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Monday, 28 June 2010

Measurement in units of constant purchasing power is not generally understood

This is what is stated in the book Principles of Generally Accepted Accounting Practice which reflects what is stated in the IASB´s Framework for the Preparation and Presentation of Financial Statements:

“2.7 Concepts of Capital and Capital Maintenance

The framework identifies two concepts of capital and capital maintenance, the selection of which should be based on users´ needs. It does not say how these needs should be established, nor does it consider the possibility that different user groups may prefer different concepts of capital maintenance.

Financial capital maintenance makes profit dependent upon end-of-period net assets exceeding beginning-of-period net assets (whether measured in nominal units of units of constant purchasing power).

Physical capital maintenance makes profit dependent upon end-of-period physical productive capacity (or operating capability) exceeding that of the beginning of the period.

In both cases, distributions to and contributions from owners must be excluded.

Physical capital maintenance requires the adoption of the current cost basis of measurement, whereas financial capital maintenance does not require the use of a particular basis of measurement, according to paragraph 106 of the framework.

The framework indicates that the principle difference between the two concepts is the treatment of the effect of the changes of prices of assets and liabilities of the enterprise. This is described in paragraphs 108-9 as follows:

* Under the concept of financial capital maintenance where capital is defined in terms of nominal monetary units, profit represents the increase in nominal money capital over the period. Thus, increases in the prices of assets held over the period, conventionally referred to as holding gains, are, conceptually, profits. They may not be recognised as such, however, until the assets are disposed of in an exchange transaction. 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. The rest of the increase is treated as a capital maintenance adjustment and, hence, as part of equity.

* Under the concept of physical capital maintenance when capital is defined in terms of the physical productive capacity, profit represents the increase in that capital over the period. All price changes affecting the assets and liabilities of the entity are viewed as changes in the measurement of the physical productive capacity of the entity; hence, they are treated as capital maintenance adjustments that are part of equity and not as profit.”

This is wrong in at least two aspects:

1. There are – in principle (remember that IFRS are principles based standards) – not only two, but three concepts of capital and capital maintenance authorized in IFRS.

2. Measurement in units of constant purchasing power does affect the economy.

The three concepts of capital defined in IFRS during low inflation and deflation are:

•(A) Physical capital. See paragraph 102 of the Framework.

•(B) Nominal financial capital. See paragraph 104 of the Framework.

•(C) Constant purchasing power financial capital. See paragraph 104 of the Framework.

The three concepts of capital maintenance authorized in IFRS during low inflation and deflation are:

•(1) Physical capital maintenance: optional during low inflation and deflation. Current Cost Accounting model prescribed by IFRS. See Par 106 of the Framework.

•(2) Financial capital maintenance in nominal monetary units (Historical cost accounting): authorized by IFRS but not prescribed—optional during low inflation and deflation. See Par 104 (a) of the Framework. Financial capital maintenance in nominal monetary units per se during inflation and deflation is a fallacy: it is impossible to maintain the real value of financial capital constant with measurement in nominal monetary units per se during inflation and deflation.

•(3) Financial capital maintenance in units of constant purchasing power: authorized by IFRS but not prescribed—optional during low inflation and deflation. See Par 104(a) of the Framework. Prescribed in IAS 29 during hyperinflation. Constant Purchasing Power Accounting. Only financial capital maintenance in units of constant purchasing power per se can maintain the real value of financial capital constant during inflation and deflation in all entities that at least break even—ceteris paribus—for an indefinite period of time. 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.

It is a Generally Accepted Accounting Practice that measurement in units of constant purchasing power does affect the economy (see the inflation-adjustment of salaries and wages, etc in the world economy).


Copyright © 2010 Nicolaas J Smith