Pages

Thursday, 6 January 2011

Accounting fallacies not yet extinct

Economic history is replete with fallacies which became extinct with the development of economic understanding.

Three accounting fallacies not yet extinct are:

1. Financial capital maintenance in nominal monetary units authorized in IFRS in the Framework (1989), Par 104 (a) which states: “Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power.”

It is impossible to maintain the real value of financial capital constant in nominal monetary units per se during inflation and deflation.

2. The stable measuring unit assumption is based on the fallacy that changes in the purchasing power of money are not sufficiently important to require continuous financial capital maintenance in units of constant purchasing power during low inflation and deflation.

Changes in the purchasing power of money logically require continuous financial capital maintenance in units of constant purchasing power during inflation and deflation.

3. Accountants´ belief that the erosion of companies´ profits and capital is caused by inflation. This is fully supported by the IASB and the US Financial Accounting Standards Board.

Accountants unknowingly, unnecessarily and unintentionally erode the real value of companies´ profits and capital never maintained constant with their free choice of implementing the stable measuring unit assumption during inflation. Inflation can only erode the real value of money and other monetary items. Inflation has no effect on the real value of non-monetary items.

The erosion of companies´ capital and profits by inflation is a very popular accounting fallacy stated by, for example, the US Financial Accounting Standards Board:

Mr. Mosso dissents because he believes that the Statement does not bring the basic problem it addresses — measuring the effect of inflation on business operations — into focus. Because of that he doubts that it will effectively communicate the erosive impact of inflation on profits and capital and the significance of that erosion on all who have an investment stake in business enterprises. FAS 33 (superseded by FAS 89), Par 67, P 22, 1979.

The FASB blamed inflation for the erosion of companies´ capital and profits, but, admitted that the traditional HCA model, or, specifically the stable measuring unit assumption, actually does the eroding:

Because most accountants and users of financial statements have been inculcated with a model of financial reporting that assumes stability of the monetary unit, accepting a change of this consequence would take a lengthy period of time under the best of circumstances. FAS 89, Par 4, P6, 1986.

The IASB also blames inflation in IAS 29 Financial Reporting in Hyperinflationary Economies:

In most countries, financial statements are prepared on the historical cost basis of accounting without regard either to changes in the general level of prices or to increases in specific prices of assets held, except to the extent that property, plant and equipment and investments may be revalued. IAS 29 Par 6

Both shareholders´ equity being a company’s capital as well as retained profits - as a separate item - are constant real value non-monetary items.

Inflation has no effect on the real value of non-monetary items: Milton Friedman famously stated that “inflation is always and everywhere a monetary phenomenon.”

This is confirmed by two Turkish academics as follows:

“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

Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.