Friday, 22 January 2010

Economic fallacies not yet extinct

Economic history is replete with fallacies which became extinct with the developement of economic understanding.

The three economic fallacies not yet extinct are:

1. The stable measuring unit assumption.

2. Financial capital maintenance in nominal monetary units.

3. The erosion of companies´ profits and capital caused by inflation.

We all know that money is not perfectly stable and that it is impossible to maintain the real value of capital with financial capital maintenance in nominal monetary units per se during inflation and deflation.

SA accountants unknowingly destroy the real value of companies´ profits and capital never maintained with their free choice of implementing the stable measuring unit assumption during inflation. Inflation can only destroy the real value of money and other monetary items. Inflation has no effect on the real value of non-monetary items.

The erosion of companies´ capital and profits by inflation is a very popular accounting fallacy stated by, for example, the US Financial Accounting Standards Board:

The basic proposition underlying Statement 33 — that inflation causes historical cost financial statements to show illusory profits and mask erosion of capital — is virtually undisputed. Financial Accounting Standard FAS 89 (voluntary disclosure), Par 4, P 5, 1986


Mr. Mosso dissents because he believes that the Statement does not bring the basic problem it addresses — measuring the effect of inflation on business operations — into focus. Because of that he doubts that it will effectively communicate the erosive impact of inflation on profits and capital and the significance of that erosion on all who have an investment stake in business enterprises. FAS 33 (superseded by FAS 89), Par 67, P 22, 1979.

The FASB blamed inflation for the erosion – which is the same as destruction – of companies´ capital and profits, but, in the same paragraph carried on to admit that the traditional Historical Cost Accounting model or, specifically, the stable measuring unit assumption does the destroying:

Because most accountants and users of financial statements have been inculcated with a model of financial reporting that assumes stability of the monetary unit, accepting a change of this consequence would take a lengthy period of time under the best of circumstances. FAS 89, Par 4, P6, 1986.

The International Accounting Standards Board also blamed inflation in IAS 15 Information Reflecting the Effects of Changing Prices (withdrawn):

The information required by this standard is designed to make users of an enterprise’s financial statements aware of the effects of changing prices on the results of its operations. IAS 15, Par 7, 1983.

Both shareholders´ equity being a company’s capital as well as retained profits are 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.

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

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