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.
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