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Saturday, 26 February 2011

Accountants abdicate one of their main functions

The function of financial accounting is not just “to convey value information about the economic resources of a business” as Harvey Kapnick stated in the 1976 Sax Lecture.
http://newman.baruch.cuny.edu/DIGITAL/saxe/saxe_1975/kapnick_76.htm

The objectives of general purpose financial reporting are:

1) Automatic maintenance of the constant purchasing power of capital in all entities that at least break even - ceteris paribus.

2) Provision of continuously updated decision-useful financial information about the reporting entity to capital providers and other users.

This can only be achieved by continuously valuing all constant real value non-monetary items in units of constant purchasing power, i.e., by continuously inflation-adjusting all constant real value non-monetary items by means of the monthly change in the annual CPI during low inflation and deflation, namely, by continuously measuring financial capital maintenance in units of constant purchasing power during inflation and deflation. Valuing both variable real value non-monetary items and all constant real value non-monetary items at the daily parallel rate in terms of IAS 29 (or Brazilian-style daily indexation) during hyperinflation will result in the real economy being maintained relatively stable during hyper inflation (see Brazil 1964 to 1994) with real value hyper-erosion in only monetary items.

Accountants have unknowingly abdicated the essential continuous financial capital maintenance in units of constant purchasing power function of accounting/financial reporting to their fiction that money is stable in real value during low inflation and deflation. In so doing, the Historical Cost Accounting model has in the past unknowingly eroded and currently unknowingly, unintentionally and unnecessarily erodes real value on a significant scale (hundreds of billions of US Dollars per annum) in the real economy when accountants implement their very erosive stable measuring unit assumption as part of the IASB-approved traditional HCA model for an unlimited period of time during indefinite inflation.

Accountants and accounting authorities do not realize that they can stop this unknowing, unintentional and unnecessary erosion by simply rejecting the stable measuring unit assumption when they freely choose the IFRS-compliant continuous financial capital maintenance in units of constant purchasing power model (Constant Item Purchasing Power Accounting) at all levels of inflation and deflation.

IFRS do – 21 years ago – allow the rejection of the stable measuring unit assumption as an alternative to HCA at all levels of inflation and deflation. The IASB´s Framework, Par 104 (a) states:

Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power.

Par 104 (a) was authorized by the IASB predecessor body, the International Accounting Standards Committee Board in April, 1989 and adopted by the IASB in 2001.

The stable measuring unit assumption is also rejected in IAS 29 Financial Reporting in Hyperinflationary Economies for restatement of Historical Cost or Current Cost financial statements at the period-end CPI to make them more useful.

The Standards already reject the stable measuring unit assumption under the above two circumstances.

The IASB-approved Framework(1989), Par 104 (a) which is applicable since there are no specific IFRS relating to the concepts of capital, the capital maintenance concepts, the valuation of constant real value non-monetary items, e.g. Issued Share Capital, Retained Earnings and other items in Shareholders´ Equity, etc during non-hyperinflationary periods, allows accountants to reject the stable measuring unit assumption during all levels of inflation and deflation when they choose to continuously measure financial capital maintenance in units of constant purchasing power as an alternative to measurement in nominal monetary units as applied in the traditional HCA model.

It is not generally realized by accountants and accounting authorities that the traditional Historical Cost Accounting model is unknowingly, unintentionally and unnecessarily responsible for the erosion of the real value of constant real value non-monetary items never maintained constant when they implement the traditional HCA model: more specifically, the very erosive stable measuring unit assumption during periods of low inflation when accountants maintain it for an unlimited period of time during indefinite inflation. Accounting professors, accounting lecturers, economists, business people and the public in general equally do not realize the above.

It is also not generally realized by accountants and accounting authorities that they can stop this erosion by selecting financial capital maintenance in units of constant purchasing power as authorized by the IASB 21 years ago in the Framework, Par 104 (a) which is applicable in the absence of specific IFRS.

It is generally accepted and a fact that inflation erodes the real value of money (the internal functional currency) and other monetary items over time. It is also generally accepted and a fact that hyperinflation can erode all the real value of a country’s entire monetary base as happened in Zimbabwe in 2008. That was the result of a significant increase in the volume and nominal value of bank notes in the country by Gideon Gono, the governor of the Reserve Bank of Zimbabwe, with an equivalent extreme rate of erosion of the real value of the Zimbabwe Dollar since the significant nominal increase in ZimDollar money supply was not in response to an equal increase in real value in the real or non-monetary economy of Zimbabwe.

“There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction.”

The Economic Consequences of the Peace by John Maynard Keynes 1919

http://socserv2.mcmaster.ca/~econ/ugcm/3ll3/keynes/peace

That certainly was true in the case of Zimbabwe.

It is generally accepted and a fact that inflation erodes the real value of money and the capital amounts of monetary savings and money lent over time (amongst other monetary items). It is generally accepted, but not a fact, that inflation erodes the real value of constant real value non-monetary items with fixed nominal payments over time, e.g. fixed salary, wage, rental payments.

The constant real non-monetary values of salaries, wages, rentals, etc are generally maintained constant, i.e. not eroded, when accountants choose to measure the existing constant real non-monetary values of these constant real value non-monetary items in units of constant purchasing power in terms of the CPI in most economies with payment in depreciating money during inflation: they inflation-adjust them during low inflation.

It is not yet generally accepted, but a fact, that the traditional Historical Cost Accounting model unknowingly, unintentionally and unnecessarily erodes the real value of existing constant real value non-monetary items never maintained constant, e.g. equity never maintained constant, of companies and banks over time as a result of insufficient revaluable fixed assets when accountants choose to measure financial capital maintenance in nominal monetary units in terms of the traditional HCA model during low inflation when they maintain the stable measuring unit assumption for an unlimited period of time during indefinite inflation.

As a result of this lack of realizing the erosive nature of the implementation of the stable measuring unit assumption, 1970-style CPPA inflation accounting was also not an accounting system implemented by accountants to correct or eliminate the erosion of the constant real value of existing constant real value non-monetary items never maintained constant by the use of the stable measuring unit assumption, but, a failed attempt to simply make financial reports more understandable and more comparable with previous year statements during periods of high inflation by inflation-adjusting all non-monetary items in year-end financial statements equally in terms of the CPI.

Accountants simply do not realize that the HCA model unknowingly erodes real value on a significant scale in all existing constant real value non-monetary items never maintained constant when accountants choose to implement the very erosive stable measuring unit assumption for an unlimited period of time during indefinite inflation. In most cases accountants do not even know that they make that choice. Neither do they realize that they will knowingly stop that erosion by freely choosing to measure financial capital maintenance in units of constant purchasing power, as approved in the IASB Framework, Par 104 (a) in 1989.

Prof Geoffrey Whittington in his definitive work on inflation accounting in the beginning of the 1980´s, Inflation Accounting - An Introduction to the Debate, published in 1983, clearly indicated that with 1970-style CPP inflation accounting all non-monetary accounts (with no distinction being made between variable real value non-monetary items and constant real value non-monetary item accounts) were updated by means of the CPI.

"Constant Purchasing Power Accounting (CPP) is a consistent method of indexing accounts by means of a general index which reflects changes in the purchasing power of money. It therefore attempts to deal with the inflation problem in the sense in which this is popularly understood, as a decline in the value of the currency. It attempts to deal with this problem by converting all of the currency unit measurement in accounts into units at a common date by means of the index."

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