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Friday, 13 May 2011

Price–level accounting does not prevail for balance sheet constant items during low inflation

Price–level accounting does not prevail for balance sheet constant items during low inflation


Price–level accounting as Harvey Kapnick hoped for in 1976 clearly does not prevail for balance sheet constant real value non–monetary items (e.g. equity) and most income statement items during low inflation. Income statement items are all constant real value non–monetary items. Price–level accounting does prevail as far as the income statement constant real value non–monetary items salaries, wages, rentals, etc are concerned since they are updated annually in units of constant purchasing power in terms of the annual change in the Consumer Price Index, but, they are then paid monthly applying the stable measuring unit assumption; i.e. they are not updated monthly in terms of the CPI.

In terms of the Historical Cost Accounting model the stable measuring unit assumption is implemented under which balance sheet constant real value non–monetary items are valued at historical cost, i.e. in nominal monetary units thus eroding the existing constant real value of these constant real value non–monetary items when their existing constant real non–monetary values are never maintained as a result of insufficient revaluable fixed assets (revalued or not) under the HC paradigm during low inflation.

Price–level accounting generally did prevail in the Brazilian economy during the 30 years from 1964 to 1994 when Brazil indexed all non-monetary items (variable real value non–monetary items and constant real value non–monetary items) in their non–monetary or real economy with daily indexation with a daily index value supplied by the different governments during that period. Brazil stopped that with the full implementation of the traditional HCA model, financial capital maintenance in nominal monetary units and the stable measuring unit assumption when they changed the Unidade Real de Valor into their latest currency, the Real, in 1994. Brazil stopped daily indexation during hyperinflation which is, in principle, continuous financial capital maintenance in units of constant purchasing power during hyperinflation. They should have changed from daily indexation of all non-monetary items (variable and constant real value non-monetary items) during hyperinflation to financial capital maintenance in units of constant purchasing power (CIPPA) during low inflation where under only constant items (not variable items) are measured in units of constant purchasing power by applying the monthly CPI.

US Professor William Paton noted in 1922, "the value of the dollar — its general purchasing power — is subject to serious change over a period of years... Accountants... deal with an unstable, variable unit; and comparisons of unadjusted accounting statements prepared at intervals are accordingly always more or less unsatisfactory and are often positively misleading.”

As quoted in FAS 33 p. 29.
Shareholder’s equity forms part of an entity’s financial resources.

“Management commentary should set out the critical financial and non–financial resources available to the entity and how those resources are used in meeting management’s stated objectives for the entity.” IASB Exposure Draft: Management Commentary, June 2009, Par 29.

Shareholders´ equity is a financial resource with a constant real non–monetary value expressed in terms of an unstable monetary unit of measure under the HCA model. The IASB statement in the Framework (1989), Par 104 (a) that “financial capital maintenance can be measured in nominal monetary units” is clearly a fallacy since it is impossible to maintain the existing constant real non–monetary value of capital constant “in nominal monetary units” during inflation and deflation.

There is no substance in the claim that the existence and value of economic resources, for example shareholders´ equity items, exists independently of how we measure them – and that the choice of the measuring unit does not affect their fundamental value, only how we choose to represent that value – and that we can use any monetary unit, Dollars of constant purchasing power, US Dollars, whatever we think best represents that value and will make sense to whoever is using the information produced. See Paton above. There is no substance in the claim that it is fine to represent value in terms of constant purchasing power and to argue that that would be a better method than using historic cost and maintaining a fiction as to the stability of the measuring unit – but that doesn't affect the nature of the underlying resources. There is no substance in the claim that the choices made in accounting will not change that value and will not affect the economy. Measuring constant real value non-monetary items in units of constant purchasing power does affect the economy. That is generally known and a fact.

If it were generally realized that the implementation of the stable measuring unit assumption during low inflation results in the unknowing, unnecessary and unintentional erosion by the implementation of the Historical Cost Accounting model (the stable measuring unit assumption) of hundreds of billions of US Dollars of real value in constant real value non–monetary items (e.g. banks´ and companies´ equity) never maintained in the world´s constant real value non–monetary item economy year in year out, the HCA model would have been rejected by now.


Nicolaas Smith

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