing power or in nominal monetary units. Maintaining the real value of all constant items in the SA economy where accountants use the double entry accounting model to account economic activity is only possible with the real value maintaining Constant Item Purchasing Power Accounting+ model as authorized by the IASB in the Framework, Par. 104 (a) which is read in conjunction with International Financial Reporting Standards during inflation and deflation. It is not possible, at present, while SA accountants implement the real value destroying traditional HCA 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 during inflation.

The specific choice of measuring financial capital maintenance in units of constant purchasing power (the Constant Item Purchasing Power Accounting 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 the constant real value non-monetary items issued share capital, retained earnings, capital reserves, share issue premium, share issue discount, all other items in Shareholders Equity, the maintenance of financial capital and the determination of profit or loss. The Framework is thus applicable. There are Standards for trade debtors, trade creditors, other non-monetary payables, other non-monetary receivables, deferred tax assets, deferred tax liabilities, taxes payable and taxes receivable. In terms of IAS8.11 the Standards take precedence over the Framework in the case of these items.

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.

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. 102, to implement a financial capital concept (instead of a physical capital concept) of invested purchasing power (instead of invested money) where under they choose, in terms of Par. 104 (a), to measure financial capital maintenance in units of constant purchasing power – the Constant Item Purchasing Power Accounting model - instead of in traditional HC nominal monetary units during non-hyperinflationary periods.

In terms of the Framework Par. 110, accountants choose the Constant Item Purchasing Power Accounting model when they choose, in terms of Par. 104 (a), to measure financial capital maintenance in units of constant purchasing power during non-hyperinflationary periods. They choose to implement the constant purchasing power financial capital concept of invested purchasing power, the constant purchasing power financial capital maintenance concept and they choose to determine profit or loss in terms of units of constant purchasing power during non-hyperinflationary periods instead of the traditional HC financial capital concept of invested money and the HC financial capital maintenance concept and the HC profit or loss determination concept in nominal monetary units non-hyperinflationary periods.

The Framework, Par. 102 states that most companies choose a financial concept of capital instead of a physical capital concept. Capital is the same as the company’s shareholders´ equity or its net assets when a financial concept of capital is adopted; either in invested purchasing power or in invested money.

The maintenance of capital being shareholders´ equity or net assets is as important as its recognition and definition. Capital maintenance is an accounting practice implementing a chosen concept of capital: either physical capital maintenance or financial capital maintenance. Financial capital maintenance can be calculated in either units of constant purchasing power or in nominal monetary units. Both methods are compliant with IFRS.


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 during non-hyperinflationary periods.

The real value maintaining Constant Item Purchasing Power Accounting model is an IASB approved price-level accounting alternative to the real value destroying traditional HCA model also approved by the IASB in Par. 104 (a).

The Framework states that the capital maintenance concept deals with how companies define the capital they want to preserve. It is the link between the concept of capital and the concept of profit or loss since it gives the point of reference for calculating profit or loss.

Examples of constant real value non-monetary items in today’s economy are income statement constant items like salaries, wages, rentals, taxes, duties, fixed interest payments, all other items in the income statement as well as balance sheet constant 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.