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Thursday, 22 July 2010

Unit of account

Inflation destroys the assumption that money is stable which is the basis of classic accountancy. In such circumstances, historical values registered in accountancy books become heterogeneous amounts measured in different units. The use of such data under traditional accounting methods without previous correction makes no sense and leads to results that are void of meaning.

Massone, 1981a. p.6

Money’s third function is that it is the unit of account in the economy. It is a monetary standard of measure of the real value of economic items to facilitate exchange without barter in order to overcome the double coincidence of wants problem. Inflation destroys the real value of money and deflation increases the real value of money. Money has never been perfectly stable in real value over an extended period of time. However, money illusion makes people believe that money maintains its real value over the short to medium term. Money is the only standard unit of measure that is not a fundamentally stable or fixed unit of value. All other standards of measure are perfectly stable units.

Accountants transformed money illusion into an official generally accepted accounting principle with their stable measuring unit assumption, also called 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 reports.

Paul H. Walgenbach, Norman E. Dittrich and Ernest I. Hanson, (1973), Financial Accounting, New York: Harcourt Brace Javonovich, Inc. Page 429.

The stable measuring unit assumption is based on the fallacy that changes in the general purchasing power are not sufficiently important to require adjustments to the basic financial reports; i.e. not sufficiently important for accountants to measure financial capital maintenance in units of constant purchasing power during inflation and deflation.

In a low inflationary economy depreciating money is used as a depreciating monetary unit of account to value and record economic activity. It is very tempting to state that it is very clear that you can not have a unit of account that is not stable – as in fixed – in real value for accounting purposes. However, we have been doing exactly that for the last 700 years. The problem stems from the difficulty in defining a universal unit of real value.

Luckily there is a perfect way of eliminating completely the destructive effect of having a depreciating monetary unit of account during inflation as well as its increasing monetary real value effect during deflation in constant real value non-monetary items in an economy implementing the basic double entry accounting model. I am not referring to the HCA model, but, simply the double entry accounting model. It is the measurement of constant item values in units of constant purchasing power by inflation-adjusting their nominal values in terms of the change in the CPI as authorized by the IASB in the Framework, Par 104 (a) in 1989. Unfortunately this is currently only used in hyperinflationary economies and with the valuation of certain income statement items, e.g. salaries, wages, rentals, etc during low inflation. SA accountants in general (do not understand the real value maintaining function (effect) of measuring financial capital maintenance in units of constant purchasing power as it relates to balance sheet constant items never maintained. If they understood it, they would not continue with their very destructive stable measuring unit assumption – as they are doing right now – and unknowingly destroy about R200 billion per annum of real value in the SA constant item economy.

They do understand it as far as salaries, wages, rentals, etc are concerned. But, not as far as balance sheet constant items never maintained are concerned.

Inflation is the real problem or enemy - as everyone knows - with depreciating money since real value is the most fundamental economic concept in any economy under any economic model including the Historical Cost Accounting model and not money as is generally accepted under the mistaken belief (money illusion) or assumption (stable measuring unit assumption) that money is stable in real value. The combination of the stable measuring unit assumption (HCA) with inflation elevates money’s function as depreciating unit of account to one of critical importance. SA accountants´ implementation of this very destructive assumption in SA´s low inflationary economy is the second unknown and hidden real value destruction process or enemy whereby they unknowingly destroy significant amounts of real value in the real economy each and every year.
Copyright © 2010 Nicolaas J Smith