Wednesday, 4 August 2010

Accountants are inconsistent.

Why don’t SA accountants value companies´ issued share capital and retained profits - which are constant real value non-monetary items - in units of constant purchasing power as they value salaries, wages, rentals – which are also constant real value non-monetary items?

Why do they refuse to value capital and retained profits in units of constant purchasing power like they do with salaries and wages?

Well, they don’t actually refuse to do it. They just don’t do it that way: that’s it!! Everybody in the world values capital and retained profits in nominal monetary units for at least the last 3000 years! It must be correct when everybody is doing it for the last 3000 years, isn’t it?

Everybody once thought the sun turns around the earth because they could actually see the sun turning around the earth.

Everybody once thought the earth is flat because they could actually go outside and see that the earth is flat all around them.

No, valuing capital and profits at historical cost is wrong during inflation and deflation! Proof: accountants assume money is perfectly stable for this purpose and we all know money is never perfectly stable for more than a month or two at a time. (Check out CPI data). Accountants apply their notorious stable measuring unit assumption: they assume the measuring unit is stable: we all know that the measuring unit – money – is never stable on a sustainable basis. So: they are wrong as well as inconsistent!! :-)

So, if SA inflation stayed at 13.8% (where it got to some months back - for the next 50 years), SA accountants would carry on assuming it is perfectly stable - zero percent - and they would just have carried on valuing SA companies´ capital and profits at historical cost as they do today at 4.2%. They would carry on doing that all the way till 25% for three years or 300 years in a row. They would not change - in terms of IFRS.

By the way, after three years of 25% inflation - which is immaterial as far as SA accountants are concerned (in terms of IFRS) - they would have unknowingly destroyed 100% of all equity not backed by revaluable fixed assets in the SA economy.

Historical Cost Accounting is the existing paradigm in the world economy for the last 3000 years – at least.

In fact, accountants know and admit that there is inflation and that inflation destroys the real value of the Rand over time. They just assume that it makes no difference. They assume that inflation from 0.0001% per annum till 25% per annum for three years in a row is immaterial: that it is not harmful to the economy. But, ONLY in the case of companies´ issued share capital, retained profits, all other items in shareholders´ equity, etc. These are all constant real value non-monetary items.

Salaries, wages, rentals, etc are also constant items. In this case accountants value them in units of constant purchasing power. They are not at all consistent in their way of reasoning.

“Historical Cost” accounting means that – originally: a very long time ago – all economic items were valued at their original Historical Cost values. 500 years ago the East Indian Company accountants valued all company fixed property at historical cost. The historical cost stayed the same from 1500 to 1800. Today fixed property can be revalued in terms of IFRS. Today all variable real value non-monetary items are valued in terms of IFRS which are – by and large – based on market value or fair value: the destruction of the real value of the monetary unit of account is allowed for in the valuation process of determining the values of variable items in the financial statements.

More in the next blog.

Kindest regards

Nicolaas Smith

Copyright © 2010 Nicolaas J Smith

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