Wednesday, 9 December 2009

Inflation illusion

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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