ACCOUNTANTS´ UNKNOWING DESTRUCTION OF ENTITIES´ CAPITAL AND PROFITS WITH HISTORICAL COST ACCOUNTING DURING LOW INFLATION AS WELL AS ITS ONLY REMEDY AUTHORIZED IN IFRS IN THE SAME STATEMENT 21 YEARS AGO.
Nicolaas Johannes SMITH
Thematic Area: IFRS 2nd April 2010
Accountant, Lisbon, Portugal, +351 911 925 778, realvalueaccounting@yahoo.com
ABSTRACT
Accountants unknowingly, unnecessarily and unintentionally destroy the real value of banks´ and companies´ shareholders´ equity never maintained constant as a result of insufficient revaluable fixed assets under the HCA model during low inflation with their free choice of implementing the stable measuring unit assumption (which is based on a fallacy) as part of financial capital maintenance in nominal monetary units per se (another popular accounting fallacy) authorized in IFRS in the Framework, Par 104 (a) in 1989. This amounts to hundreds of billions of US Dollars of unnecessary real value destruction in the world economy each and every year. The IASB, FASB and accountants mistakenly blame this on inflation and act as if they are powerless to do anything about it. They are wrong. Inflation has no effect on the real value on non-monetary items.
Accountants would maintain the real value of all constant real value non-monetary items – e.g. banks´ and companies´ capital and retained profits – constant for an unlimited period of time – ceteris paribus – thus boosting the world economy with hundreds of billions of US Dollars every year in all entities that at least break even when they freely choose the other financial capital maintenance option also authorized in IFRS in exactly the same Framework, Par 104 (a) twenty one years ago, namely, continuous financial capital maintenance in units of constant purchasing power during low inflation and deflation. This would happen whether these entities own revaluable fixed assets or not and without the requirement of more capital or additional retained profits to simply maintain the existing constant real value of existing shareholders´ equity constant.
The critical difference in this change of basic accounting model compared to previous attempts to replace the HCA model is that it is clearly and undeniably proven that accountants unknowingly and unnecessarily destroy a significant amount of real value in the world economy with traditional HCA during low inflation each and every year. They know and admit that real value is being destroyed in companies’ capital and profits: they mistakenly blame inflation. Fortunately, the only and perfect remedy was authorized in IFRS in the same Framework, Par 104 (a) twenty one years ago for implementation during low inflation and deflation.
Keywords: constant real value non-monetary items, variable real value non-monetary items, continuous financial capital maintenance in units of constant purchasing power, the Framework Par 104 (a), Constant Item Purchasing Power Accounting.
1) Introduction
The three fundamentally different basic economic items in the economy are:
1) Monetary items
2) Variable real value non-monetary items
3) Constant real value non-monetary items
“Non-monetary items include variable real value non-monetary items valued, for example, at fair value, market value, present value, net realizable value or recoverable value.” 1
“Retained Income is a constant real value non-monetary item.” 2
Monetary items are money held and items with an underlying monetary nature. Examples are bank notes, bank coins, money loans, government bonds, commercial bonds, home loans, car loans, student loans, consumer loans, credit card loans, notes payable, etc. Monetary items are always valued in nominal monetary units during the current accounting period under all accounting models and under all economic models.
Variable items are non-monetary items with variable real values over time. Examples are property, plant, equipment, inventory, foreign exchange, listed and unlisted shares, etc, valued during low inflation and deflation in terms of specific IFRS at, for example, fair value, market value, present value, net realizable value, recoverable value, etc. Variable items, being non-monetary items, are required in terms of IAS 29 to be restated in terms of the measuring unit current at the balance sheet date by applying the period-end Consumer Price Index during hyperinflation.
Constant items are non-monetary items with constant real values over time. Examples are all income statement items, retained income, all other shareholders´ equity items, trade debtors, trade creditors, taxes payable, taxes receivable, provisions, all other non-monetary payables, all other non-monetary receivables, etc. Constant items have to be continuously valued in units of constant purchasing power by applying the monthly change in the annual CPI in terms of continuous financial capital maintenance in units of constant purchasing power as authorized in IFRS in the Framework, Par 104 (a) during low inflation and deflation and the daily parallel rate in terms of IAS 29 Financial Reporting in Hyperinflationary Economies during hyperinflation.
Certain income statement constant items, e.g. salaries, wages, rentals, etc, are generally inflation-adjusted under HCA during low inflation. Other income statement constant items and all balance sheet constant items are valued in nominal monetary units, i.e. at Historical Cost, by accountants implementing the stable measuring unit assumption under HCA during low inflation and deflation.
International Financial Reporting Standards (IFRS) is the single term used to designate Standards, Interpretations and the Framework for the Interpretation and Presentation of Financial Statements adopted and issued by the International Accounting Standards Board (IASB).
“In the absence of a Standard or an Interpretation that specifically applies to a transaction, management must use its judgement in developing and applying an accounting policy that results in information that is relevant and reliable. In making that judgement, IAS 8.11 requires management to consider the definitions, recognition criteria, and measurement concepts for assets, liabilities, income, and expenses in the Framework. This elevation of the importance of the Framework was added in the 2003 revisions to IAS 8.” ³
There are no specific Standards or Interpretations applicable to the concepts of capital, the concepts of capital maintenance and the valuation of constant items. The definitions and concepts in the Framework (1989) are thus applicable.
“Concepts of Capital
Par. 102. A financial concept of capital is adopted by most entities in preparing their financial statements. Under a financial concept of capital, such as invested money or invested purchasing power, capital is synonymous with the net assets or equity of the entity. Under a physical concept of capital, such as operating capability, capital is regarded as the productive capacity of the entity based on, for example, units of output per day.
Concepts of Capital Maintenance and the Determination of Profit
Par 104 The concepts o capital in paragraph 102 give rise to the following concepts of capital maintenance:
(a) Financial capital maintenance. Under this concept a profit is earned only if the financial (or money) amount of the net assets at the end of the period exceeds the financial (or money) amount of net assets at the beginning of the period, after excluding any distributions to, and contributions from, owners during the period. Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power.
(b) Physical capital maintenance. Under this concept a profit is earned only if the physical productive capacity (or operating capability) of the entity (or the resources or funds needed to achieve that capacity) at the end of the period exceeds the physical productive capacity at the beginning of the period, after excluding any distributions to, and contributions from, owners during the period.
Par 108 When the concept of financial capital maintenance is defined in terms of constant purchasing power units, profit represents the increase in invested purchasing power over the period. Thus, only that part of the increase in the prices of assets that exceeds the increase in the general level of prices is regarded as profit.” 4
The three concepts of capital defined in IFRS during low inflation and deflation are:
•(1) Physical capital. Par 102.
•(2) Nominal financial capital. Par 104 (a).
•(3) Constant purchasing power financial capital. Par 104 (a) and 108.
The three concepts of capital maintenance authorized in IFRS during low inflation and deflation are:
•(a) Physical capital maintenance: optional during low inflation and deflation. The Current Cost basis of measurement is prescribed in the Framework, Par 106 when the physical capital maintenance concept is chosen.
•(b) Financial capital maintenance in nominal monetary units (traditional Historical Cost Accounting): authorized in IFRS but not prescribed - optional during low inflation and deflation. Par 104 (a). It is adopted by most entities in preparing their financial statements. It is a popular accounting fallacy: it is impossible to maintain the real value of financial capital constant during inflation and deflation with measurement in nominal monetary units per se. It requires the implementation of the stable measuring unit assumption which is also based on a fallacy.
•(c) Financial capital maintenance in units of constant purchasing power: authorized in IFRS but not prescribed - optional during low inflation and deflation. Par 104 (a) and 108. Only constant real value non-monetary items are continuously measured in units of constant purchasing power by applying the monthly change in the annual CPI during low inflation and deflation. Variable items are measured in terms of specific IFRS during low inflation and deflation. Monetary items are and can only be measured in nominal monetary units during the current accounting period under all economic environments and under all accounting models. The net monetary loss or gain from holding net monetary assets or net monetary liabilities would be calculated and accounted in the income statement. The stable measuring unit assumption is rejected under this concept. Constant Item Purchasing Power Accounting (CIPPA), namely continuous financial capital maintenance in units of constant purchasing power during low inflation and deflation as authorized in IFRS in the Framework, Par 104 (a) is the only basic accounting model that can automatically maintain the real value of all constant items constant for an unlimited period of time in all entities that at least break even – ceteris paribus – whether they own revaluable fixed assets or not and without the need for extra capital or extra retained profits simply to maintain the existing constant real value of existing shareholders´ equity constant during low inflation and deflation.
“Having decided on what concept of capital is to be adopted, the company then decides on which type of capital maintenance is most appropriate to report. It can report on the basis of Financial Capital Maintenance (and this can be in Nominal Monetary Units or in Constant Purchasing Power units) or it can report in terms of Physical Capital Maintenance. There is much to be gained from moving away from reporting on the basis of Financial Capital Maintenance in Nominal Monetary Units.” 5
Constant Purchasing Power Accounting (CPPA) is the IASB´s inflation accounting model defined in IAS 29 which requires the restatement of all non-monetary items – constant and variable items – in Historical Cost or Current Cost financial statements by applying a price index at the period-end during hyperinflation. This paper is not about CPPA inflation accounting during hyperinflation as required in IAS 29.
“In most countries, primary financial statements are prepared on the historical cost basis of accounting without regard either to changes in the general level of prices or to increases in specific prices of assets held, except to the extent that property, plant and equipment and investments may be revalued.” 6
IFRS only define two economic items: monetary items in IAS 29 Par 12 and IAS 21 Par 8 and non-monetary items in IAS 29 Par 14. There are, however, three fundamentally different basic economic items in the economy as defined above. Constant real value non-monetary items and variable real value non-monetary items are defined indirectly in IFRS. According to the Framework, Par 104 (a) financial capital maintenance can be measured in units of constant purchasing power during low inflation and deflation. Although IAS 29 is only to be applied during hyperinflation, it defines monetary and non-monetary items in general. According to IAS 29 Par 12: “Monetary items are not restated because they are already expressed in terms of the monetary unit current at the balance sheet date.” IAS 29 Par 14 defines non-monetary items as all items that are not monetary items. Since monetary items are not restated only non-monetary items can thus be measured in units of constant purchasing power or inflation-adjusted or restated or updated or maintained constant. As such, non-monetary items measured in units of constant purchasing power during low inflation and deflation in terms of the Framework, Par 104 (a) are thus constant real value non-monetary items; e.g. all income statement items, all items in shareholders´ equity, trade debtors, trade creditors, taxes payable and receivable, etc. Consequently, non-monetary items that are not measured in units of constant purchasing power during low inflation and deflation are thus variable real value non-monetary items since they have variable real values over time valued in terms of specific IFRS.
IFRS do not split non-monetary items in constant and variable items as a result of the stable measuring unit assumption. One of the basic principles in accounting is “The Measuring Unit principle: The unit of measure in accounting shall be the base money unit of the most relevant currency. This principle also assumes the unit of measure is stable; that is, changes in its general purchasing power are not considered sufficiently important to require adjustments to the basic financial statements.” 7
Non-monetary items under the HCA model include Historical Cost items based on the stable measuring unit assumption. Accountants value both variable real value non-monetary items (e.g. inventory and fixed property) stated at HC in terms of IFRS, as well as constant real value non-monetary items (e.g. shareholders´ equity items) also stated at HC in terms of the HCA model as authorized in IFRS, in nominal monetary units applying the stable measuring unit assumption during non-hyperinflationary periods. Both HC variable and HC constant items are thus considered by accountants to be simply HC non-monetary items.
Accountants simply assume that changes in the real value or constant purchasing power of the functional currency (money) are not sufficiently important for them to continuously measure financial capital maintenance in units of constant purchasing power as they have been authorized in IFRS in the Framework, Par 104 (a) in low inflationary and deflationary economies for the purpose of valuing most constant items which they value as HC items; they measure them in nominal monetary units when they choose financial capital maintenance in nominal monetary units and implement the stable measuring unit assumption.
It is a generally accepted accounting practice for accountants not to apply the stable measuring unit assumption to the valuing of certain income statement constant items, namely salaries, wages, rentals, etc which they generally inflation-adjust annually. Accountants value all other income statement items and all balance sheet constant items in nominal monetary units when they implement financial capital maintenance in nominal monetary units during low inflation and deflation.
However, it is impossible to maintain the real value of financial capital constant with financial capital maintenance in nominal monetary units per se applying the stable measuring unit assumption during inflation and deflation. The measuring unit (money) is not perfectly stable during inflation and deflation. Inflation destroys the real value of money and other monetary items while deflation creates more real value in money and other monetary items over time. Sustainable zero annual inflation has never been achieved in the past and is not likely to be achieved any time soon in the future. Financial capital maintenance in nominal monetary units per se during inflation and deflation as authorized in IFRS in the Framework, Par 104 (a) is a popular accounting fallacy. IFRS should not be based on popular accounting fallacies as they currently are.
“Under a financial concept of capital, such as invested money or invested purchasing power, capital is synonymous with the net assets or equity of the entity.” 8
Shareholders´ equity’s real value can only be maintained constant (excluding continuous additions of fresh capital or additional retained profits at the rate of inflation) with financial capital maintenance in nominal monetary units (traditional HCA) during low inflation when 100% of the updated original real value of all contributions to the shareholders´ equity balance are invested in revaluable fixed assets with an equivalent updated fair value – revalued or not. Valuing a revaluable fixed asset at HC (in nominal monetary units applying the stable measuring unit assumption) does not destroy its real value. It would normally be revalued when it is eventually sold or exchanged. It can also be revalued via the revaluation reserve before it is finally sold.
However, the portion of shareholders´ equity’s real value, under HCA, that is never maintained constant with sufficient revaluable fixed assets during low inflation, is unknowingly and unnecessarily being treated by accountants the same as a monetary item (e.g. cash). Accountants unknowingly, unnecessarily and unintentionally destroy its real value at a rate equal to the annual rate of inflation because they freely choose in terms of the Framework, Par 104 (a) - as authorized in IFRS - to implement financial capital maintenance in nominal monetary units and apply the stable measuring unit assumption during low inflation. This amounts to hundreds of billions of US Dollars of unnecessary real value destruction in the world economy each and every year.
Shareholders´ equity’s value is expressed in terms of a monetary unit of account (the functional currency or money) and inflation destroys the real value of money. It is not inflation doing the destroying of the real value of the constant real value non-monetary item shareholders´ equity: it is accountants´ free choice of financial capital maintenance in nominal monetary units when they implement their very destructive stable measuring unit assumption as authorized in IFRS in the Framework, Par 104 (a) during low inflation.
Inflation can only destroy the real value of money and other monetary items – nothing else. Inflation is always and everywhere a monetary phenomenon. Inflation has no effect on the real value of non-monetary items. Shareholders´ equity is a constant real value non-monetary item.
“Purchasing power of non monetary items does not change in spite of variation in national currency value.” 9
“It is an undeniable fact that South Africa’s functional currency’s internal real value is constantly being destroyed by cash inflation in the case of our low inflationary economy, but this is not considered important enough to adjust the real values of constant real value non-monetary items in the financial statements - the universal stable measuring unit assumption.
Everybody suddenly then agrees to destroy hundreds of billions of Dollars in real value in all companies´ Retained Income balances all around the world.” 10
3. The basis for continuous financial capital maintenance in units of constant purchasing power
When accountants freely choose the other option also authorized in IFRS in the Framework, Par 104 (a), namely continuous financial capital maintenance in units of constant purchasing power, they would maintain the real value of all constant real value non-monetary items constant for an unlimited period of time – ceteris paribus – in all entities that at least break even whether these entities own revaluable fixed assets or not and without the requirement of additional capital or additional retained profits simply to maintain the existing constant real value of existing shareholders´ equity constant at all levels of inflation and deflation. It is thus not inflation doing the destroying, but accountants´ free choice of financial capital maintenance in nominal monetary units during low inflation.
The stable measuring unit assumption is based on the fallacy that changes in the purchasing power of money are not sufficiently important for entities to choose to continuously measure financial capital maintenance in units of constant purchasing power during low inflation and deflation as authorized in IFRS in the Framework, Par 104(a). Hyperinflation is defined in IFRS as a cumulative inflation rate approaching or equal to 100% over three years, i.e. 26% annual inflation for 3 years in a row. Financial capital maintenance in units of constant purchasing power is required in IFRS in IAS 29 during hyperinflation: it is thus required at 26% annual inflation for 3 years in a row. It is, however, left as an option at 20% or 15% or 6% or 2% for three years in a row or any number of years. Real value destruction in constant items never maintained constant by the implementation of the stable measuring unit assumption at continuous 20% inflation (which would wipe out 100% of the real value of shareholders´ equity never maintained constant in 4 years) is currently considered as not sufficiently important for the implementation of continuous financial capital maintenance in units of constant purchasing power. Accountants currently unknowingly, unnecessarily and unintentionally destroy 51% of the real value of shareholders´ equity and all other constant items never maintained constant over 35 years in all economies with continuous 2% annual inflation implementing financial capital maintenance in nominal monetary units per se as authorized in IFRS in the Framework, Par 104 (a).
“The erosion of business profits and invested capital caused by inflation” is generally accepted as stated in the US Financial Accounting Standard FAS 33: “In Mr. Mosso's view, conventional accounting measurements fail to capture the erosion of business profits and invested capital caused by inflation.” 11
There is absolutely no doubt in the accounting profession that real value is being destroyed in entities´ capital and profits and there is equally absolutely no doubt in the accounting profession that it is caused by inflation. In fact, “the erosion of business profits and invested capital caused by inflation” is a fallacy. Inflation is always and everywhere a monetary phenomenon as per the late American Nobel Laureate Milton Friedman. Inflation destroys the real value of money and other monetary items – nothing else. Inflation has no effect on the real value of non-monetary items. It is impossible for inflation per se to destroy the real value of non-monetary items. See Gucenme and Arsoy above.
Continuous financial capital maintenance in units of constant purchasing power only results in zero destruction of real value in constant items for an unlimited period of time at any level of inflation or deflation in entities that at least break even – ceteris paribus. It has no direct effect on the rate of inflation or deflation.
4. Examples
Example: Sufficient fixed assets revalued by HC accountant
Historical Cost Accounting
Company started in Jan 1981 CPI = 7.3 (2008 = 100 Source: Statistics South Africa) Monetary unit: South African Rand
Opening Accounts
Dr Issued Share Capital Cr
Dr Land Cr
Closing Accounts
Dec 2009 CPI = 109.2 (Source: Statistics SA)
Cumulative inflation from Jan 1981 to Dec 2009 1 395.9 %
Update factor from Jan 1981 to Dec 2009 109.2 / 7.3 = 14.959
Dr Issued Share Capital Cr
Dr Land Cr
Jan 81 O Bal R 1 000 000 |
Dec 09 Reval. Res 13 959 000 |
Dec 09 C Bal 14 959 000 |
Dr Revaluation Reserve Cr
| Dec 09 Land R 13 959 000
In the above example it is assumed that the Land was revalued at a rate equal to the cumulative inflation rate over the period. This is only the assumption made for this example. It is not normally the case in practice. In practice, properties are revalued by experts in this field or at the actual market rate, where possible.
Statement of Changes in Equity for the year ended 31 Dec 2009
Issued Share Revaluation Total
Capital Reserve
R´000 R´000 R´000
Bal at 31 Dec 2008 1 000 --- 1 000
Reval Land Dec 2009 - 13 959 13 959
Bal 31 Dec 2009 1 000 13 959 14 959
It can be seen from the above Statement of Changes in Equity that the revaluation of fixed assets can be used under the HCA model to maintain the real value of Shareholders Equity. This is obviously only possible for companies with sufficient revaluable fixed assets to revalue in this manner. Very few companies are in this position: mainly hotel groups and property companies.
If the board of directors in 1981 had decided to measure financial capital maintenance in units of constant purchasing power and this was continued till 31 Dec, 2009, the closing accounts would be as follows:
Example: Constant Item Purchasing Power Accounting
Closing accounts
Dec 2009 CPI = 109.2
Dr Issued Share Capital Cr
| Dec 09 Cl Bal R 14 959 000
Dr Land Cr
Dec 09 C Bal R 14 959 000 |
Statement of Changes in Equity for the year ended 31 Dec 2009
Dec 2009 CPI 109.2
Issued Share Total
Capital
R´000 R´000
Balance at 31 Dec 2008 14 959 14 959
Profit for the year - -
Balance at 31 Dec 2009 14 959 14 959
There is no Revaluation Reserve - in this particular example - because of the assumption that the Land’s revaluation is equal to the cumulative rate of inflation over the period. See above. Capital is valued monthly in units of constant purchasing power every time the value of the CPI changes. Land is revalued monthly too applying the change in the CPI (only for this example).
When the revaluation of the Land is a value higher than the value at the beginning of the period times the change in the CPI over the period, then the difference would be shown in the revaluation reserve account.
If a company during the period from Jan 1981 to December 2009 had R 1 000 000 in Land – with no revaluation till the end of 2009 - and there were an extra R 1 000 000 in retained earnings and R1 000 000 in trade debtors account in Jan 1981 with the same items remaining in the company till 31 Dec 2009 then the opening and closing accounts would be as follows:
Example: Insufficient fixed assets to revalue by HC accountant
Historical Cost Accounting
Jan 1981 CPI = 7.3
Dr Issued Share Capital Cr
| Jan 81 O Bal R 1 000 000
Dr Retained Earnings Cr
| Jan 81 O Bal R 1 000 000
Dr Trade Debtors Cr
Jan 81 O Bal R 1 000 000 |
Dr Land Cr
Jan 81 O Bal R 1 000 000 |
Statement of Changes in Equity for the year ended 31st Dec 1981
Issued Share Retained Total
Capital Earnings
R´000 R´000 R´000
Balance 1 Jan 1981 1 000 1 000 2 000
Profit for the year - - -
Balance 31 Dec 1981 1 000 1 000 2 000
Equity can be increased in Dec 2009 by R13 959 000 to reflect the revaluation of the Land. At the same time we can see that R13 959 000 was unknowingly destroyed by the company accountants in the real value of the Retained Earnings balance from Jan 1981 to Dec 2009 – which can not be updated under HCA during low inflation - because they implemented the stable measuring unit assumption as part of the Historical Cost Accounting model during low annual inflation.
Historical Cost Accounting
Dec 2009 CPI = 109.2
Dr Issued Share Capital Cr
| Dec 09 C Bal R 1 000 000
Dr Retained Earnings Cr
| Dec 09 C Bal R 1 000 000
Dr Trade Debtors Cr
Dec 09 C Bal R 1 000 000 |
Dr Land Cr
Jan 81 O Bal R 1 000 000 |
Dec 09 Reval Res 13 959 000 |
Dec 09 C Bal 14 959 000 |
Dr Revaluation Reserve Cr
| Dec 09 Land R 13 959 000
Statement of Changes in Equity for the year ended Dec 2009
Retained Issued Share Revaluation Total
Earnings Capital Reserve
R´000 R´000 R´000 R´000
Bal 31 Dec 08 1 000 1 000 --- 2 000
Reval Land - - 13 959 13 959
Bal 31 Dec 09 1 000 1 000 13 959 15 959
If the board of directors in January, 1981 had decided to measure financial capital maintenance in units of constant purchasing power and this was continued till Dec, 2009, the closing accounts would be as follows:
Constant Item Purchasing Power Accounting
Dec 2009 CPI = 109.2
Dr Issued Share Capital Cr
| Dec 09 C Bal R 14 959 000
Dr Retained Earnings Cr
| Dec 09 C Bal R 14 959 000
Dr Trade Debtors Cr
Dec 09 C Bal R 14 959 000 |
Dr Land Cr
Dec 09 C Bal R 14 959 000 |
Statement of Changes in Equity for the year ended 31 Dec 2009
Issued Share Retained Total
Capital Earnings
R´000 R´000 R´000
Bal 31 Dec 2008 14 959 14 959 29 918
Profit for the year - - -
Bal at 31 Aug 2009 14 959 14 959 29 918
It can be seen from the above that there is no extra capital or extra profits required to maintain the real value of existing shareholders´ equity. It is simply a matter of maintaining the real value of existing constant real value non-monetary items constant (trade debtors, retained earnings and issued share capital in this case) in a double entry accounting model while variable real value non-monetary items (Land in this case) are valued in terms of specific IFRS. Net monetary losses and gains would be calculated and accounted in the income statement. This is Constant Item Purchasing Power Accounting or continuous financial capital maintenance in units of constant purchasing power during low inflation and deflation as authorized in IFRS in the Framework, Par 104 (a). It can also be seen from the above that continuously maintaining the constant purchasing power of capital is a fundamental basic function or objective of accounting / general purpose financial reporting during inflation and deflation.
Accountants unknowingly and unnecessarily, in this manner, destroy hundreds of billions of US Dollars each and every year in the real values of banks´ and companies´ reported constant items never maintained constant, e.g. retained earnings, implementing their very destructive stable measuring unit assumption as a result of their free choice to measure financial capital maintenance in nominal monetary units – which is a fallacy – as authorized in IFRS in the Framework, Par 104 (a).
5. The Inflation Mistake
Accountants clearly know and admit that there is real value being destroyed in non-monetary items, namely in companies´ profits and capital: “the erosion of business profits and capital caused by inflation” as it is so generally accepted. Accountants just do not realize that they are actually unknowingly doing the destroying when they freely choose to implement the stable measuring unit assumption during low inflation. They think it is inflation doing the destroying. It is impossible for inflation per se to destroy the real value of any non-monetary item.
Accountants mistakenly think the erosion (which is the same as destruction) of business profits and invested capital is caused by inflation. Everybody knows the actual cost of inflation – the net monetary loss from holding a net monetary balance of monetary assets during the accounting period – is not accounted under HCA during low inflation and deflation. Accounting authorities and accountants think it is the monetary authorities´ task to reduce inflation which would reduce the cost of inflation and “the erosion of business profits and invested capital caused by inflation”. First of all, the erosion (destruction) of business profits and invested capital is not caused by inflation but by accountants´ free choice of implementing financial capital maintenance in nominal monetary units during low inflation.
Yes, reducing inflation reduces the actual cost of inflation (the net monetary loss) and it also reduces the cost of the stable measuring unit assumption. However, sustained zero annual inflation - required to eliminate the cost of the stable measuring unit assumption completely in this manner - has never been achieved in the past in any economy using money and is not likely to be achieved any time soon in the future. So, central bankers will, most probably, never eliminate the cost of the stable measuring unit assumption completely in the world’s constant item economy, namely, the hundreds of billions of US Dollars unnecessarily, unknowingly and unintentionally being destroyed by accountants´ free choice of financial capital maintenance in nominal monetary units during low inflation. However, continuous financial capital maintenance in units of constant purchasing power which accountants can freely implement any time they want and which has been authorized in IFRS in the Framework, Par 104 (a) twenty one years ago will permanently eliminate the entire cost of the stable measuring unit assumption forever at any level of inflation and would prevent economic instability during deflation caused by the appreciation in the real value of constant items under HCA. Accountants would then knowingly maintain hundreds of billions of US Dollars per annum in the world’s real economy for an unlimited period of time during indefinite low inflation – all else being equal.
It is no use repeating the third not yet extinct accounting fallacy, namely that “the erosion of business profits and invested capital is caused by inflation” (which is not true since inflation per se can only destroy the real value of money and other monetary items) and that lowering inflation would lower the cost of the stable measuring unit assumption when sustainable zero inflation is not an option (and most probably never will be an option) while IFRS-authorized continuous financial capital maintenance in units of constant purchasing power would result in zero inflation (zero destruction of real value) in all constant items forever – ceteris paribus – at any rate of inflation: 2% or 2 000% or 2 million per cent per annum in all entities that at least break even whether they own revaluable fixed assets or not and without the requirement of more capital or additional retained profits to simply maintain the real value of existing constant items constant.
Accountants mistakenly regard the unnecessary destruction caused by their choice to implement the stable measuring unit assumption as “the erosion of business profits and invested capital caused by inflation” as it was described by a member of the US Financial Accounting Standards Board in FAS 33 in 1979.
They and accounting authorities thus consider it to be the same as the cost of inflation which is not calculated and accounted under HCA during low inflation. They are consequently satisfied that they “correctly” follow a generally accepted accounting practice of not accounting the net monetary loss or gain from inflation during low inflation when they refer to “the erosion of business profits and invested capital caused by inflation” which is in fact the cost of their very destructive stable measuring unit assumption. They do not see the destruction of the real value of companies´ profits and capital (the destruction of the real value of constant items never maintained constant under HCA) as separate from the destruction of the real value of money and other monetary items actually caused by inflation. To them the net monetary loss from holding a net balance of monetary assets and the “erosion of business profits and invested capital caused by inflation” are both the same thing – both caused by inflation. They are mistaken. Inflation has no effect on the real value of non-monetary items. Inflation can only destroy the real value of money and other monetary items which are items with an underlying monetary nature. All items in shareholders´ equity are constant real value non-monetary items.
The IASB authorized an alternative basic accounting model - financial capital maintenance in units of constant purchasing power - in the Framework, Par 104 (a) which accountants are free to choose which would allow them to stop their unknowing destruction caused by their choice of the stable measuring unit assumption during low inflation.
Unfortunately, accountants do not realize they are destroying hundreds of billions of US Dollars in real value each and every year when they freely choose, also in terms of the Framework, Par 104 (a), an IASB-authorized 700 year old traditional, generally accepted accounting model complaint with IFRS; consequently, they do not look for a solution in IFRS: they ignore the IFRS-authorized option in the Framework, Par 104 (a), namely, continuous financial capital maintenance in units of constant purchasing power during low inflation and deflation.
The cost of inflation, i.e., the net weighted average monetary loss from holding a net weighted average balance of monetary assets during the accounting period is not required to be accounted under HCA during low inflation although it is specifically required in IFRS in IAS 29 during hyperinflation in a generally accepted contradiction of accounting and economic logic in IFRS. The cost of inflation is not the same as the cost of the stable measuring unit assumption; i.e. the cost of the unknowing and unnecessary destruction of the real value of constant items never maintained by accountants´ free choice of measuring them in nominal monetary units during low inflation when it is a fact that inflation can only destroy the real value of money (the functional currency) which is the monetary unit of account in the economy. The cost of the stable measuring unit assumption is the unnecessary cost of a destructive accounting practice by accountants which is authorized in IFRS.
IAS 29 requires the calculation of the net monetary gain or loss from holding monetary items during hyperinflation. Theoretically, IAS 29 rejects the stable measuring unit assumption, but, actually only in restatement of HC or Current Cost financial statement in a hyperinflationary economy; i.e. in presentation or restatement of period-end HC or Current Cost financial statements to make them more useful after the period-end. As PricewaterhouseCoopers states: “Inflation adjusted financial statements are an extension to and not a departure from historic cost accounting.” 12 IAS 29 clearly states that historical cost or current cost financial statements have to be restated in terms of the period-end CPI. The IASB does not require the complete rejection of the highly destructive HCA model during hyperinflation when, in fact, it should specifically be banned by law during hyperinflation.
The destruction of the real values of constant items never maintained caused by accountants´ implementation of the stable measuring unit assumption during low inflation and hyperinflation is eliminated completely and the real values of constant items are maintained constant in all entities that at least break even whether they own revaluable fixed assets or not for an unlimited period of time when accountants reject the stable measuring unit assumption and constant real value non-monetary items are continuously valued or measured in units of constant purchasing power over time during the accounting period. This only happens to a limited extent during hyperinflation when IAS 29 is implemented and when a country’s tax authorities accept the year-end HC or CC financial statement restated values for the purpose of calculating taxes as in the case of Turkey in 2004.
Constant items´ real values are still hyper-destroyed by accountants´ implementation of the stable measuring unit assumption during hyperinflation even with the implementation of IAS 29 in hyperinflationary economies when they do not implement continuous financial capital maintenance in units of constant purchasing power by applying the daily parallel rate or index the non-monetary economy daily in terms of normally the US Dollar parallel rate. When accountants restate their HC or CC financial statements after they have unknowingly hyper-destroyed their constant item economy with their very destructive stable measuring unit assumption (during hyperinflation) and the restated values are not accepted by the tax authorities as the real values of items for tax calculation purposes, for example Turkey in 2003, then IAS 29 has a limited effect in the economy. It had no effect in Zimbabwe’s hyperinflationary economy. This normally happens in hyperinflationary economies which do not follow the Brazilian example by indexing non-monetary items daily in terms of a US Dollar based rate, which Brazil did – in principle – for 30 years from 1964 to 1994.
As per the Banco Central do Brasil:
Prezado Senhor
Não temos como fornecer, conforme solicitado, os detalhes exatos do indexador utilizado durante o período de alta inflação no Brasil. Vale esclarecer que, desde 1964, quando foi implementado o Programa de Ação Econômica do Governo - PAEG, vários mecanismos de indexação foram introduzidos na economia brasileira objetivando reduzir os efeitos da inflação não antecipada sobre o lado real da economia. Podemos destacar os mecanismos destinados à taxa de câmbio, aos salários e e à correção monetária de ativos financeiros. Ao longo da existência das ORTNs e de seus sucedâneos, por exemplo, os governos mudaram em diversas oportunidades as fórmulas de cálculo da correção monetária e trocaram várias vezes os índices de preços que eram utilizados no cálculo da mesma.
Assim sendo, sugerimos uma consulta ao Ministério da Fazenda, que talvez possa fornecer o histórico dos indexadores utilizados no País.
Atenciosamente,
DEPEP/RJ”
Accountants´ application of the stable measuring unit assumption during the accounting period in a hyperinflationary economy hyper-destroys the real value of the constant real value non-monetary item part of the real or non-monetary economy while hyperinflation hyper-destroys the real value of money and other monetary items in the monetary economy. That is what happened in Zimbabwe but it did not happen in Brazil during 30 years of high and hyperinflation. Hyperinflation only hyper-destroyed the real value of the Brazilian monetary unit during those 30 years. They maintained the real value of their real economy more or less stable with indexation, which – in broad principle – is the same as continuous financial capital maintenance in units of constant purchasing power as authorized in the Framework, Par 104 (a). The results of the two different approaches (in Brazil and in Zimbabwe) are very clear in 2010 in those two countries.
It appears that it is not the IASB´s IAS 29´s intention to stop accountants´ unknowing hyper-destruction of real value in constant items never maintained by continuously implementing the stable measuring unit assumption during hyperinflation. IAS 29 appears simply to be intended to make hyper-destroyed HC or CC financial reports more meaningful by restating them in terms of the period-end CPI at the end of the accounting period after accountants have already unknowingly hyper-destroyed the constant item economy in a hyperinflationary economy by implementing the stable measuring unit assumption – during hyperinflation - as accepted by the IASB in IAS 29.
The two enemies in the economy: the one very well known; the other a stealth enemy camouflaged by authorization in IFRS. The one – inflation - seen as an enemy in most instances; the other – accountants´ free choice of the stable measuring unit assumption - wreaking possibly even more damage in the real economy than inflation in the monetary economy. The stable measuring unit assumption is a very destructive stealth enemy very effectively camouflaged by IFRS authorization during low inflation and IFRS acceptance during hyperinflation as supported by Big Four accounting firms like PricewaterhouseCoopers. See above.
The net monetary loss or gain from inflation is required by IFRS to be accounted under the two circumstances when the stable measuring unit assumption is rejected in terms of IFRS: (1) during hyperinflation in terms of IAS 29 and (2) when accountants would choose to measure financial capital maintenance in units of constant purchasing power during low inflation and deflation in terms of the Framework, Par 104 (a). The cost of inflation has to be debited to the Profit and Loss Account as a net monetary loss.
There would obviously be no destruction in constant items´ real values at permanently sustainable zero inflation – an economic model never achieved in the past and not likely to be achieved any time soon in the future.
The cost of low inflation, although not calculated and accounted under HCA, is experienced by everyone in a low inflationary economy holding money and other monetary items over time: the money and the original real values of other monetary items are worth less because inflation destroys their real values over time. Take for example South Africa: The cost of inflation amounts to R119 billion per annum at 6.2% annual inflation in SA´s monetary base M3 of R1 923.538 billion while the cost of real value destroyed in SA constant item economy unknowingly caused by SA accountants´ implementation of the stable measuring unit assumption amounts to about R200 billion per annum at the same time. The full R200 billion per annum can be maintained instead of destroyed at 6% annual inflation with continuous financial capital maintenance in units of constant purchasing power for an unlimited period of time. SA will still suffer the destruction of R119 billion per annum in the real value of the Rand money supply as long as inflation stays at 6.2% per annum – all else being equal, but, SA accountants would knowingly boost the SA real economy with about R200 billion per annum for an unlimited period of time as long as they would implement financial capital maintenance in units of constant purchasing power. This applies to all accountants in low inflationary economies.
In most companies in which the above situation applies, this annual destruction would be at least equal to the weighted average annual value of Retained Earnings times the average annual inflation rate. This cost can be calculated to know its constant real value and the magnitude of real value destroyed like this (or to be gained per annum in all entities at least breaking even for an unlimited period of time – all else being equal - from freely changing over to financial capital maintenance in units of constant purchasing power), but, it is never accounted as a loss in the Profit and Loss account at any time under the HCA model – similar to the non-accounting of the cost of inflation during low inflation. Because Retained Profits never maintained are, in principle, in this manner treated the same as monetary items under HCA during low inflation, this destruction of real value operates similar to – but it is not the same as - the cost of inflation in monetary items, but in Retained Profits and other constant items never maintained. Most people mistakenly think it is also caused by inflation.
In the case of companies with no revaluable fixed assets at all implementing HCA during low inflation this results in their total equity being valued in nominal monetary units thus being destroyed by accountants´ choice of the stable measuring unit assumption over time at a rate equal to the annual rate of inflation
6. Conclusions
HC accountants unknowingly, unnecessarily and unintentionally destroy hundreds of billions of US Dollars each and every year in the world economy in the real value of banks´ and companies´ shareholders´ equity never maintained constant with sufficient revaluable fixed assets under Historical Cost Accounting because they freely choose financial capital maintenance in nominal monetary units per se as authorized in IFRS in the Framework, Par 104 (a) twenty one years ago during low inflation implementing their very destructive stable measuring unit assumption. They mistakenly blame this on inflation. However, inflation is always and everywhere a monetary phenomenon. It has no effect on the real value of non-monetary items.
Accountants would knowingly stop this destruction and instead boost the world economy with hundreds of billions of US Dollars for an unlimited period of time – ceteris paribus – in all entities which at least break even whether these entities own revaluable fixed assets or not and without the requirement of additional capital or additional retained profits to simply maintain the existing constant real value of existing shareholders´ equity constant during low inflation when they freely choose continuous financial capital maintenance in units of constant purchasing power as authorized in IFRS in the exact same Framework, Par 104 (a) during low inflation and deflation.
References
1, 2, 10 Nicolaas Smith, Financial Statements, Inflation & The Audit Report (Johannesburg: Accountancy SA, Sept 2007) 38.
http://www.accountancysa.org.za/resources/ShowItemArticle.asp?ArticleId=1235&issue=857
3 Deloitte, Summaries of International Financial Reporting Standards (IAS Plus, Deloitte, 28th March, 2010) http://www.iasplus.com/standard/framewk.htm
4, 8 International Accounting Standards Board, Framework for the Preparation and Presentation of Financial Statements (London: IASB, 1989) 96-97.
http://www.iasb.org/IFRSs/IFRs.htm
5 Rachel F. Baskerville, 100 Questions (and Answers) about IFRS (Wellington: Victoria University, 15th March 2010) 19.
6 International Accounting Standards Board, International Accounting Standard IAS 29 Financial Reporting in Hyperinflationary Economies (London: IASB, 1989) Par 6.
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7 Paul H. Walgenbach, Norman E. Dittrich and Ernest I. Hanson, Financial Accounting (New York: Harcourt Brace Javonovich, Inc., 1973) 429.
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http://www.mufad.org/index2.php?option=com_docman&task=doc_view&gid=9&Itemid=100
11 Financial Accounting Standards Board, Financial Accounting Standard 33, Financial Reporting and Changing Prices (Norwalk: FASB, 1979) 24.
12 PricewaterhouseCoopers, Financial Reporting in Hyperinflationary Economies, Understanding IAS 29 (London: PricewaterhouseCoopers, 2002) 5.
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Copyright © 2010 Nicolaas J Smith All Rights Reserved
World Institute for Research and Publication
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