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Wednesday, 20 April 2011

Constant Item Purchasing Power Accounting - Abstract - Part 5 of 5

The cost of the stable measuring unit assumption

It is clearly known and admitted that there is real value being eroded in non-monetary items, namely in companies´ profits and capital: “the erosion of business profits and capital caused by inflation” as it is so generally accepted. It is just not realized that the stable measuring unit assumption - not inflation - is doing the eroding during inflation.
Everybody knows the actual cost of inflation – the net monetary loss from holding a net monetary balance of monetary item assets during the accounting period – is not calculated and accounted under HCA during low inflation and deflation. It is thought that it is the central bank´s task to reduce inflation which reduces the cost of inflation and “the erosion of business profits and invested capital caused by inflation.

First of all, the erosion of business profits and invested capital is not caused by inflation but by the stable measuring unit assumption during low inflation. Yes, reducing inflation reduces the actual cost of inflation (the net monetary loss) and it also reduces the cost of the stable measuring unit assumption during inflation. However, sustained zero annual inflation - required to eliminate the cost of the stable measuring unit assumption completely in this manner - has never been achieved in the past in any economy using money and is not likely to be achieved any time soon in the future. So, central bankers will, most probably, never eliminate the cost of the stable measuring unit assumption completely in the world’s constant item economy, namely, the hundreds of billions of US Dollars being eroded unnecessarily by the stable measuring unit assumption during inflation.

On the other hand, continuous financial capital maintenance in units of constant purchasing power during low inflation and deflation (CIPPA) will automatically eliminate the entire cost of the stable measuring unit assumption forever at any level of inflation in all entities that at least break even and would prevent economic instability during deflation caused by the appreciation in the real value of constant items under HCA. Accountants would then knowingly maintain hundreds of billions of US Dollars per annum in the world’s real economy for an unlimited period of time during indefinite low inflation – all else being equal – in all entities that at least break even.

The cost of the stable measuring unit assumption is considered to be the same as the cost of inflation which is not calculated and accounted under HCA during low inflation. Everybody is consequently satisfied that a generally accepted accounting practice of not accounting the net monetary loss or gain from inflation during low inflation is correctly followed when “the erosion of business profits and invested capital caused by inflation” is referred to, which is in fact, not the cost of inflation, but, the cost of the very erosive stable measuring unit assumption. The erosion of the existing constant real value of companies´ profits and capital (the erosion of the existing constant real value of constant items never maintained constant under HCA) is not seen as separate from the erosion of the real value of money and other monetary items actually caused by inflation. The net monetary loss from holding a net balance of monetary item assets and the “erosion of business profits and invested capital caused by inflation” are seen as both being the same thing – both caused by inflation and not required to be calculated and accounted. That is a fundamental mistake.
Consequently, no-one looks for a solution in IFRS: the IFRS-authorized option in the Framework, Par 104 (a), namely, continuous financial capital maintenance in units of constant purchasing power during low inflation and deflation (CIPPA) has until now been ignored mainly because the split in non-monetary items in variable and constant items has only been identified in 2005.

Not only one, but, two enemies in the economy

The one very well known; the other a stealth enemy camouflaged by general acceptance in US GAAP and authorization in IFRS. The one – inflation - seen as an enemy in most instances; the other – the free choice of the stable measuring unit assumption - wreaking possibly even more damage in the real economy than inflation in the monetary economy. The stable measuring unit assumption is a very erosive stealth enemy perfectly camouflaged by US GAAP and IFRS authorization during low inflation and IFRS acceptance during hyperinflation as supported by Big Four accounting firms like PricewaterhouseCoopers which states: “Inflation adjusted financial statements are an extension to and not a departure from historic cost accounting.”  Understanding IAS 29
In most companies annual erosion would be at least equal to the weighted average annual value of Retained Earnings times the average annual inflation rate. This cost can be calculated to know its constant real value and the magnitude of real value eroded like this (or to be gained per annum in all entities at least breaking even for an unlimited period of time – all else being equal - from freely changing over to financial capital maintenance in units of constant purchasing power - CIPPA), but, it is never accounted as a loss in the Profit and Loss account at any time under the HCA model – similar to the non-accounting of the cost of inflation during low inflation. Because Retained Profits never maintained are, in principle, in this manner treated the same as monetary items under HCA during low inflation, this erosion of real value operates similar to – but it is not the same as - the cost of inflation in monetary items, but in Retained Profits and other constant items never maintained.  Most people mistakenly think it is also caused by inflation when it is in fact caused by the stable measuring unit assumption: stop the stable measuring unit assumption and there is no erosion of real value in constant items in all entities that at least break even.

In the case of companies with no revaluable fixed assets at all implementing HCA during low inflation this results in their total equity being valued in nominal monetary units thus being eroded by the stable measuring unit assumption over time at a rate equal to the annual rate of inflation.
Nicolaas Smith 

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