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Friday, 12 February 2010

Capital maintenance without more money or profits

Capital maintenance logically means maintaining the real value of existing capital. Any other definition is obviously wrong. The IASB´s financial capital maintenance in nominal monetary units is a joke besides being a fallacy. Unfortunately the world economy is based on that statement. Capital is a constant real value non-monetary item: thus, it is a constant item from the moment it is contributed and logically should remain a constant real value non-monetary item forever - all else being equal - providing the company breaks even: a loss is a loss.

Financial capital can be measured in nominal monetary units for historical purposes only during inflation and deflation. The IASB´s statement in the Framework, Par 104 (a) that "Financial capital maintenance can be measured in nominal monetary units" is a fallacy during inflation and deflation - that means always: we have never had zero inflation and we are not likely to have zero inflation any time soon.

Capital is saved up real value used to create more real value. In the case of human capital it is accumulated experience and knowledge used to create more real value via a company structure.

In general most companies start off with a capital base more or less sufficient for the purpose the company was created for. Under the traditional Historical Cost Accounting model fixed assets used to be accounted only at historical cost. Obviously land and buildings bought many years ago and accounted at their original cost do not appear at their current values in the financial statements. There are thus hidden or unreported holding gains often assumed sufficient to maintain the real value of capital.

Capital maintenance used to imply not paying dividends from capital. A company´s nominal capital was seen as a guarantee for creditors for amounts owed to them.

Today a SA company can pay dividends from capital as long as it is still solvent and liquid after the payment.

It can not pay dividends from capital if there are reasonable grounds for believing:

(a) that the company is or would after the payment be unable to pay its debts as they become due in the ordinary course of business (this is known as the “liquidity” test); or
(b) the consolidated assets of the company fairly valued would after the payment be less than the consolidated liabilities of the company (this is known as the “solvency” test).

When a company has no revaluable fixed assets its capital is simply a monetary item: the same as cash and its real value is simply destroyed at the annual rate of inflation.

Most companies do not have revaluable fixed assets equal to the original real value of all contributions to shareholders´ equity. The real value of their retained profits and capital are thus being destroyed at the annual rate of inflation in proportion of the original real value not backed by revaluable fixed assets to the total original real value of all contributions to equity.

SA companies thus ended up with insufficient equity. They continuously attempt to fix this problem by retaining more and more profits in the company instead of paying them out as dividends. This is very evident in many quite old and large companies and groups. They have small amounts of capital and share premium but huge amounts of retained profits. They try to maintain their capital base with always more additions to retained profits because their accountants are unknowingly destroying the real value of their existing equity with their very destructive stable measuring unit assumption. Their accountants are very efficient and relentlessly unknowingly also destroy the real value of the retained profits and the vicious never ending annual cycle of unknowing real value destruction by SA accountants applying their very destructive stable measuring unit assumption just carries on and on.

When SA companies change over to financial capital maintenance in units of constant purchasing power they will maintain the real value of their equity with financial capital maintenance in units of constant purchasing power forever: no extra money or retained profits required. All they have to do is break even and implement financial capital maintenance in unit of constant purchasing power instead of their current financial capital maintenance in nominal monetary units which is a fallacy: financial capital maintenance in nominal monetary units per se during low inflation and deflation is impossible even though the IASB authorized it 21 years ago.

The IASB´s International Financial Reporting Standards are thus based on popular accounting fallacies. They should not be. In the case of South Africa, it costs us about R200 billion per annum in real value unnecessarily, unknowingly and unintentionally destroyed by our accountants implementing their very destructive stable measuring units assumption - as approved by the IASB in 1989. World wide that costs the world economy hundreds of billions of Euros per annum.

SA accountants do not understand what financial capital maintenance in units of constant purchasing power during low inflation means. If they did, they would have done something to stop the stable measuring unit assumption by now. SA accountants implement the stable measuring unit assumption.
Copyright © 2010 Nicolaas J Smith