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Friday, 27 May 2011

The two different meanings of the word inflation

It is correct, essential and compliant with IFRS to update constant items by means of the monthly change in the CPI during low inflation and deflation. The reason for this is that constant items are expressed in terms of money, i.e. in terms of an unstable monetary unit of account which is the same as the unstable monetary medium of exchange within an economy or monetary union. Inflation erodes the real value of the unstable monetary medium of exchange – which is also the unstable monetary unit of account in accounting and the economy in general. Constant items thus have to be updated at a rate equal to the rate of low inflation or deflation, i.e. valued or measured in units of constant purchasing power, in order to maintain their real values constant during low inflation and deflation because the unit of measure in accounting is an unstable monetary unit of account and consequently hardly ever absolutely stable during periods of low inflation and deflation. Months of zero annual inflation are very few and far between. Sustainable zero annual inflation has never been achieved before and it does not seem very likely that it will be achieved any time soon in the future.


Variable real value non–monetary items do not need to be and are not valued in units of constant purchasing power during low inflation because they are valued in terms of IFRS or GAAP at, for example, fair value, market value, present value, recoverable value, net realizable value, etc which always automatically take inflation – amongst many other items – into account. Variable real value non–monetary items are only valued in units of constant purchasing power during hyperinflation as required in IFRS in IAS 29 since the IASB regards hyperinflation as an exceptional circumstance.

There is a school of thought that 2% inflation is completely unharmful and that it has no disadvantages compared to absolute price stability (sustainable zero inflation). That is not correct. 2% inflation will erode, for example, 51% of the real value of all monetary items and all constant real value non–monetary items never maintained constant, e.g. Retained Profits never maintained constant, over 35 years – all else being equal – when the stable measuring unit assumption is implemented for an indefinite period of time during indefinite low inflation.

It is not necessary to updated by means of the CPI, which is a general price index, variable real value non–monetary items (e.g. properties, plant, equipment, shares, raw material, etc.) which are subject to product specific price increases for the purpose of valuing these variable items during the accounting period on a primary valuation basis during non–hyperinflationary periods. These variable items are generally subject to market–based real value changes determined by supply and demand. They incorporate product specific price changes also stated as product specific inflation where the word inflation is, very unfortunately, also used to simply mean a product or product group price increase instead of the general use of the word in economics to mean the erosion of the real value of money and other monetary items over time, i.e. an erosion of the general purchasing power of money which is caused by/results in an increase in the general price level over time.

It is thus generally accepted in economics that the word inflation has two different meanings:

(1) inflation meaning the erosion of the real value of only money and other monetary items over time; i.e. an erosion of the general purchasing power of money which is caused by/results in an increase in the general price level over time, and

(2) inflation meaning any single or non-general price increase.

1970–style Constant Purchasing Power Accounting (CPPA) inflation accounting was a popular but failed attempt at inflation accounting at the time. It was a form of inflation accounting which tried unsuccessfully to make corporate accounts more informative when comparing current transactions with previous transactions by updating all non–monetary items (without distinguishing between variable real value non–monetary items and constant real value non–monetary items) equally by means of the Consumer Price Index during high in the 1970´s. 1970–style CPPA inflation accounting was abandoned as a failed and discredited inflation accounting model when general inflation decreased to low levels thereafter.

Constant Item Purchasing Power Accounting (CIPPA) is not an inflation accounting model to be used during high and hyperinflation. IAS 29 requires CPPA for that. CIPPA is the IASB´s alternative to Historical Cost Accounting during low inflation and deflation . CIPPA implements financial capital maintenance in units of constant purchasing power to be used during low inflation and deflation which was authorized in IFRS in the original Framework (1989), Par 104 (a).


Nicolaas Smith

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