Three popular accounting fallacies
Updated on 14-06-2016
The real values of many constant real value non–monetary items, for example, that portion of shareholders´ equity never maintained constant by sufficient revaluable fixed assets (revalued or not) under the HCA model, are not automatically maintained constant (as they are under Capital Maintenance in Units of Constant Purchasing Power in terms of the Daily CPI) in the world´s low inflation economies. This was clearly evident during the recent financial crisis that necessitated huge amounts of additional capital for under–capitalized banks and companies whose capital has been eroded by the stable measuring unit assumption (not inflation - as generally accepted) during low inflation. Inflation has no effect on the real value of non-monetary items. The constant real non–monetary values of their capital are still unnecessarily, unknowingly and unintentionally being eroded at a rate equal to the annual rate of inflation by the implementation of the very erosive stable measuring unit assumption as it forms part of the traditional HCA model. HCA is based on the accounting fallacy that financial capital maintenance can be measured (implied: maintained) in nominal monetary units per se during inflation and deflation as originally authorized in IFRS in the Framework (1989), Par 104 (a) as well as approved in the FASB´s Statement of Financial Accounting Concepts No. 5, Recognition and Measurement in Financial Statements of Business Enterprises (1984).
Many people see financial reporting as simply providing historic economic information. It is not realized that it is a basic objective of accounting (financial reporting) to automatically maintain the constant purchasing power of capital constant in all entities that at least break even in real value for an indefinite period of time by continuously measuring all constant real value non–monetary items in units of constant purchasing power in terms of the Daily CPI during inflation, deflation and hyperinflation.
The reasons for this are:
(1) The Three Popular Accounting Fallacies.
(a) The stable measuring unit assumption based on the fallacy that changes in the purchasing power of money (the montary unit of measure) are not sufficiently important to require the measurement of financial capital maintenance in units of constant purchasing power in terms of the Daily CPI during low inflation, deflation and hyperinflation originally authorized in IFRS in the Framework (1989), Par 104 (a) and in the FASB´s FA Concepts No. 5.
(b) Financial capital maintenance in nominal monetary units per se (the belief that the real value of financial capital can be maintained in nominal monetary units per se) during low inflation and deflation originally authorized in IFRS in the Framework (1989), Par 104 (a) and in the FASB´s FA Concepts No. 5.
(c) The generally accepted belief that the erosion of companies´ profits and capital is caused by inflation fully supported in IFRS and by the FASB.
(2) It is not realized (understood) that it is the stable measuring unit assumption and not inflation that erodes the real value of constant real value non–monetary items never maintained constant when financial capital maintenance in nominal monetary units (the traditional HCA model) is implemented during low inflationary and hyperinflationary periods. Reject the stable measuring unit assumption, i.e., implement financial capital maintenance in units of constant purchasing power in terms of the Daily CPI) and the real value of capital is automatically maintained constant in all entities that at least break even in real value, ceteris paribus.
(3) It is not realized (understood) that continuous measurement of financial capital maintenance in units of constant purchasing power (Capital Maintenance in Units of Constant Purchasing Power in terms of the Daily CPI) automatically remedies this erosion by the stable measuring unit assumption during low inflation and hyperinflation.
If the above were generally understood then the stable measuring unit assumption / financial capital maintenance in nominal monetary units, i.e. the HCA model, would have been stopped during low inflation, deflation and hyperinflation by now.
Although the principle of financial capital maintenance in units of constant purchasing power in terms of the Daily CPI during inflation and hyperinflation was authorized in IFRS in 1989, it has not been implemented generally during low inflations and hyperinflation because the eroding effect of the stable measuring unit assumption on the real value of constant items never maintained constant is not recognized (understood) as such. It is generally believed that it is inflation doing the eroding in, for example, companies´ invested capital and profits – as specifically stated in FAS 89 - when this erosion in constant item real value is, in fact, caused by the stable measuring unit assumption. Inflation has no effect on the real value of non–monetary items. Capital and profits are constant real value non–monetary items.
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
Saturday, 30 April 2011
Friday, 29 April 2011
Monetary meltdown
Monetary meltdown
The monetary economy (the total real value of a fiat money supply) can disappear completely. It happened three times during three months towards the end of hyperinflation in Yugoslavia. It happened at the end of hyperinflation in Zimbabwe in 2008, terminating hyperinflation in that country. Zimbabwe did not try hyperinflation again like Yugoslavia which has the distinction of having wiped out the real value of their entire monetary economy three times in three months. In Zimbabwe the economy dollarized spontaneously after a decision by the Reserve Bank of Zimbabwe to close the Zimbabwe Stock Exchange which stopped the Old Mutual Implied Rate being the final exchange rate of the Zimbabwe Dollar with a foreign currency – the British Pound. The Zimbabwean economy dollarized spontaneously after that because it was a sufficiently open economy right next to the stable South African and Botswana and other stable economies in the Southern African region. Those stable economies supplied the Zimbabwean economy with essential goods and services. Zimbabwe then had the opportunity to slowly recover from total monetary meltdown and the devastating effect of implementing the very erosive stable measuring unit assumption – the Historical Cost Accounting model - during hyperinflation as authorized in International Financial Reporting Standards and supported by Big Four accounting firms like PricewaterhouseCoopers. Zimbabwe spontaneously adopted a multi-currency dollarization model using the US Dollar, the Euro, the SA Rand, the British Pound and the Botswana Pula as relatively stable foreign currencies in the Zimbabwean economy.
The variable real value non-monetary item economy (property, plant, equipment, inventory, etc) cannot disappear because of wrong monetary policies. Inflation is always and everywhere a monetary phenomenon. Inflation and hyperinflation have no effect on the real value of non-monetary items. After monetary meltdown in Zimbabwe the properties, plant, equipment, raw materials, finished goods, etc., were still there. The variable item economy can be destroyed by natural disasters like earth quakes and tsunamis and by man-made events like war.
The constant item economy (shareholders´ equity, trade debtors, trade creditors, salaries, wages, rentals, etc.) also cannot be eroded by inflation and hyperinflation because inflation and hyperinflation have no effect on the real value of non-monetary items: both variable and constant real value non-monetary items. However, the stable measuring unit assumption (i.e. the Historical Cost Accounting model or financial capital maintenance in nominal monetary units per se during inflation and hyperinflation) erodes the constant real non-monetary value of constant items not maintained constant during inflation and hyperinflation, e.g. trade debtors, trade creditors, salaries, wages, rentals, that portion of shareholder´s equity never maintained constant as a result of insufficient revaluable fixed assets (revalued or not), all other non-monetary payables and receivables, etc., at a rate equal to the annual rate of inflation or hyperinflation.
Equity is equal to net assets; i.e., the constant real non-monetary value of shareholders´ equity is equal to the constant real value of net assets. Under Constant Item Purchasing Power Accounting (CIPPA) the constant real non-monetary value of equity is automatically maintained constant in all entities that at least break even for an unlimited period of time (forever) during low inflation and deflation whether these entities own any revaluable fixed assets or not.
Only capital maintenance in units of constant purchasing power in terms of the daily US Dollar or other hard currency parallel rate or a daily Brazilian-style index under Constant Purchasing Power Accounting (CPPA) will automatically maintain the constant real value of constant items constant for an indefinite period of time in all entities that at least break even during hyperinflation. This includes shareholders´ equity whether these entities own any revaluable fixed assets or not.
The monetary economy can be totally eroded like in the case of the Zimbabwe Dollar, not simply as a result of hyperinflation, but, as a result of a monetary meltdown after a period of severe hyperinflation. Hyperinflation is defined by Cagan as 50% monthly inflation and in International Financial Reporting Standards as cumulative inflation approaching or equal to 100% over three years; i.e. 26% annual inflation for three years in a row. The IFRS definition is followed in this book. Severe hyperinflation is normally the final stage of a devastating hyperinflationary spiral with a continuously super-increasing rate of hyperinflation when hyperinflation reaches millions of percent per annum. Exchangeability of the monetary unit, under those conditions, becomes limited to very few or just one single foreign currency like in the case of the Zimbabwe where the Zimbabwe Dollar only had exchangeability with the British Pound via the Old Mutual Implied Rate as derived from continued trade in Old Mutual shares on the Zimbabwe Stock Exchange even during severe hyperinflation. A monetary meltdown takes place when a monetary unit stops having exchangeability with all foreign currencies normally after, first, a period of hyperinflation and then a period of severe hyperinflation.
Hyperinflation only erodes the real value of the monetary unit extremely rapidly. Hyperinflation has no effect on the real value of non-monetary items. All non-monetary items (variable and constant items) maintain their real values during hyperinflation when they are updated (measured in units of constant purchasing power) daily in terms of a daily parallel rate (a black market or street rate) normally the daily unofficial US Dollar or other hard currency exchange rate or a daily non-monetary index normally almost totally based on the daily US Dollar exchange rate as Brazil did during 30 years of very high and hyperinflation.
The stable measuring unit assumption (Historical Cost Accounting) – not hyperinflation – unknowingly, unnecessarily and unintentionally erodes the real value of constant real value non-monetary items, e.g. salaries, wages, rents, shareholders´ equity, trade debtors, trade creditors, etc. not maintained constant as fast as hyperinflation erodes the real value of the local currency and other monetary items, e.g. loans stated in the local currency. A monetary meltdown erodes all real value only in the monetary economy; i.e. in the local currency money supply.
Hyperinflation is not always stopped with first a period of severe hyperinflation in the final stage and then a complete monetary meltdown. Hyperinflation was successfully overcome by various countries, e.g. Turkey, Brazil and Angola, without dollarization or a monetary meltdown. However, severe hyperinflation (hyperinflation at millions of per cent per annum) would normally lead to a complete monetary meltdown as happened in Zimbabwe in 2008.
Brazil actually grew their non-monetary economy in real value during 30 years of very high and hyperinflation of up to 2000 per cent per annum from 1964 to 1994 and never had severe hyperinflation followed by a complete monetary meltdown at the end. Brazil managed to have positive GDP growth during 30 years of very high and hyperinflation because the various governments during those three decades supplied the population with a daily non-monetary index based almost entirely on the daily US Dollar exchange rate with their monetary unit which was used to update all non-monetary items (variable and constant real value non-monetary items), e.g. goods, services, equity, trade debtors, trade creditors, salaries, wages, taxes, etc., in the economy daily.
Brazil would not have been able to do that if they had applied the IASB´s IAS 29 Financial Reporting in Hyperinflationary Economies simply because IAS 29 does not provide for continuous daily updating of all non-monetary items during hyperinflation. IAS 29 was authorized in 1989. IAS 29 does not provide for continuous daily updating in terms of the US Dollar parallel rate or a Brazilian-style daily index rate. IAS 29 simply requires restatement of Historical Cost and Current Cost financial statements during hyperinflation applying the monthly Consumer Price Index at the end of the reporting period (monthly, quarterly, six monthly or annual) - generally available a month or two months after the current month - to make these financial statements more useful. It is not the intention of IAS 29 to, and in its current form it cannot, stop the continuous daily rapid erosion of the real value of constant real value non-monetary items as Brazil did for 30 years of high and hyperinflation generating positive economic growth.
This daily very rapid erosion of constant items is caused, not by hyperinflation, but, by the implementation of the stable measuring unit assumption (HCA) during hyperinflation. Applying the monthly CPI a month or two months after the current month is very ineffective during hyperinflation as far as the constant real value of salaries, wages, rentals, equity, trade debtors, trade creditors, positive economic growth, economic stability, the maintenance of internal demand and the continuous daily maintenance of the constant real value of these items are concerned. All non-monetary items (variable and constant items) have to be updated daily in terms of the parallel US Dollar rate or a Brazilian-style daily index rate in order to maintain the real economy relatively stable during hyperinflation in the monetary unit. That is financial capital maintenance in units of constant purchasing power during hyperinflation as originally authorized in IFRS in the Framework (1989), Par 104 (a).
The Framework (1989), Par. 104 (a) states:
Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power.
The original Framework (1989), Par 104 (a) authorizes financial capital maintenance in units of constant purchasing power during low inflation and deflation (Constant Item Purchasing Power Accounting - CIPPA) under which only constant real value non-monetary items (not variable real value non-monetary items) are measured in units of constant purchasing power by applying the monthly change in the annual CPI during low inflation and deflation. It is also applicable during hyperinflation (Constant Purchasing Power Accounting - CPPA) where under all non-monetary items - constant and variable real value non-monetary items - are updated daily in terms of the US Dollar parallel rate or a Brazilian-style daily index rate. IFRS authorize financial capital maintenance in units of constant purchasing power at all levels of inflation and deflation.
The stable measuring unit assumption (HCA or financial capital maintenance in nominal monetary units, also originally authorized in IFRS in the Framework (1989), Par 104 a ) assumes, in principle, that there was, is and never ever will be inflation, deflation or hyperinflation as far as the valuation of constant real value non-monetary items never maintained constant are concerned. The stable measuring unit assumption (HCA) assumes, in principle, that money was forever in the past, is and will always in the future be perfectly stable under all levels of inflation, hyperinflation and deflation.
Various authoritative commentators in the accounting profession are requesting a fundamental revision of IAS 29.
Severe hyperinflation is defined as a period at the end of completely uncontrolled hyperinflation when exchangeability between the hyperinflationary monetary unit and most relatively stable foreign currencies does not exist. However, at least one exchangeability has to exist for prices to be established in the hyperinflationary monetary unit; i.e. for hyperinflation to exist. Severe hyperinflation is only possible when there is exchangeability with at least one relatively stable foreign currency in order for prices to continue to be set in the hyperinflationary monetary unit in terms of this final exchangeability. The one exchange rate that lasted till the end of hyperinflation in Zimbabwe was the Old Mutual Implied Rate (OMIR).
The ratio of the Old Mutual share price in Harare to that in London equals the Zimbabwe dollar/sterling exchange rate. p8 1
Severe hyperinflation stops the moment exchangeability between the currency and all foreign currencies does not exist.
Zimbabwe’s hyperinflation came to an abrupt halt. The trigger was an intervention by the Reserve Bank of Zimbabwe. On November 20, 2008, the Reserve Bank’s governor, Dr. Gideon Gono, stated that the entire economy was “being priced via the Old Mutual rate whose share price movements had no relationship with economic fundamentals, let alone actual corporate performance of Old Mutual itself” (Gono 2008: 7–8). In consequence, the Reserve Bank issued regulations that forced the Zimbabwe Stock Exchange to shut down. This event rapidly cascaded into a termination of all forms of non-cash foreign exchange trading and an accelerated death spiral for the Zimbabwe dollar. Within weeks the entire economy spontaneously “dollarized” and prices stabilized. p 9-10 2
There was severe hyperinflation in Zimbabwe while there was exchangeability (prices could still be set in the ZimDollar) with at least one relatively stable foreign currency – the British Pound in this case as it was made possible via the OMIR. When this last exchangeability stopped it was not possible to set prices in the ZimDollar anymore and severe hyperinflation stopped: no exchangeability means no hyperinflation. That was a monetary meltdown. The entire ZimDollar money supply had no value as from that moment. Monetary items expressed in the ZimDollar had no value as from that moment. All variable real value non-monetary items maintained their real values despite the monetary meltdown. The IASB authorized an addition to IAS 1 in 2011 to allow for the fair value valuation of all non-monetary items in the opening balance sheet of companies after severe hyperinflation and a monetary meltdown. Inflation and hyperinflation have no effect on the real value of non-monetary items.
No exchangeability with all relatively stable foreign currencies means no exchange rates which means no severe hyperinflation (no prices being set in the local currency) and vice versa: no exchange rate with any relatively stable foreign currency means no exchangeability which means no hyperinflation (no prices being set in the local currency).
No prices being set in the local currency means monetary meltdown: the total money supply and all money and other monetary items stated in the local currency have no value.
The real or non-monetary economy (houses, properties, buildings, infrastructure, inventories, finished goods, consumer goods, trademarks, goodwill, logos, copyright, trade debtors, trade creditors, royalties payable, royalties receivable, taxes payable, taxes receivable, all other non-monetary payables, all other non-monetary receivables, etc,) cannot be eroded by hyperinflation or a total monetary meltdown: inflation is always and everywhere a monetary phenomenon. Inflation and hyperinflation have no effect on the real value of non-monetary items.
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
The monetary economy (the total real value of a fiat money supply) can disappear completely. It happened three times during three months towards the end of hyperinflation in Yugoslavia. It happened at the end of hyperinflation in Zimbabwe in 2008, terminating hyperinflation in that country. Zimbabwe did not try hyperinflation again like Yugoslavia which has the distinction of having wiped out the real value of their entire monetary economy three times in three months. In Zimbabwe the economy dollarized spontaneously after a decision by the Reserve Bank of Zimbabwe to close the Zimbabwe Stock Exchange which stopped the Old Mutual Implied Rate being the final exchange rate of the Zimbabwe Dollar with a foreign currency – the British Pound. The Zimbabwean economy dollarized spontaneously after that because it was a sufficiently open economy right next to the stable South African and Botswana and other stable economies in the Southern African region. Those stable economies supplied the Zimbabwean economy with essential goods and services. Zimbabwe then had the opportunity to slowly recover from total monetary meltdown and the devastating effect of implementing the very erosive stable measuring unit assumption – the Historical Cost Accounting model - during hyperinflation as authorized in International Financial Reporting Standards and supported by Big Four accounting firms like PricewaterhouseCoopers. Zimbabwe spontaneously adopted a multi-currency dollarization model using the US Dollar, the Euro, the SA Rand, the British Pound and the Botswana Pula as relatively stable foreign currencies in the Zimbabwean economy.
The variable real value non-monetary item economy (property, plant, equipment, inventory, etc) cannot disappear because of wrong monetary policies. Inflation is always and everywhere a monetary phenomenon. Inflation and hyperinflation have no effect on the real value of non-monetary items. After monetary meltdown in Zimbabwe the properties, plant, equipment, raw materials, finished goods, etc., were still there. The variable item economy can be destroyed by natural disasters like earth quakes and tsunamis and by man-made events like war.
The constant item economy (shareholders´ equity, trade debtors, trade creditors, salaries, wages, rentals, etc.) also cannot be eroded by inflation and hyperinflation because inflation and hyperinflation have no effect on the real value of non-monetary items: both variable and constant real value non-monetary items. However, the stable measuring unit assumption (i.e. the Historical Cost Accounting model or financial capital maintenance in nominal monetary units per se during inflation and hyperinflation) erodes the constant real non-monetary value of constant items not maintained constant during inflation and hyperinflation, e.g. trade debtors, trade creditors, salaries, wages, rentals, that portion of shareholder´s equity never maintained constant as a result of insufficient revaluable fixed assets (revalued or not), all other non-monetary payables and receivables, etc., at a rate equal to the annual rate of inflation or hyperinflation.
Equity is equal to net assets; i.e., the constant real non-monetary value of shareholders´ equity is equal to the constant real value of net assets. Under Constant Item Purchasing Power Accounting (CIPPA) the constant real non-monetary value of equity is automatically maintained constant in all entities that at least break even for an unlimited period of time (forever) during low inflation and deflation whether these entities own any revaluable fixed assets or not.
Only capital maintenance in units of constant purchasing power in terms of the daily US Dollar or other hard currency parallel rate or a daily Brazilian-style index under Constant Purchasing Power Accounting (CPPA) will automatically maintain the constant real value of constant items constant for an indefinite period of time in all entities that at least break even during hyperinflation. This includes shareholders´ equity whether these entities own any revaluable fixed assets or not.
The monetary economy can be totally eroded like in the case of the Zimbabwe Dollar, not simply as a result of hyperinflation, but, as a result of a monetary meltdown after a period of severe hyperinflation. Hyperinflation is defined by Cagan as 50% monthly inflation and in International Financial Reporting Standards as cumulative inflation approaching or equal to 100% over three years; i.e. 26% annual inflation for three years in a row. The IFRS definition is followed in this book. Severe hyperinflation is normally the final stage of a devastating hyperinflationary spiral with a continuously super-increasing rate of hyperinflation when hyperinflation reaches millions of percent per annum. Exchangeability of the monetary unit, under those conditions, becomes limited to very few or just one single foreign currency like in the case of the Zimbabwe where the Zimbabwe Dollar only had exchangeability with the British Pound via the Old Mutual Implied Rate as derived from continued trade in Old Mutual shares on the Zimbabwe Stock Exchange even during severe hyperinflation. A monetary meltdown takes place when a monetary unit stops having exchangeability with all foreign currencies normally after, first, a period of hyperinflation and then a period of severe hyperinflation.
Hyperinflation only erodes the real value of the monetary unit extremely rapidly. Hyperinflation has no effect on the real value of non-monetary items. All non-monetary items (variable and constant items) maintain their real values during hyperinflation when they are updated (measured in units of constant purchasing power) daily in terms of a daily parallel rate (a black market or street rate) normally the daily unofficial US Dollar or other hard currency exchange rate or a daily non-monetary index normally almost totally based on the daily US Dollar exchange rate as Brazil did during 30 years of very high and hyperinflation.
The stable measuring unit assumption (Historical Cost Accounting) – not hyperinflation – unknowingly, unnecessarily and unintentionally erodes the real value of constant real value non-monetary items, e.g. salaries, wages, rents, shareholders´ equity, trade debtors, trade creditors, etc. not maintained constant as fast as hyperinflation erodes the real value of the local currency and other monetary items, e.g. loans stated in the local currency. A monetary meltdown erodes all real value only in the monetary economy; i.e. in the local currency money supply.
Hyperinflation is not always stopped with first a period of severe hyperinflation in the final stage and then a complete monetary meltdown. Hyperinflation was successfully overcome by various countries, e.g. Turkey, Brazil and Angola, without dollarization or a monetary meltdown. However, severe hyperinflation (hyperinflation at millions of per cent per annum) would normally lead to a complete monetary meltdown as happened in Zimbabwe in 2008.
Brazil actually grew their non-monetary economy in real value during 30 years of very high and hyperinflation of up to 2000 per cent per annum from 1964 to 1994 and never had severe hyperinflation followed by a complete monetary meltdown at the end. Brazil managed to have positive GDP growth during 30 years of very high and hyperinflation because the various governments during those three decades supplied the population with a daily non-monetary index based almost entirely on the daily US Dollar exchange rate with their monetary unit which was used to update all non-monetary items (variable and constant real value non-monetary items), e.g. goods, services, equity, trade debtors, trade creditors, salaries, wages, taxes, etc., in the economy daily.
Brazil would not have been able to do that if they had applied the IASB´s IAS 29 Financial Reporting in Hyperinflationary Economies simply because IAS 29 does not provide for continuous daily updating of all non-monetary items during hyperinflation. IAS 29 was authorized in 1989. IAS 29 does not provide for continuous daily updating in terms of the US Dollar parallel rate or a Brazilian-style daily index rate. IAS 29 simply requires restatement of Historical Cost and Current Cost financial statements during hyperinflation applying the monthly Consumer Price Index at the end of the reporting period (monthly, quarterly, six monthly or annual) - generally available a month or two months after the current month - to make these financial statements more useful. It is not the intention of IAS 29 to, and in its current form it cannot, stop the continuous daily rapid erosion of the real value of constant real value non-monetary items as Brazil did for 30 years of high and hyperinflation generating positive economic growth.
This daily very rapid erosion of constant items is caused, not by hyperinflation, but, by the implementation of the stable measuring unit assumption (HCA) during hyperinflation. Applying the monthly CPI a month or two months after the current month is very ineffective during hyperinflation as far as the constant real value of salaries, wages, rentals, equity, trade debtors, trade creditors, positive economic growth, economic stability, the maintenance of internal demand and the continuous daily maintenance of the constant real value of these items are concerned. All non-monetary items (variable and constant items) have to be updated daily in terms of the parallel US Dollar rate or a Brazilian-style daily index rate in order to maintain the real economy relatively stable during hyperinflation in the monetary unit. That is financial capital maintenance in units of constant purchasing power during hyperinflation as originally authorized in IFRS in the Framework (1989), Par 104 (a).
The Framework (1989), Par. 104 (a) states:
Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power.
The original Framework (1989), Par 104 (a) authorizes financial capital maintenance in units of constant purchasing power during low inflation and deflation (Constant Item Purchasing Power Accounting - CIPPA) under which only constant real value non-monetary items (not variable real value non-monetary items) are measured in units of constant purchasing power by applying the monthly change in the annual CPI during low inflation and deflation. It is also applicable during hyperinflation (Constant Purchasing Power Accounting - CPPA) where under all non-monetary items - constant and variable real value non-monetary items - are updated daily in terms of the US Dollar parallel rate or a Brazilian-style daily index rate. IFRS authorize financial capital maintenance in units of constant purchasing power at all levels of inflation and deflation.
The stable measuring unit assumption (HCA or financial capital maintenance in nominal monetary units, also originally authorized in IFRS in the Framework (1989), Par 104 a ) assumes, in principle, that there was, is and never ever will be inflation, deflation or hyperinflation as far as the valuation of constant real value non-monetary items never maintained constant are concerned. The stable measuring unit assumption (HCA) assumes, in principle, that money was forever in the past, is and will always in the future be perfectly stable under all levels of inflation, hyperinflation and deflation.
Various authoritative commentators in the accounting profession are requesting a fundamental revision of IAS 29.
Severe hyperinflation is defined as a period at the end of completely uncontrolled hyperinflation when exchangeability between the hyperinflationary monetary unit and most relatively stable foreign currencies does not exist. However, at least one exchangeability has to exist for prices to be established in the hyperinflationary monetary unit; i.e. for hyperinflation to exist. Severe hyperinflation is only possible when there is exchangeability with at least one relatively stable foreign currency in order for prices to continue to be set in the hyperinflationary monetary unit in terms of this final exchangeability. The one exchange rate that lasted till the end of hyperinflation in Zimbabwe was the Old Mutual Implied Rate (OMIR).
The ratio of the Old Mutual share price in Harare to that in London equals the Zimbabwe dollar/sterling exchange rate. p8 1
Severe hyperinflation stops the moment exchangeability between the currency and all foreign currencies does not exist.
Zimbabwe’s hyperinflation came to an abrupt halt. The trigger was an intervention by the Reserve Bank of Zimbabwe. On November 20, 2008, the Reserve Bank’s governor, Dr. Gideon Gono, stated that the entire economy was “being priced via the Old Mutual rate whose share price movements had no relationship with economic fundamentals, let alone actual corporate performance of Old Mutual itself” (Gono 2008: 7–8). In consequence, the Reserve Bank issued regulations that forced the Zimbabwe Stock Exchange to shut down. This event rapidly cascaded into a termination of all forms of non-cash foreign exchange trading and an accelerated death spiral for the Zimbabwe dollar. Within weeks the entire economy spontaneously “dollarized” and prices stabilized. p 9-10 2
There was severe hyperinflation in Zimbabwe while there was exchangeability (prices could still be set in the ZimDollar) with at least one relatively stable foreign currency – the British Pound in this case as it was made possible via the OMIR. When this last exchangeability stopped it was not possible to set prices in the ZimDollar anymore and severe hyperinflation stopped: no exchangeability means no hyperinflation. That was a monetary meltdown. The entire ZimDollar money supply had no value as from that moment. Monetary items expressed in the ZimDollar had no value as from that moment. All variable real value non-monetary items maintained their real values despite the monetary meltdown. The IASB authorized an addition to IAS 1 in 2011 to allow for the fair value valuation of all non-monetary items in the opening balance sheet of companies after severe hyperinflation and a monetary meltdown. Inflation and hyperinflation have no effect on the real value of non-monetary items.
No exchangeability with all relatively stable foreign currencies means no exchange rates which means no severe hyperinflation (no prices being set in the local currency) and vice versa: no exchange rate with any relatively stable foreign currency means no exchangeability which means no hyperinflation (no prices being set in the local currency).
No prices being set in the local currency means monetary meltdown: the total money supply and all money and other monetary items stated in the local currency have no value.
The real or non-monetary economy (houses, properties, buildings, infrastructure, inventories, finished goods, consumer goods, trademarks, goodwill, logos, copyright, trade debtors, trade creditors, royalties payable, royalties receivable, taxes payable, taxes receivable, all other non-monetary payables, all other non-monetary receivables, etc,) cannot be eroded by hyperinflation or a total monetary meltdown: inflation is always and everywhere a monetary phenomenon. Inflation and hyperinflation have no effect on the real value of non-monetary items.
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
Wednesday, 27 April 2011
Measurement during low inflation
Measurement during Low inflation
The real values of many constant real value non-monetary items, for example, that portion of shareholders´ equity never covered by sufficient revaluable fixed assets (revalued or not) under the HCA model, are not automatically maintained constant (as they should be) in the world´s low inflation economies as demonstrated during the recent financial crisis that necessitated huge amounts of additional capital for under-capitalized banks and companies. To the contrary: their constant real non-monetary values are unnecessarily, unknowingly and unintentionally being eroded at a rate equal to the annual rate of inflation by the implementation of the very erosive stable measuring unit assumption as it forms part of the traditional HCA model. HCA is based on the accounting fallacy that financial capital maintenance can be measured in nominal monetary units per se during inflation and deflation as originally authorized in IFRS in the Framework (1989), Par 104 (a) as well as approved in the FASB´s Statement of Financial Accounting Concepts No. 5, Recognition and Measurement in Financial Statements of Business Enterprises (1984).
Many people see financial reporting as simply providing historic economic information. It is not realized that it is a basic objective of accounting (financial reporting) to automatically maintain the constant purchasing power of capital constant in all entities that at least break even for an indefinite period of time by continuously measuring all constant real value non-monetary items in units of constant purchasing power during inflation and deflation.
The reasons for this are:
(1) The Three Popular Accounting Fallacies.
(a) The stable measuring unit assumption based on the fallacy that changes in the purchasing power of money are not sufficiently important to measure financial capital maintenance in units of constant purchasing power during low inflation and deflation.
(b) Financial capital maintenance in nominal monetary units per se during low inflation and deflation.
(c) The generally accepted belief that the erosion of companies´ profits and capital is caused by inflation fully supported in IFRS and by the FASB.
(2) It is not realized that it is the stable measuring unit assumption and not inflation that erodes the real value of constant real value non-monetary items never maintained constant when financial capital maintenance in nominal monetary units (the traditional HCA model) is implemented during low inflationary periods .
(3) It is not realized that continuous measurement of financial capital maintenance in units of constant purchasing power during low inflation (CIPPA) automatically remedies this erosion by the stable measuring unit assumption.
If the above were realized then the stable measuring unit assumption / financial capital maintenance in nominal monetary units, i.e. the HCA model, would have been stopped during low inflation, deflation and hyperinflation by now.
Although the principle of financial capital maintenance in units of constant purchasing power during inflation and deflation was authorized in IFRS in 1989, it has not been implemented generally because the eroding effect of the stable measuring unit assumption on the real value of constant items never maintained is not recognized as such. It is generally believed that it is inflation doing the eroding in, for example, companies´ invested capital and profits when this erosion in constant item real value is actually caused by the stable measuring unit assumption. Inflation has no effect on the real value of non-monetary items. Capital and profits are non-monetary items.
The real values of many constant real value non-monetary items, for example, that portion of shareholders´ equity never covered by sufficient revaluable fixed assets (revalued or not) under the HCA model, are not automatically maintained constant (as they should be) in the world´s low inflation economies as demonstrated during the recent financial crisis that necessitated huge amounts of additional capital for under-capitalized banks and companies. To the contrary: their constant real non-monetary values are unnecessarily, unknowingly and unintentionally being eroded at a rate equal to the annual rate of inflation by the implementation of the very erosive stable measuring unit assumption as it forms part of the traditional HCA model. HCA is based on the accounting fallacy that financial capital maintenance can be measured in nominal monetary units per se during inflation and deflation as originally authorized in IFRS in the Framework (1989), Par 104 (a) as well as approved in the FASB´s Statement of Financial Accounting Concepts No. 5, Recognition and Measurement in Financial Statements of Business Enterprises (1984).
Many people see financial reporting as simply providing historic economic information. It is not realized that it is a basic objective of accounting (financial reporting) to automatically maintain the constant purchasing power of capital constant in all entities that at least break even for an indefinite period of time by continuously measuring all constant real value non-monetary items in units of constant purchasing power during inflation and deflation.
The reasons for this are:
(1) The Three Popular Accounting Fallacies.
(a) The stable measuring unit assumption based on the fallacy that changes in the purchasing power of money are not sufficiently important to measure financial capital maintenance in units of constant purchasing power during low inflation and deflation.
(b) Financial capital maintenance in nominal monetary units per se during low inflation and deflation.
(c) The generally accepted belief that the erosion of companies´ profits and capital is caused by inflation fully supported in IFRS and by the FASB.
(2) It is not realized that it is the stable measuring unit assumption and not inflation that erodes the real value of constant real value non-monetary items never maintained constant when financial capital maintenance in nominal monetary units (the traditional HCA model) is implemented during low inflationary periods .
(3) It is not realized that continuous measurement of financial capital maintenance in units of constant purchasing power during low inflation (CIPPA) automatically remedies this erosion by the stable measuring unit assumption.
If the above were realized then the stable measuring unit assumption / financial capital maintenance in nominal monetary units, i.e. the HCA model, would have been stopped during low inflation, deflation and hyperinflation by now.
Although the principle of financial capital maintenance in units of constant purchasing power during inflation and deflation was authorized in IFRS in 1989, it has not been implemented generally because the eroding effect of the stable measuring unit assumption on the real value of constant items never maintained is not recognized as such. It is generally believed that it is inflation doing the eroding in, for example, companies´ invested capital and profits when this erosion in constant item real value is actually caused by the stable measuring unit assumption. Inflation has no effect on the real value of non-monetary items. Capital and profits are non-monetary items.
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
Real estate and a mortgage are not one and the same thing
Real estate is a variable real value non-monetary item. Inflation has no effect on the real value of non-monetary items, never had in the past and never will in the future. The same is true for deflation and hyperinflation. As Milton Friedman so correctly stated: inflation is always and everywhere a monetary phenomenon. That is also true for deflation and hyperinflation.
A buyer normally negotiates a mortgage with a bank or other credit institution. The mortgage is not the same as the real estate. The real estate is one thing: a variable real value non-monetary item. The mortgage is a completely different thing/item: another item/thing. It is a monetary item, not a non-monetary item. It is not the same as the real estate. You can live in a house. You cannot live in a mortgage. A mortgage is normally a contract written on paper. Real estate is normally a house or an apartment or other physical property. The contract is also written on physical paper. That does not make the real estate and the mortgage the same thing.
Only the capital amount of a mortgage is a monetary item. The real value of the capital amount of a mortgage is eroded by inflation and hyperinflation and increased by deflation.
The interest paid and received on a mortgage are constant real value non-monetary items once accounted in the income statement.
Interest paid and received on a mortgage are generally immediately claimed or paid by banks - claimed from or paid into bank accounts which are monetary items. The entries in the bank accounts are part of the monetary item balances of the bank accounts.
A bank balance is one thing/item: a monetary item. Interest is another thing/item: a constant real value non-monetary item once payable or receivable or accounted in the income statement.
The money in the bank accounts is the monetary medium of exchange by which the constant real value non-monetary items interest paid and interest received are mutually agreed to be settled.
The interest paid and interest received entries in the bank accounts are simply the descriptions of what the money paid or received relates to, the same as the entries for deposits and withdrawals or bank charges, for example.
Interest payable or receivable (not yet paid or received) are constant real value non-monetary items and have to measured in units of constant purchasing power, i.e. updated over time under the constant item purchasing power paradigm, i.e. financial capital maintenance in units of constant purchasing power as authorized in IFRS.
Under the Historical Cost paradigm, i.e. financial capital maintenance in units of nominal monetary units - also authorized in IFRS in the same statement that authorized financial capital maintenance in units of constant purchasing power, interest paid, received, payable and receivable are all treated as if they are monetary items.
Real estate is a non-monetary item and a mortgage is a monetary item under both paradigms authorized in IFRS.
Inflation only affects the real value of the capital amount of the mortgage. Inflation has no effect, never had in the past and will never in the future have an effect on the real value of the real estate.
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
A buyer normally negotiates a mortgage with a bank or other credit institution. The mortgage is not the same as the real estate. The real estate is one thing: a variable real value non-monetary item. The mortgage is a completely different thing/item: another item/thing. It is a monetary item, not a non-monetary item. It is not the same as the real estate. You can live in a house. You cannot live in a mortgage. A mortgage is normally a contract written on paper. Real estate is normally a house or an apartment or other physical property. The contract is also written on physical paper. That does not make the real estate and the mortgage the same thing.
Only the capital amount of a mortgage is a monetary item. The real value of the capital amount of a mortgage is eroded by inflation and hyperinflation and increased by deflation.
The interest paid and received on a mortgage are constant real value non-monetary items once accounted in the income statement.
Interest paid and received on a mortgage are generally immediately claimed or paid by banks - claimed from or paid into bank accounts which are monetary items. The entries in the bank accounts are part of the monetary item balances of the bank accounts.
A bank balance is one thing/item: a monetary item. Interest is another thing/item: a constant real value non-monetary item once payable or receivable or accounted in the income statement.
The money in the bank accounts is the monetary medium of exchange by which the constant real value non-monetary items interest paid and interest received are mutually agreed to be settled.
The interest paid and interest received entries in the bank accounts are simply the descriptions of what the money paid or received relates to, the same as the entries for deposits and withdrawals or bank charges, for example.
Interest payable or receivable (not yet paid or received) are constant real value non-monetary items and have to measured in units of constant purchasing power, i.e. updated over time under the constant item purchasing power paradigm, i.e. financial capital maintenance in units of constant purchasing power as authorized in IFRS.
Under the Historical Cost paradigm, i.e. financial capital maintenance in units of nominal monetary units - also authorized in IFRS in the same statement that authorized financial capital maintenance in units of constant purchasing power, interest paid, received, payable and receivable are all treated as if they are monetary items.
Real estate is a non-monetary item and a mortgage is a monetary item under both paradigms authorized in IFRS.
Inflation only affects the real value of the capital amount of the mortgage. Inflation has no effect, never had in the past and will never in the future have an effect on the real value of the real estate.
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
Historical Cost Accounting should be banned during hyperinflation
Historical Cost Accounting should be banned during hyperinflation
Valuation in units of constant purchasing power is required for all non-monetary items (variable and constant real value non-monetary items) in IFRS during hyperinflation as per the Constant Purchasing Power Accounting (CPPA) inflation accounting model defined in IAS 29 Financial Reporting in Hyperinflationary Economies. The only way a hyperinflationary country can maintain its non-monetary or real economy relatively stable (at a rate of real value erosion by the stable measuring unit assumption in constant real value non-monetary items never maintained constant limited to a rate equal to the annual rate of inflation of the hard currency used for determining the parallel rate – normally the US Dollar) during hyperinflation is by continuously measuring all non-monetary items (variable and constant real value non-monetary items) in units of constant purchasing power. However, not by restating HC and Current Cost financial statements at the end of the reporting period in terms of the period-end CPI to make them more useful as required by IAS 29, but, by applying the daily parallel US Dollar exchange rate, or - as was done in Brazil during the 30 years from 1964 to 1994 - with daily indexation which is, in principle, the better than measurement in units of constant purchasing power by applying the daily US Dollar parallel rate since Brazilian-style indexation, theoretically, keeps the constant item economy perfectly stable: the erosion of the real value of constant items never maintained caused by the stable measuring unit assumption as applied to the US Dollar is eliminated in the formulation of the index value.
The implementation of IAS 29 Financial Reporting in Hyperinflationary Economies by Zimbabwean listed companies as required by the Zimbabwean Stock Exchange made no difference to the Zimbabwean economy during the final stages of the hyperinflationary erosion of the real value of the monetary unit in Zimbabwe, i.e. the Zimbabwe Dollar. The IASB has agreed that it was not possible to implement IAS 29 during severe hyperinflation at the end of the hyperinflationary period in Zimbabwe since there was no CPI available. The daily Old Mutual Implied Rate (OMIR) was, however, available till 20th November, 2008, the day Gideon Gono, the governor of the Reserve Bank of Zimbabwe issued regulations that closed down the Zimbabwe Stock Exchange and effectively led to the end of the Zimbabwe Dollar.
Severe hyperinflation is only possible when there is exchangeability with at least one relatively stable foreign currency. The one exchange rate that lasted till the end of hyperinflation in Zimbabwe was the Old Mutual Implied Rate (OMIR).
“The ratio of the Old Mutual share price in Harare to that in London equals the
Zimbabwe dollar/sterling exchange rate." P 8 ¹
Severe hyperinflation stops the moment exchangeability between the currency and all foreign currencies does not exist.
“Zimbabwe’s hyperinflation came to an abrupt halt. The trigger was an intervention by the Reserve Bank of Zimbabwe. On November 20, 2008, the Reserve Bank’s governor, Dr. Gideon Gono, stated that the entire economy was “being priced via the Old Mutual rate whose share price movements had no relationship with economic fundamentals, let alone actual corporate performance of Old Mutual itself” (Gono 2008: 7–8). In consequence, the Reserve Bank issued regulations that forced the Zimbabwe Stock Exchange to shut down. This event rapidly cascaded into a termination of all forms of non-cash foreign exchange trading and an accelerated death spiral for the Zimbabwe dollar. Within weeks the entire economy spontaneously “dollarized” and prices stabilized.” P 9-10 ²
¹,² Hanke, S. H. and Kwok, A. K. F., On the Measurement of Zimbabwe’s Hyperinflation,
Cato Journal, Vol. 29, No. 2 (Spring/Summer 2009), pp. 353-64 Available at
There was severe hyperinflation in Zimbabwe while there was exchangeability with at least one relatively stable foreign currency – the British Pound in this case as made possible via the OMIR. When this last exchangeability stopped it was not possible to set prices in the ZimDollar any more and hyperinflation stopped: no exchangeability means no hyperinflation.
Valuing all non-monetary items as required by the IAS 29 CPPA inflation accounting model in terms of the period-end Consumer Price Index which was published a month or more after the month to which it related when the real value of the Zimbabwe Dollar halved every day, obviously, had no effect at all.
“The Zimbabwe government last published an official Zimbabwe Zimbabwe
The stable measuring unit assumption as it forms part of the Historical Cost Accounting model - as accepted by the IASB and PricewaterhouseCoopers (amongst others) as an appropriate accounting model to be restated during hyperinflation - unnecessarily, unknowingly and unintentionally eroded Zimbabwe´s real economy by implementing HCA during the financial year, as required by the IASB in IAS 29, and then restated their year-end HC financial statements of their very much hyper-eroded companies in terms of the year-end CPI (while the CPI was made available in Zimbabwe) to make them more useful for comparison purposes. That did not stop them from unknowingly eroding their real or non-monetary economy with HCA - as supported by the IASB and PricewaterhouseCoopers - during the course of the financial year during hyperinflation.
PricewaterhouseCoopers state the following regarding the use of the HCA model during hyperinflation:
"Inflation-adjusted financial statements are an extension to, not a departure from, historic cost accounting."
Financial Reporting in Hyperinflationary Economies – Understanding IAS 29, PricewaterhouseCoopers, May 2006, p 5.
IAS 29 states: The financial statements of an entity whose functional currency is the currency of a hyperinflationary economy, whether they are based on a historical cost approach or a current cost approach shall be stated in terms of the measuring unit current at the end of the reporting period. IAS 29, Par 8.
How anyone can use or recommend the use of the HCA model during hyperinflation is completely incomprehensible. The use of the HCA model during hyperinflation should specifically be banned by law.
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
Tuesday, 26 April 2011
Valuing the three basic economic items - Part 2
Valuing the three basic economic items - Part 2
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
Monetary items
(1) Accountants value and account monetary items at their original historical cost nominal values in nominal monetary units during the current accounting period under all accounting models and under all economic models: during low inflation, hyperinflation and deflation. Low inflation, deflation and hyperinflation determine the always current real value of the monetary unit (US Dollar, Euro, British Pound, Bolívar, Yen, Yuan, etc.) and other monetary items within a monetary economy or monetary union like the European Monetary Union. This is the result of the fact that the real value of money and other monetary items cannot be updated or inflation-adjusted or valued in units of constant purchasing power during the current accounting period because of the monetary nature of money. The real value of the monetary unit and other monetary items in the monetary economy changes equally (all monetary units are affected evenly) normally on a monthly basis during low inflation and deflation. The change is confirmed or quantified with the monthly publication of the new CPI value. Currently, the applicable CPI value can become available up to a month and a half after the date of a transaction in many low inflationary economies. The daily black market or parallel US Dollar exchange rate or street rate is generally constantly (24/7, 365 days a year) available in a hyperinflationary economy. The CPI is the internal exchange rate between the real value of a unit of the monetary unit and real value in an economy. The daily parallel US Dollar (or other hard currency) exchange rate or a Brazilian-style daily index rate fulfils this role in a hyperinflationary economy.
Variable items
(2) Variable real value non-monetary items in a national economy are valued and accounted in terms of IFRS or GAAP at, for example, fair value, market value, net realizable value, recoverable value, present value, etc. These prices change all the time: even minute by minute in many markets.
Constant real value non-monetary items
(3) The real values of constant real value non-monetary items in the constant real value non-monetary item economy have to be continuously maintained constant under Constant Item Purchasing Power Accounting during low inflation and deflation by means of continuous financial capital maintenance in units of constant purchasing power, i.e. valuing / measuring them in units of constant purchasing power monthly during low inflation and deflation by means of the CPI as originally authorized in IFRS in the Framework (1989), Par 104 (a). Annual measurement in units of constant purchasing power is only currently being done under the Historical Cost Accounting model, generally in the case of certain (not all) income statement items, e.g., salaries, wages, rentals, etc. in non-hyperinflationary economies.
Harvey Kapnick was correct when he stated in the Saxe Lecture in 1976: “In the long run both value accounting and price-level accounting should prevail.”
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
Valuing the three basic economic items
Valuing the three basic economic items
Accountants have to take all three scenarios - occurring simultaneously - into account over time when they account economic activity and prepare and present financial reports.
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
Financial reporting does not simply report on what took place
Financial reporting does not simply report on what took place
There is no substance in the statement that financial reporting simply reports on what took place. It can be correctly stated that the above statement has no substance when we refer to the IFRS-approved basic accounting option of continuous financial capital maintenance in units of constant purchasing power which requires the valuing of only constant real value non-monetary items in units of constant purchasing power during low inflation and deflation as orginally authorized 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.”
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
There is no substance in the statement that financial reporting simply reports on what took place. It can be correctly stated that the above statement has no substance when we refer to the IFRS-approved basic accounting option of continuous financial capital maintenance in units of constant purchasing power which requires the valuing of only constant real value non-monetary items in units of constant purchasing power during low inflation and deflation as orginally authorized 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.”
The first option in Par 104 , namely, financial capital maintenance in nominal monetary units during inflation and deflation is a fallacy: it is impossible to maintain the real value of capital constant in nominal monetary units per se during inflation and deflation. Continuous financial capital maintenance in units of constant purchasing power during low inflation and deflation is generally applicable in the economy as a result of the absence of specific IFRS as per IAS 8, Par 11. However, that is not the same as comprehensive CPI-based adjustment of accounts themselves as accountants and accounting authorities automatically assume when financial capital maintenance in units of constant purchasing power during low inflation and deflation is suggested. Only constant real value non-monetary items (not variable real value non-monetary items) are continuously valued in units of constant purchasing power by continuously applying the CPI on a monthly basis during low inflation and deflation to implement a constant purchasing power capital concept of invested constant purchasing power and a constant purchasing power financial capital maintenance concept with measurement in units of constant purchasing power which includes a constant purchasing power profit or loss determination concept with the continuous valuation of only constant real value non-monetary items in units of constant purchasing power during low inflation and deflation.
The real values of banks´ and companies´ existing constant real value non-monetary items never maintained constant, e.g. retained profits, are unnecessarily, unknowingly and unintentionally being eroded at a rate equal to the annual rate of inflation when companies´ boards of directors choose to apply the stable measuring unit assumption as it forms part of the traditional HCA model during low inflation.
It is a fact that continuous financial capital maintenance in units of constant purchasing power (CIPPA) as originally authorized in IFRS in the Framework (1989), Par 104 (a), i.e. measurement of only constant real value non-monetary items (not variable items) in the economy in units of constant purchasing power during low inflation automatically remedies this unknowing, unintentional and unnecessary erosion by the application of the stable measuring unit assumption as it forms part of the HCA model in companies that at least break even whether they own revaluable fixed assets or not and without the requirement of extra capital from capital providers in the form of extra money or extra retained profits simply to maintain the existing constant real value of quity constant.
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
Monday, 25 April 2011
Accountants value everything they account
Accountants value everything they account
The debate concerning whether value accounting or price-level accounting should prevail is not on point, because in the long run both should prevail.
Harvey Kapnick, Chairman, Arthur Andersen & Company, “Value Based Accounting – Evolution or Revolution”, Sax Lecture, 1976.
Accounting is a measurement instrument.
Economic items have economic value. Accountants deal with economic items all the time. They deal with economic values when they account economic items and prepare financial reports. Accountants value economic items when they account economic transactions and events. Financial reporting does not simply report on what took place in the past. Accountants are not just scorekeepers of what happened in the past. Accountants value everything they account in the economy.
The three fundamentally different basic economic items in the economy, namely variable real value non-monetary items, monetary items and constant real value non-monetary items, have economic values expressed in terms of money; i.e. the monetary unit. Accountants account economic transactions and events involving these three basic economic items in an organized manner when they implement the double entry accounting model: journal entries, general ledger accounts, trial balances, cash flow statements, income and expenses in the income statement, assets and liabilities in the balance sheet plus other financial, management and costing reports.
Accountants value economic items when they account economic activity in the accounting records and prepare financial reports of economic entities based on the double entry accounting model. Accounting entries are valuations of the economic items (the debit items and the credit items) being accounted.
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
The debate concerning whether value accounting or price-level accounting should prevail is not on point, because in the long run both should prevail.
David Mosso, Comment letter, Proposal for a Principles-based Approach to US Standard Setting, 2002, p1.
Many accountants still think that accounting is simply a recording exercise during which they merely record past economic activity. That is not correct. Accountants value economic items when they account them. Financial reporting / accounting – under CIPPA – is, firstly, the automatic maintenance of the constant purchasing power of capital in all entities that at least break even for an indefinite period of time and, secondly, the provision of continuously updated decision-useful financial information about the reporting entity to capital providers and other users.
It includes the valuing, recording, classifying, summarizing and reporting of an entity’s economic activity.
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
Objectives of general purpose financial reporting / accounting
The objectives of general purpose financial reporting / accounting are:
An entity has continuously maintained the constant real non-monetary value of equity (equal to net assets) if it has as much equity - expressed in units of constant purchasing power - at the end of the reporting period as it had at the beginning of the period, after excluding any distributions to, and contributions from, owners during the period. Consequently: a profit is earned only if the constant purchasing power of equity at the end of the period exceeds the constant purchasing power of equity at the beginning of the period, after excluding any distributions to, and contributions from, owners during the period.
Variable items are continuously valued in terms of IFRS excluding the stable measuring unit assumption during low inflation and deflation under CIPPA. Variable items are continuously valued in units of constant purchasing power (CPPA) by applying the daily parallel US Dollar (or other hard currency) exchange rate or a Brazilian-style daily index rate when it is intended to keep the real economy stable during hyperinflation.
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
1) Automatic maintenance of the constant purchasing power of capital in all entities that at least break even - ceteris paribus.¹ ² ³
2) Provision of continuously updated decision-useful financial information about the reporting entity to capital providers and other users.
An entity has continuously maintained the constant real non-monetary value of equity (equal to net assets) if it has as much equity - expressed in units of constant purchasing power - at the end of the reporting period as it had at the beginning of the period, after excluding any distributions to, and contributions from, owners during the period. Consequently: a profit is earned only if the constant purchasing power of equity at the end of the period exceeds the constant purchasing power of equity at the beginning of the period, after excluding any distributions to, and contributions from, owners during the period.
The German economist Werner Sombart (1863-1941) wrote in "Medieval and Modern Commercial Enterprise" that "The very concept of capital is derived from this way of looking at things; one can say that capital, as a category, did not exist before double-entry bookkeeping. Capital can be defined as that amount of wealth which is used in making profits and which enters into the accounts." ^
^ Lane, Frederic C; Riemersma, Jelle, eds (1953). Enterprise and Secular Change: Readings in Economic History. R. D. Irwin. p. 38. (quoted in "Accounting and rationality)."
The objectives of general purpose financial reporting are supposed to answer the question: what is financial reporting, i.e. accounting, supposed to do? The only accounting model possible to be used by entities implementing a capital concept is double-entry accounting: without double-entry accounting the concept of capital as an legal economic item separate from its owner or owners is not possible: for every debit/asset (e.g. cash) there is an equivalent credit/liability (e.g. capital) in double-entry accounting. The existing constant real non-monetary value of this existing capital has to be automatically maintained constant in all entities that at least break even during inflation and deflation for an indefinite period of time. This is only possible with financial capital maintenance in units of constant purchasing power.
Every concept of capital logically gives rise to its respective capital maintenance concept.
The IASB´s Conceptual Framework for Financial Reporting (2010)
The following paragraphs remain the same as originally stated in the Framework (1989).
Concepts of Capital Maintenance and the Determination of Profit
Par. 4.59. The concepts of capital in paragraph 4.57 give rise to the following concepts of capital maintenance:
(a) Financial capital maintenance. Under this concept a profit is earned only if the financial (or money) amount of the net assets at the end of the period exceeds the financial (or money) amount of net assets at the beginning of the period, after excluding any distributions to, and contributions from, owners during the period. Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power.
(b) Physical capital maintenance. Under this concept a profit is earned only if the physical productive capacity (or operating capability) of the entity (or the resources or funds needed to achieve that capacity) at the end of the period exceeds the physical productive capacity at the beginning of the period, after excluding any distributions to, and contributions from, owners during the period. *
*The Conceptual Framework (2010), Par 4.59.
The concepts of capital in the Conceptual Framework (2010), paragraph 4.57 give rise to the following three concepts of capital during low inflation and deflation:
(A) Physical capital. See Par 4.57 & 4.58
(B) Nominal financial capital. See Par 4.59 (a).
(C) Constant purchasing power financial capital. See Par 4.59 (a).
The concepts of capital in Par 4.57 give rise to the following three concepts of capital maintenance during inflation and deflation:
(1) Physical capital maintenance: optional during low inflation and deflation. Current Cost Accounting model prescribed by IFRS. See Par 4.61.
(2) Financial capital maintenance in nominal monetary units (Historical Cost Accounting): authorized in IFRS but not prescribed—optional during low inflation and deflation. See Par 4.59 (a). Financial capital maintenance in nominal monetary units per se during inflation and deflation is a fallacy: it is impossible to maintain the constant real non-monetary value of financial capital constant with measurement in nominal monetary units per se during inflation and deflation.
(3) Financial capital maintenance in units of constant purchasing power (Constant Item Purchasing Power Accounting – CIPPA – during low inflation and deflation): authorized in IFRS but not prescribed—optional during low inflation and deflation. See Par 4.59 (a). Financial capital maintenance in units of constant purchasing power is, however, prescribed in IAS 29 during hyperinflation: i.e. Constant Purchasing Power Accounting (CPPA) which is mostly unsuccessfully attempted via the restatement of Historical Cost of Current Cost financial statements during hyperinflation.
Only financial capital maintenance in units of constant purchasing power can automatically maintain the existing constant real non-monetary value of financial capital constant during low inflation, deflation and hyperinflation in all entities that at least break even—ceteris paribus—for an indefinite period of time. This would happen whether these entities own revaluable fixed assets or not and without the requirement of more capital in the form of more money or additional retained profits simply to maintain the real value of shareholders´ equity constant.
Financial capital maintenance in nominal monetary units (HCA) per se during inflation and deflation is impossible. It is a very popular accounting fallacy. It was originally authorized by the IASB in IFRS in the Framework (1989), Par 104 (a). It is based on the 3000 years old stable measuring unit assumption under which it is assumed that money is, in principle, stable in real vale. It is a Generally Accepted Accounting Practice. It is the concept of capital maintenance and one of the measurement bases used in traditional Historical Cost Accounting generally implemented worldwide. It still is an accounting fallacy that costs the world economy hundreds of billions of US Dollars per annum in existing constant real non-monetary value unknowingly, unnecessarily and unintentionally eroded by the implementation of the very erosive stable measuring unit assumption.
Financial capital maintenance in nominal monetary units during low inflation is only possible in entities that continuously invest at least 100% of the updated original real value of all contributions to equity in revaluable fixed assets with an updated equivalent fair value (revalued or not) .
Only CIPPA automatically maintains the real value of all constant real value non-monetary items constant in all entities that at least break even, including banks´ and companies´ capital base, for an unlimited period of time (forever) - all else being equal - whether these entities own revaluable fixed assets or not and without the requirement of additional capital from capital providers in the form of extra money or extra retained profits simply to maintain the real value of equity. This is opposed to the traditional HCA model under which the stable measuring unit assumption unknowingly, unnecessarily and unintentionally erodes the real value of that portion of shareholders´ equity never maintained constant as a result of insufficient revaluable fixed assets (revalued or not) during low inflation.
Continuous financial capital maintenance in units of constant purchasing power (CIPPA) automatically maintains the constant purchasing power of all constant items constant for an indefinite period of time in all entities that at least break even by continuously applying the monthly change in the annual CPI to the valuation of only constant items during low inflation and deflation. The daily parallel US Dollar (or other hard currency) exchange rate is continuously applied in the valuation of all non-monetary items (variable and constant items) during hyperinflation (CPPA) which only results in automatically maintaining the real or non-monetary economy relatively – not absolutely – stable. The constant item economy in a hyperinflationary economy is still subject to real value erosion at a rate equal to the annual inflation rate applicable to the hard currency (normally the US Dollar) used in supplying the parallel rate. The real economy would theoretically be completely stable during hyperinflation when a Brazilian-style daily index (which allows for the elimination of the stable measuring unit assumption in the parallel hard currency rate too) is used in the valuing of all non-monetary items (variable and constant items) during hyperinflation.
Variable items are continuously valued in terms of IFRS excluding the stable measuring unit assumption during low inflation and deflation under CIPPA. Variable items are continuously valued in units of constant purchasing power (CPPA) by applying the daily parallel US Dollar (or other hard currency) exchange rate or a Brazilian-style daily index rate when it is intended to keep the real economy stable during hyperinflation.
Monetary items are money held and items with an underlying monetary nature valued in nominal monetary units during the current reporting period. The net monetary loss or gain from holding monetary items is calculated and accounted in the income statement under both CIPPA and CPPA, i.e. during low inflation, deflation and hyperinflation in terms of IFRS.
¹ “It is the overall objective of reporting for price changes to ensure the maintenance of the business as an entity.”
Accounting for Price Changes: An Analysis of Current Developments in Germany, Adolf G Coenenberg and Klaus Macharzina, Journal of Business Finance & Accounting, 3.1 (1976), P 53.
² Framework (1989), Par 104 (a): "Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power.”
³ It is essential to the credibility of financial reporting to recognize that the recovery of the real cost of investment is not earnings — that there can be no earnings unless and until the purchasing power of capital is maintained.
FAS 33 (1979), p 24
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
Sunday, 24 April 2011
Brazilian indexation compared to accounting dollarization
Brazil indexed all non-monetary items (variable and constant items) during the 30 years from 1964 to 1994 by means of a daily non-monetary index supplied by the various governments over that period for everybody in the economy to use daily. Although the Brazilian indexes used during those 30 years were almost entirely based on the daily US Dollar exchange rate with the Brazilian currency, it was not a parallel rate used parallel to another “official” US Dollar exchange rate arbitrarily set by the government as happens in most cases where a parallel market for the US Dollar develops in hyperinflationary economies. However, the daily index supplied by the government was not the actual daily US Dollar exchange rate. Thus, although the Brazilian indexation was financial capital maintenance in units of constant purchasing power during those 30 years, and very similar to accounting dollarization, it was not exactly the same. It was better than accounting dollarization.
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
Brazilian indexation theoretically maintained the constant real value non-monetary item economy perfectly stable whereas there is still real value erosion in the constant real value non-monetary item economy as a result of the stable measuring unit assumption at a rate equal to the inflation rate in the US Dollar when accounting dollarization is employed. Brazilian-style indexation is thus better than accounting dollarization since real value erosion because of the use of the stable measuring unit assumption is completely eliminated with financial capital maintenance in units of constant purchasing power in terms of the daily index rate.
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
Accounting dollarization
Accounting dollarization is not the same as normal dollarization of an economy. An economy is dollarized when the national monetary unit is physically substituted with a relative stable foreign currency, normally the US Dollar. That is how the phrase “dollarization” originated. The national currency is not used anymore. There is no national currency in use in the economy. Its legal tender is legally terminated. Dollarization is generally adopted after a period of severe hyperinflation, e.g. in Zimbabwe in 2008.
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
Accounting dollarization as opposed to functional currency dollarization is doing all your daily business operations and accounting in US Dollars or in a any other relatively stable foreign currency during hyperinflation in your national monetary unit in an economy that does not use the US Dollar as a functional currency. It most probably never means that you do all your actual business transaction in US Dollars. You normally do some business in US Dollars and some in the local hyperinflationary currency. You may even do no business in actual US Dollars.
You simply note down the daily – normally unofficial - parallel US Dollar rate and use it in all your daily accounting and business operations. The existence of a parallel rate is essential for the application of accounting dollarization. When there is only one official US Dollar rate and no parallel rate the economy will normally not be in hyperinflation and accounting dollarization will not be required. Sometimes the US Dollar parallel rate changes more than the normal once per day. It can change every 8 hours, for example, during severe hyperinflation.
Accounting dollarization is the same as Constant Purchasing Power Accounting as defined in IAS 29 which requires financial capital maintenance in units of constant purchasing power during hyperinflation under which all non-monetary items (variable and constant items) are measured in units of constant purchasing power, but, not applying the period-end CPI, as required in IAS 29, but the daily US Dollar parallel rate.
I implemented it for the first time in Auto-Sueco (Angola), the Volvo agents in Angola, starting in January, 1996. Auto-Sueco (Angola) is the subsidiary of Auto-Sueco in Portugal.
Accounting dollarization is also not the same as the US GAAP requirement that US companies with subsidiaries in hyperinflationary economies simply translate the year-end HCA financial statements prepared in the hyperinflationary local currency into US Dollars at the year-end rate before consolidation into the controlling US company´s consolidated accounts. Accounting dollarization is running any local business in a hyperinflationary economy in US Dollars on a daily basis applying the daily parallel rate in all accounting and business operations. This eliminates the hyper-eroding effect of the stable measuring unit assumption only as far as the local hyperinflationary currency is concerned as implemented under HCA on the existing real value of all non-monetary items (variable and constant real value non-monetary items) in a hyperinflationary economy.
Accounting dollarization is a price-level accounting model applying financial capital maintenance in units of constant purchasing power as originally authorized in IFRS in the Framework (1989), Par 104 (a).
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
Saturday, 23 April 2011
Capital is a variable or monetary item in the economy
Capital is a constant real value non-monetary item.
However, there is currently no constant real value capital in the world economy under HCA during low inflation and deflation. The portion of the original real value of all contributions to Shareholders´ Equity in companies covered by revaluable fixed assets is, in fact, treated as a variable real value non-monetary item under HCA during low inflation. This existing constant real non-monetary value is not maintained constant under the HCA model during low inflation and deflation. Its real value depends on the variable real non-monetary value of the fixed assets determined at fair value from time to time in terms of IFRS and US GAAP during low inflation since equity is equal to net assets under HCA with financial capital maintenance measured in nominal monetary units.
Capital will only – for the first time ever during low inflation and deflation - correctly be treated as a constant item and its existing constant value maintained constant in entities that at least break even for an unlimited period of time – ceteris paribus - when financial capital maintenance in units of constant purchasing power as authorized in IFRS in the Conceptual Framework (2010), Par 4.59 (a) is freely chosen by entities. There is no other way during low inflation and deflation.
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
However, there is currently no constant real value capital in the world economy under HCA during low inflation and deflation. The portion of the original real value of all contributions to Shareholders´ Equity in companies covered by revaluable fixed assets is, in fact, treated as a variable real value non-monetary item under HCA during low inflation. This existing constant real non-monetary value is not maintained constant under the HCA model during low inflation and deflation. Its real value depends on the variable real non-monetary value of the fixed assets determined at fair value from time to time in terms of IFRS and US GAAP during low inflation since equity is equal to net assets under HCA with financial capital maintenance measured in nominal monetary units.
The portion of the original real value of all contributions to Shareholders´ Equity not covered by revaluable fixed assets is unknowingly, unnecessarily and unintentionally being eroded by the stable measuring unit assumption (mistakenly believed to be inflation) at a rate equal to the annual rate of inflation as part of financial capital maintenance in nominal monetary units when the traditional HCA model is implemented during low inflation. This unknowing erosion by the stable measuring unit assumption amounts to about R200 billion in the SA constant real value non-monetary item economy and hundreds of billions of US Dollars in the world´s constant item economy each and every year.
When companies have no revaluable fixed assets at all under HCA, Capital is, in principle, treated the same as a monetary item (money or cash) and the stable measuring unit assumption erodes its real value at a rate equal to the annual rate of inflation in low inflationary economies.
Capital will only – for the first time ever during low inflation and deflation - correctly be treated as a constant item and its existing constant value maintained constant in entities that at least break even for an unlimited period of time – ceteris paribus - when financial capital maintenance in units of constant purchasing power as authorized in IFRS in the Conceptual Framework (2010), Par 4.59 (a) is freely chosen by entities. There is no other way during low inflation and deflation.
Financial capital maintenance in units of constant purchasing power during low inflation and deflation was originally authorized in the IASB´s Framework for the Preparation and Presentation of Financial Statements in 1989.
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
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