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Friday, 26 March 2010

Capital maintenance - Part 1

No-one will disagree that 5.7% annual inflation and not SA accountants destroy the real value of the Rand and other monetary items in the SA monetary economy despite the fact that the SARB regards the destruction of about R114 billion per annum in the real value of the Rand as the achievement and maintenance of “price stability” in the SA economic system. Obviously it is not price stability at all. It is 5.7 % or R114 billion per annum away from price stability. It is the SARB´s choice of “price stability”: their definition of “price stability”. Absolute price stability is a year-on-year increase of zero percent in the Consumer Price Index.

SA accountants freely choose HCA

By doing listed companies´ accounts in terms of IFRS as required by the rules of the Johannesburg Stock Exchange, SA boards of directors – advised by the accountants on the boards - have to choose between a physical and a financial capital concept in terms of the IASB´s Framework, Par 102. According to Par103 the choice of the appropriate concept of capital by a company should be based on the needs of the users of its financial reports.

A company’s capital is synonymous with its Shareholders´ Equity or Net Assets when a financial concept of capital, such as invested purchasing power or invested money, is chosen. Most, if not all, boards of directors of SA companies decide that they will adopt, in terms of the Framework, Par 102, a financial (instead of a physical) concept of capital, namely invested money (instead of invested purchasing power), in preparing their companies’ financial statements. As a result of choosing a financial concept of capital, namely invested money in terms of Par 102, the boards of directors next choose a financial concept of capital maintenance in terms of Par 104.

Under the financial capital maintenance concept a company, in terms of the Framework, Par 104, only earns a profit when the financial (or money) value of the net assets at the end of the accounting period exceeds the financial (or money) value of net assets at the beginning of the period, after excluding any contributions from and distributions to shareholders during the accounting period. This is obviously not correct in real or constant purchasing power terms - only in nominal terms.

SA listed company boards of directors generally choose financial capital maintenance in nominal monetary units in terms of Par 104 (a) because, in their opinion - in terms of Par 103 - the users of the company’s financial statements are primarily concerned with the maintenance of nominal invested capital instead of the maintenance of the purchasing power of invested capital when a financial capital maintenance in units of constant purchasing power concept – as per Par 104 (a) – should be used. The boards of directors thus choose to do their companies´ accounts based on the traditional Historical Cost Accounting model. They believe and support the IASB statement in Par 104 (a) that “financial capital maintenance can be measured in nominal monetary units” which is a complete fallacy during inflation and deflation. It is impossible to maintain the real value of Shareholders´ Equity constant with financial capital maintenance in nominal monetary units per se during inflation and deflation.

In my opinion, the users of SA companies´ financial statements are generally primarily concerned with the maintenance of the constant purchasing power (real value) instead of the nominal value of their invested capital.

It is only possible to maintain the real value of Shareholders´ Equity constant in nominal monetary units when 100% of the inflation-adjusted original real values of all contributions to Shareholders´ Equity are invested in revaluable fixed assets with an equivalent fair value - either revalued or with unrecorded holding gains - under the traditional Historical Cost Accounting model implemented by most companies in South Africa during low inflation. It is not normally the case in the SA economy that companies invest 100% of the original real values of all contributions to Shareholders´ Equity in revaluable fixed assets.

In terms of the Framework, Par 105, the capital maintenance concept deals with how companies define the capital they want to preserve. It is the link between the concept of capital and the concept of profit or loss since it is the point of reference for calculating profit or loss. A company first has to choose a capital maintenance concept before its return of capital and return on capital can be calculated. Only acquired net asset values greater than the capital maintenance requirement can be taken as profit; i.e. a return on capital.

Kindest regards

Nicolaas Smith
realvalueaccounting@yahoo.com

Copyright © 2010 Nicolaas J Smith