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Thursday, 1 April 2010

It is not inflation doing the destroying

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 1989 in low inflationary and deflationary economies for the purpose of valuing most constant items which they account 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.” The Framework, Par 102

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. 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: 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. When they freely choose the other option also authorized 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.

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.”

Ümit GUCENME, Aylin P. ARSOY, Changes in financial reporting in Turkey, Historical Development of Inflation Accounting 1960 – 2005 (Bursa: Uludag University, 2005) 9.

http://www.mufad.org/index2.php?option=com_docman&task=doc_view&gid=9&Itemid=100

Kindest regards

Nicolaas Smith
realvalueaccounting@yahoo.com

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