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Friday, 30 July 2010

Inflation myths in layman terms – Part 2

SA accountants, implementing traditional 700-year-old Historical Cost Accounting, unknowingly, unnecessarily and unintentionally destroy the real value of that portion of SA companies´ equity (capital) that is not backed or covered 100% by revaluable fixed assets at a rate EQUAL TO the annual inflation rate - because they account companies´ capital in money - the Rand in SA - and inflation destroys the real value of the Rand, but, SA accountants ignore that basic fact when they value companies´ equity (capital) and most other constant real value non-monetary items at original historical cost.

How do SA accountants destroy the real value of SA companies´ capital doing traditional Historical Cost Accounting?

As follows:

They implement the stable measuring unit assumption during inflation. They accept that inflation destroys the real value of the Rand, but, they assume that makes no real difference and is not harmful at all (from 0.001 to 25% per annum for three years in a row). So, for certain items, not all items, they, in principle, assume there is no inflation; they assume the Rand is perfectly stable even at 25% per annum inflation for three years in a row recurring.

Which items? Issued share capital, retained profits, capital reserves, all other items in shareholders´ equity, for example.

R1 million on 1st Jan 1981 was the same as R14 million today.

So if you invested the R1 million on 1st Jan 1981 in revaluable fixed property your balance sheet from 1st Jan 1981 till today would always be the same: Capital R1 million and Fixed Property R1 million. You can keep it like that forever. The real value of your capital would be maintained although you value both Capital and Fixed Property in nominal monetary units, i.e. at Historical Cost. You can only maintain the real value of your capital like that if you invest 100% of the original real value of all contributions to equity in revaluable fixed property – under HCA during inflation.

Let´s say you only invested half in fixed property and half in beer for resale on 1st Jan 1981, you pay all your profit out in dividends and you keep on buying R500 000 in beer stock for resale. You keep doing that from Jan 1981 till today. Your balance sheet today will be: Capital R1 million, Fixed Property R500 000 and Stock R500 000.

Your R1 million capital on 1st Jan 1981 was worth R14 million in today´s money.

Today you can sell the property in your books at a Historical Cost of R500 000 for R7 million and the R500 000 beer stock (greatly reduced in units of beer) for a profit. So, you have paid away R6.5 million of the real value of your capital you started your business with in dividends.

That is how SA accountants, including CA(SA)s, unknowingly, unnecessarily and unintentionally destroy about R167 billion PER ANNUM in the investment base of SA companies – the S A real economy - doing traditional Historical Cost Accounting: with their stable measuring unit assumption. They, the IASB and FASB blame inflation and, they say, there is absolutely nothing they can do about it. They are all dead wrong.

All of them also do not understand the above: if they understood it, they would have done something about it by now.

What would have happened if they had inflation-adjusted their equity as they had been authorized by the International Accounting Standards Board in International Financial Reporting Standards in the Framework, Par 104 (a) in 1989?

I will explain next time.
Copyright © 2010 Nicolaas J Smith