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Tuesday, 3 August 2010

Inflation myths in layman terms – Part 4

3. "Inflation destroys the value of non-monetary items which do not hold their value in terms of purchasing power" is authoritatively stated.

I agreed with that when it was stated in 2008. My first book Real Value Accounting (2005) was based on the premise that inflation has two components: a monetary and a non-monetary component. I have since realized that it was a mistake. We often advance science from making mistakes. It was definitely worth my while writing the first book. It helped me to realize that inflation per se does not destroy the real value of non-monetary items.

Inflation can only destroy the real value of monetary items - nothing else. Inflation - per se - has no effect on the real value of non-monetary items. It is impossible for inflation - per se - to destroy the real value of non-monetary items.

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.

What destroys the real value of non-monetary items if it is not inflation?

There are three fundamentally different economic items in the economy:

1.Monetary items

2.Variable real value non-monetary items

3.Constant real value non-monetary items

We all know that inflation destroys the real value of monetary items over time – and nothing else. So, that is settled: the real value of money and other monetary items are destroyed by inflation over time. Obviously if you burn bank notes or they are physically destroyed in some other way, their real values are destroyed too: they do not physically exist any more. All central banks replace very worn-out bank notes in the physical money supply.

Variable items are things like property, plant, equipment, foreign exchange, raw material and finished goods stock, consumer items, etc. Their real values can be destroyed in many different ways: they go out of fashion, they become useless, they stop working, better products are developed, etc, etc.

Inflation can not destroy their real value: when you own a variable item, for example, a house, and you know many very similar houses sell for R1 million Rand, you know your house is worth R1 million. If nothing except inflation changes to 4% over a year, you adjust your value for your house to R1 040 000.

You cannot do that with R1 million you keep in a zero interest bank account.

The third item, constant items are items like salaries, wages, rentals, issued share capital, retained profits, trade debtors, trade creditors, etc. Accountants account all these items in terms of money (the Rand) in the books of account – like everything they account.

All SA accountants accept without a shadow of doubt that any level of inflation – whether 0.0001% or 25% or whatever level per annum - destroys the real value of the Rand and they inflation-adjust the nominal values of salaries, wages, rentals, etc on an annual basis: they choose / decide / accept / agree to value these items in unit of constant purchasing power. They are all very well educated in accounting. Accounting is a very well developed discipline: measurement in units of constant purchasing power is a well known and well established generally accepted accounting practice over the last 100 years or more of maintaining the real value of an economic item during inflation. SA accountants are all very well educated in implementing measurement in units of constant purchasing power: the proof? They apply it every year to salaries, wages, rentals, etc. There is absolutely no doubt about the fact that SA accountants understand the concept of measurement in units of constant purchasing power to maintain the real value of an economic item during inflation. They know that they have to increase the nominal values of these items by an amount at least equal to the annual rate of inflation because they are accounting them in terms of the Rand and inflation destroys the real value of the Rand. That is why they value / measure them in units of constant purchasing power.

So, they accept and admit what we all know: there is no such thing as perfectly stable money or a perfectly stable monetary measuring unit. They maintain the real value of salaries, wages, rentals, etc by implementing measurement in units of constant purchasing power. How clever and how reasonable and how intelligent and how normal of them. SA accountants are really well-educated and very normal professionals in this respect.

However, you will not believe what I am going to tell you next!!

When it comes to items like issued share capital and retained profits SA accountants suddenly change their very educated attitude completely: now they suddenly assume the Rand is perfectly stable. They suddenly forget everything they have learnt and know about inflation: they, in principle, suddenly assume there has never been inflation in the past, there is no inflation in the present and there will never ever be inflation in the future.

What in fact happens is that whereas they accept that any level of inflation destroys the real value of salaries, wages, rentals, etc, they now suddely assume the following: inflation from 0.001% to 25.9% for three years in a row is now, suddenly, immaterial: for example 25% inflation for three years in a row (which – by the way – will wipe out 100% of the real value of constant items never maintained under HCA) is now immaterial and will not do any harm to the economy.

They implement their notorious and very destructive stable measuring unit assumption: they account companies´ issued share capital, retained profits, etc at their original nominal historical costs: they measure them in nominal monetary units.

Crazy is it not?

Well, that is how all accountants in SA - including the 30 404 CA(SA)s - do accounting.

So, what happens?

Obviously they destroy the real value of companies´ capital, retained profits and other constant items never maintained at a rate equal to the annual rate of inflation because they refuse to measure them in units of constant purchasing power although they have been authorized to do that 21 years ago: they measure them in nominal monetary units.

This time they actually destroy the real value of these constant items never maintained because they refuse point blank to value them in units of constant purchasing power. It is not inflation doing the destroying (as their accounting professors tell them) because they can freely stop their unnecessary destruction by valuing these items in units of constant purchasing power like they do with salaries and wage and rentals, etc. They refuse to do that.

They are told at university that it is inflation doing the destroying.
Why do they do this?

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