Pages

Wednesday, 1 June 2011

Automatic maintenance of the constant purchasing power of capital

Automatic maintenance of the constant purchasing power of capital

Automatic maintenance of the constant purchasing power of capital can only be achieved by continuously valuing all constant real value non–monetary items in units of constant purchasing power, i.e., by continuously updating all constant items by means of the monthly change in the annual CPI during low inflation and deflation. Valuing / measuring all non-monetary items - both variable real value non–monetary items and all constant items - at the daily parallel rate (usually the daily US Dollar parallel rate) in terms of IAS 29 (or Brazilian–style daily indexation) during hyperinflation results in the real or non-monetary economy being maintained relatively stable during hyperinflation (see Brazil from 1964 to 1994) with real value hyper–erosion in only monetary items.


Historical Cost Accounting has unknowingly, unintentionally and unnecessarily abdicated the essential automatic financial capital maintenance in units of constant purchasing power function of financial reporting to the fiction that money is stable in real value during low inflation and deflation. In so doing, the Historical Cost Accounting model has in the past unknowingly eroded and currently unknowingly, unintentionally and unnecessarily erodes real value on a significant scale (hundreds of billions of US Dollars per annum) in the world´s real economy when the very erosive stable measuring unit assumption is implemented as part of the IFRS–approved traditional HCA model for an unlimited period of time during indefinite inflation.

It is not realized that this unknowing, unintentional and unnecessary erosion can be permanently stopped by simply rejecting the stable measuring unit assumption when the IFRS–compliant Constant Item Purchasing Power Accounting model is implemented during low inflation and deflation.

IFRS do – since 1989 – allow the rejection of the stable measuring unit assumption as an alternative to HCA at all levels of inflation and deflation. The IASB´s original Framework (1989), Par 104 (a) [now the Conceptual Framework (2010), Par 4.59 (a)] states:

Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power.

Par 104 (a) was authorized by the IASB predecessor body, the International Accounting Standards Committee Board in April, 1989 and adopted by the IASB in 2001.

The stable measuring unit assumption is also rejected in IAS 29 Financial Reporting in Hyperinflationary Economies for restatement of Historical Cost or Current Cost financial statements at the period–end CPI to make them more useful during hyperinflation. Simple restatement of HC or CC financial statements in terms of the period-end CPI is not the same as daily measuring or valuing all non-monetary items in terms of a Brazilian-style non-monetary index or a daily hard currency parallel rate. Simple restatement of period-end HC financial statements in terms of IAS 29 had no effect during hyperinflation in Zimbabwe.

It is not generally realized that the very erosive stable measuring unit assumption is unknowingly, unintentionally and unnecessarily responsible for the erosion of the real value of constant real value non–monetary items never maintained constant when the traditional HCA model is implemented for an unlimited period of time during indefinite inflation. It is still generally believed that inflation instead of the stable measuring unit assumption is doing the eroding.

It is also not generally realized that this erosion can be permanently stopped by selecting financial capital maintenance in units of constant purchasing power as authorized in IFRS in the original Framework (1989), Par 104 (a) which is applicable in the absence of specific IFRS.

It is generally accepted and a fact that inflation erodes the real value of money and other monetary items over time. It is also generally accepted and a fact that hyperinflation can erode all the real value of a country’s entire monetary base as happened in Zimbabwe in 2008. That was the result of an extreme increase in the volume and nominal value of bank notes in the country by Gideon Gono, the governor of the Reserve Bank of Zimbabwe, which resulted in an equivalent extreme rate of erosion of the real value of the Zimbabwe Dollar since the nominal increase in the ZimDollar money supply was not an appropriate response to an increase in real value in the real or non–monetary economy of Zimbabwe.

“There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of erosion.”

The Economic Consequences of the Peace by John Maynard Keynes, 1919

http://socserv2.mcmaster.ca/~econ/ugcm/3ll3/keynes/peace

That certainly was true in the case of Zimbabwe.

It is generally accepted and a fact that inflation erodes the real value of money and the capital amounts of monetary savings and money lent over time. It is generally accepted, but not a fact, that inflation erodes the real value of constant real value non–monetary items with fixed nominal payments over time, e.g. fixed salary, wage and rental payments. The implementation of the stable measuring unit assumption (not inflation) erodes the constant real value of fixed salaries, wages, rentals, etc.

The constant real non–monetary values of salaries, wages, rentals, etc are generally maintained constant on an annual basis, i.e. not eroded, when it is chosen to measure the existing constant values of these constant items in units of constant purchasing power in terms of the annual CPI in most economies with monthly payment in depreciating money during inflation. They are updated on an annual basis during low inflation but then paid on a monthly basis applying the stable measuring unit assumption.

It is not yet generally accepted, but a fact, that the traditional Historical Cost Accounting model unknowingly, unintentionally and unnecessarily erodes the real value of existing constant real value non–monetary items never maintained constant, e.g. equity of companies and banks never maintained constant over time as a result of insufficient revaluable fixed assets, when it is chosen to measure financial capital maintenance in nominal monetary units in terms of the traditional HCA model during low inflation when the stable measuring unit assumption is implemented for an unlimited period of time during indefinite inflation.

As a result of this lack of realizing the erosive nature of the implementation of the stable measuring unit assumption, 1970–style CPPA inflation accounting was also not an accounting system implemented to correct or eliminate the erosion of the constant real value of only constant real value non–monetary items never maintained constant by the use of the stable measuring unit assumption. The split of non-monetary items in variable and constant items has not yet been identified at that time. The split was only identified in 2005.

It was not realized that the HCA model unknowingly erodes real value on a significant scale in all existing constant real value non–monetary items never maintained constant when it is chosen to implement the very erosive stable measuring unit assumption for an unlimited period of time during indefinite inflation. In most cases it is not even known that a choice is made as presented in the original Framework (1989), Par 104 (a). Neither is it realized that the erosion will be stopped automatically by freely choosing to measure financial capital maintenance in units of constant purchasing power by updating only constant items in all entities that at least break even, as approved in IFRS in the Framework (1989).

Prof Geoffrey Whittington in his definitive work on inflation accounting in the beginning of the 1980´s, Inflation Accounting – An Introduction to the Debate, published in 1983, clearly indicated that with 1970–style CPP inflation accounting all non–monetary accounts (with no distinction being made between variable real value non–monetary items and constant real value non–monetary item accounts) were updated by means of the CPI.

"Constant Purchasing Power Accounting (CPP) is a consistent method of indexing accounts by means of a general index which reflects changes in the purchasing power of money. It therefore attempts to deal with the inflation problem in the sense in which this is popularly understood, as a decline in the value of the currency. It attempts to deal with this problem by converting all of the currency unit measurement in accounts into units at a common date by means of the index."

Updated income statement constant real value non–monetary items, for example, salaries, wages, rentals, etc. are – right this very moment – a blessing to users all around the world because they maintain the constant real value or purchasing power of salaries, wages, rentals, etc. constant during low inflation as long as the adjustment is at least equal to inflation over the period in question. Millions of workers, their trade unions, governments, economists and people in general would agree that the practice of updating accounts in a low inflation environment is a blessing to users. In fact, it is one of the basic pillars of a stable economy as has been amply proven by Brazilian accountants, economists and the Brazilian Central Bank during the 30 years of very high and hyperinflation from 1964 to 1994 when they maintained their internal demand in the country relatively stable by updating salaries, wages, rentals and other non–monetary items in their real economy.

Updated balance sheet constant real value non–monetary items, e.g. Issued Share capital, Retained Earnings, Share premiums, Capital Reserves, General Reserves, all other items in Shareholders´ Equity, trade debtors, trade creditors, taxes payable, taxes receivable, salaries payable, salaries receivable, all other non–monetary payables, all other non–monetary receivables, etc in a low inflation economy is a blessing to everyone in that economy when it is simply decided to change from the current implementation of the very erosive stable measuring unit assumption – which is based on a fallacy – and financial capital maintenance in nominal monetary units (the traditional Historical Cost Accounting model) which is impossible during inflation and another fallacy, and it is freely chosen to implement the real value maintaining financial capital maintenance in units of constant purchasing power model during low inflation and deflation ( as applied in the Constant Item Purchasing Power Accounting model) as approved by the IASB in the original Framework (1989), Par 104 (a). Implementing financial capital maintenance in units of constant purchasing power during low inflation knowingly maintains – instead of the generally accepted HCA model currently unknowingly, unnecessarily and unintentionally eroding real value in constant real value non–monetary items never maintained as it also did last year and all the years before and will do next year if the very erosive stable measuring unit assumption is not stopped – all else being equal.


Nicolaas Smith

Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.