Saturday, 20 February 2010

Inflation Accounting

One of the inflation accounting models that was tried unsuccessfully in the 1970´s and 1980´s was Constant Purchasing Power Accounting (CPPA).

The Financial Accounting Standards Board issued an exposure draft in the United States in January, 1975, that required supplemental financial reports on a Constant Purchasing Power inflation accounting price-level basis. The Securities and Exchange Commission in the USA proposed in 1976 the disclosure of the current replacement cost of amortizable, depletable and depreciable assets used for production as well as most inventories at the financial year-end. It also proposed the disclosure of the approximate value of amortization, depletion and depreciation as well as the approximate value of cost of sales that would have been accounted in terms of the current replacement cost of productive capacity and inventories.

Both supplemental Constant Purchasing Power inflation accounting financial statements and value accounting were experimented with in Canada. Australia tried both replacement-cost inflation accounting and CPP price-level inflation accounting. Netherland companies experimented with value accounting. Replacement-cost disclosures for equity capital financed items were considered in Germany. CPP inflation accounting supplemental financial statements were tried in Argentina. Brazil successfully used various indexes to update constant and variable non-monetary items for the 30 years from 1964 to 1994. In the United Kingdom an original proposal of supplementary CPP financial accounting financial reports was replaced by the Sandilands Committee proposal for a value accounting approach for inventories, marketable securities and productive property. South Africa had published a discussion paper on value accounting at the time.

The FASB issued FAS 33 Financial Reporting and Changing Prices in 1979. It only applied to certain large, publicly held enterprises. No changes were to be made in the primary financial statements; the information required by FAS 33 was to be presented as supplementary information in published annual reports.

These companies were required to calculate and report:

a. Income from continuing operations reflecting the effects of general inflation
b. The purchasing power loss or gain on net monetary items.
c. Calculate income from continuing operations on a current cost basis
d. Calculate the current cost amounts of property, plant, equipment and inventory at the end of the fiscal year
e. Report increases or decreases in current cost amounts of property, plant, equipment and inventory, net of inflation.

FAS 89 Financial Reporting and Changing Prices superseded FASB Statement No. 33 in 1986 and made voluntary the supplementary disclosure of constant purchasing power/current cost information.

Presently, inflation accounting describes a complete price-level inflation accounting model, namely the Constant Purchasing Power inflation accounting model defined in IAS 29 Financial Reporting in Hyperinflationary Economies required to be implemented only during hyperinflation which is an exceptional circumstance according to the IASB. It serves to make HC and CC financial statements more useful at the period end by restating all non-monetary items – variable and constant real value non-monetary items - by inflation-adjusting them by applying the period-end CPI during hyperinflation.

“In a hyperinflationary economy, reporting of operating results and financial position in the local currency without restatement is not useful. Money loses value at such a rate that comparison of amounts from transactions and other events that have occurred at different times, even within the same accounting period, is misleading.” IAS 29 Par 2.

The fallacy that inflation destroys the real value of non-monetary items is currently still generally accepted. It is still mistakenly accepted as a fact that the erosion or destruction of companies´ capital and profits is caused by inflation.
It became very clear to me during 2008 that inflation has no effect on the real value of non-monetary items over time. The understanding of the real value destroying effect of the stable measuring unit assumption on constant items never maintained is an ongoing process. Not inflation, per se, but SA accountants´ implementation of the very destructive stable measuring unit assumption during low inflation as it forms part of the HCA model, destroys the real value of constant real value non-monetary items never maintained over time. There is no substance in the statement that inflation destroys the real value of non-monetary items which do not hold their real value over time. Inflation has no effect on the real value on 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.

Copyright © 2010 Nicolaas J Smith

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