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Tuesday, 6 October 2009

Capital illusion

Capital illusion is the mistaken belief by accountants, economists, analysts, investors and business people that the real value of companies´ capital and retained profits are always adequately maintained during low inflation under the Historical Cost paradigm.

Capital illusion is aided and abetted by the International Accounting Standards Board’s unqualified statement in the Framework, Par. 104 (a) that financial capital maintenance can be measured in nominal monetary units.

It is impossible to maintain the real value of financial capital in nominal monetary units – per se – during inflation.

100% of the inflation-adjusted original real values of all contributions to Shareholders´ Equity have to be invested during inflation in revaluable variable item fixed assets with an equivalent updated fair value (revalued or with unrecorded hidden holding gains) in order not to destroy Shareholders Equity’s original real value at a rate equal to the rate of inflation under the traditional Historical Cost Accounting model implemented by most companies in South Africa.

Very few companies in SA abide by the 100% of equity invested in fixed assets rule.

There is neither capital illusion nor massive unnecessary capital destruction when financial capital maintenance is measured in units of constant purchasing power as authorized by the IASB in the Framework, Par. 104 (a) in 1989: the real value of Shareholders´ Equity is maintained even without fixed assets in companies that break even.

Kindest regards,

Nicolaas Smith

Summary: Capital illusion is the mistake everyone makes in thinking that the real value of companies´ equity (capital and retained profits) is always backed by their fixed assets - either revalued or with unaccounted holding gains. Inflation-adjusting all constant items will maintain the real value of your equity forever as long as you break even - even if you have no fixed assets at all - instead of destroying the unbacked part at the rate of inflation as accountants are unknowingly doing at the moment, unnecessarily decapitalizing SA companies and banks by about R200 billion per year.