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Saturday, 12 February 2011

Historical Cost Accounting is very erosive during inflation

Also approving the traditional Historical Cost Accounting model in the Framework(1989), Par 104 (a) has been very costly for the world economy as amply illustrated by the deficiency in bank and company capital during the recent financial crisis. This clearly illustrates the lack of understanding the very erosive effect of the stable measuring unit assumption on balance sheet constant real value non-monetary items (e.g. shareholders´ equity) during low inflationary periods.
The school of thought that the effects of 2% inflation are not more harmful than zero per cent inflation may have contributed to this. This school of thought is wrong in two of the three valuation processes in our current HC economy and would also be wrong in one of the three valuation processes under continuous financial capital maintenance in units of constant purchasing power, i.e. a constant item purchasing power paradigm during low inflation. The three valuation processes in our economy under both the HC and constant item purchasing power paradigms are the valuation of monetary items, variable real value non-monetary items and constant real value non-monetary items.

Variable items are valued in terms of International Financial Reporting Standards under both the Historical Cost and constant item purchasing power paradigms with the stable measuring unit assumption being applied under HCA. The stable measuring unit assumption is rejected under the Constant Item Purchasing Power Accounting option.

In the first instance, the view that a high degree of price stability of a positive inflation rate of up to two per cent per annum is completely unharmful and that it has no disadvantages compared to absolute price stability is never true in the case of monetary items under any accounting model – either the HCA model or the Constant Item Purchasing Power Accounting model – since monetary items are incapable of being updated as a result of the current nature of fiat money. A high degree of price stability of two per cent per annum in this case erodes two per cent per annum of the real value of all money and other monetary items that cannot be updated in any way or form; that equates to the erosion of 51 per cent of real value in all current monetary items over the next 35 years and will over a long enough time period lead to all current monetary items arriving at the point of being completely worthless. See the Real Value Table for some other levels of value erosion over the respective time periods involved. In the case of monetary items we can thus confidently disagree completely with those who assume that a high degree of price stability of above zero and up to two per cent per annum is unharmful in all respects and that it has absolutely no disadvantages compared to absolute price stability or zero inflation.

The assumption that 2% inflation is unharmful and that it has no disadvantages compared to zero inflation is acceptable in the case of variable real value non-monetary items valued continuously in terms of IFRS under both the HC model and the Constant Item Purchasing Power Accounting model. The nature of the valuing processes in valuing variable real value non-monetary items continuously, for example, at fair value or net realizable value or market value, as applicable, in terms IFRS, allows this idea to be justifiable under both models. The above view is acceptable in this instance, because, in principle, any level of inflation or deflation – high or low – is automatically adjusted for in determining the price of a variable real value non-monetary item in terms of IFRS excluding, of course, the stable measuring unit assumption.

2% inflation erodes 2% per annum - i.e. 51% over 35 years - of the real value of constant real value non-monetary items never maintained, e.g. retained profits and issued share capital, under the current HC paradigm. All existing constant real value non-monetary items´ real values would be maintained constant with continuous measurement in units of constant purchasing power at any level of inflation or deflation under the Constant Item Purchasing Power Accounting paradigm for an unlimited period of time in companies at least breaking even – all else except inflation and deflation being equal. We can thus safely disagree in the instance of constant real value non-monetary items under the HC paradigm too, that the effects of 2% inflation is completely unharmful. 2% inflation – in fact, any level of inflation or deflation - would be the same as zero inflation as far as the valuation of constant real value non-monetary items under the Constant Item Purchasing Power Accounting paradigm is concerned.

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