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Thursday, 29 July 2010

Inflation myths in layman terms – Part 1

1. "Inflation erodes companies´ invested capital and profits" - as per the FASB.

The FASB is the US Financial Accounting Standards Board. They set accounting standards in the US. In the 1970´s their Mr Mosso famously stated the above term in one of their standards, either Financial Accounting Standard 33 or FAS 89 which superceded FAS 33.

All accountants will tell you that inflation “erodes” companies´ capital and profits. They never use the term destroy: always “erode”. Well, erode and destroy is the same thing.

Accountants truly believe that. They are trained at university like that. They write their CA exams and pass and become CA (SA)s in the best Financial Director and CEO positions in SA believing that.

One of their arguments goes something like this: the cost of an item sold is not inflation-adjusted. The selling price is at the current price level while the cost of the item is at another, past or historic, price level. So, the profit is overstated. These overstated profits eventually may all be paid out in dividends. This basically results in the capital of the company not being maintained: it may be paid away in dividends. So, companies´ capital is eroded by inflation.

Accountants do not control the level of inflation. That is determined by the central bank and the government’s economic policy. So, this happens, but, accountants can do absolutely nothing about it. It is out of their hands.

This is an absolutely generally accepted “fact” appearing in most accounting and economics text books.

However: inflation is always and everywhere a monetary phenomenon as so eloquently stated by the late American Nobel Laureate Milton Friedman. Inflation can only affect, i.e. destroy, the real value of money and other monetary items, i.e. items with an underlying monetary nature – nothing else. Inflation per se has no effect on the real value of any non- monetary item ever. It is impossible for inflation to destroy the real value of any non-monetary item – ever.

Companies´ issues share capital and retained profits are all non-monetary items. All accountants would confirm that. So, it is impossible for inflation to erode or destroy companies´ invested capital and profits.

I am not the only person understanding that and stating that.

This is what two Turkish academics state:

“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.

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

So, if it is not inflation eroding or destroying companies´ capital - then, what is?

It is accountants´ choice of accounting model; more specifically the stable measuring unit assumption that is part of the traditional Historical Cost Accounting model.

Accountants choose the accounting model? Not really. Historical Cost Accounting is the generally accepted basic accounting model world-wide for more than 700 years.

However, they are not forced to use HCA. No-one forces them.

In 1989 the International Accounting Standards Board, the other main accounting standard setter, authorized the following in their Framework, Par 104 (a):

“Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power.”

So, all accountants in companies implementing International Financial Reporting Standards, i.e. in SA all JSE listed companies, actually do have to choose: they are given a specific choice in the Framework, Par 104 (a): either the one of the other: they all “choose” HCA. In fact, when they changed over to IFRS they just carried on doing traditional HCA. Most probably not a single accountant in the world implementing IFRS realized that they are actually given a choice in IFRS.

What is the stable measuring unit assumption?

SA accountants simple assume that the Rand is perfectly stable; i.e. that there is no inflation, only as far as certain, not all, items in their companies are concerned.

However, we all know that money is not perfectly stable. There is something called inflation and deflation.

So, under inflation SA accountants unknowingly destroy the real value of that portion of SA companies´ equity (capital) that is not backed or covered by revaluable fixed assets.

I will explain how tomorrow.
Copyright © 2010 Nicolaas J Smith

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