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Saturday, 4 June 2011

CIPPA is not inflation accounting

CIPPA is not inflation accounting


This project is not about inflation accounting during high and hyperinflationary periods.

This project is not about implementing 1970–style inflation accounting in low inflationary economies by inflation–adjusting all non–monetary items equally by means of the CPI.

The following peer reviewed article Financial Statements, Inflation & The Audit Report I wrote was published in SAICA´s journal– Accountancy SA – in September 2007.

“In most countries, primary financial statements are prepared on the historical cost basis of accounting without regard either to changes in the general level of prices or to increases in specific prices of assets held, except to the extent that property, plant and equipment and investments may be revalued.” ¹


The International Accounting Standards Board (IASB) only recognizes two economic items:


1.) Monetary items defined as “money held and items to be received or paid in money;” and


2.) Non–monetary items: All items that are not monetary items.


Non–monetary items include variable real value non–monetary items valued, for example, at fair value, market value, present value, net realizable value or recoverable value.


They also include Historical Cost items based on the stable measuring unit assumption.


One of the basic principles in accounting is “The Measuring Unit principle: The unit of measure in accounting shall be the base money unit of the most relevant currency.

This principle also assumes the unit of measure is stable; that is, changes in its general purchasing power are not considered sufficiently important to require adjustments to the basic financial statements.” ²


This makes these Historical Cost items equal to monetary items in the case of companies´ Retained Income balances and the issued share capital values of companies with no well located and well maintained land and/or buildings or other variable real value non–monetary items able to be revalued at least equal to the original real value of each contribution of issued share capital.


Retained Income is a constant real value non–monetary item valued at Historical Cost which makes it subject to the destruction of its real value by inflation – exactly the same as in cash.


It is an undeniable fact that South Africa’s monetary unit’s internal real value is constantly being destroyed by inflation in the case of our low inflationary economy, but this is not considered important enough to adjust the real values of constant real value non–monetary items in the financial statements – the universal stable measuring unit assumption.


The combination of the Historical Cost Accounting model and low inflation is thus indirectly responsible for the destruction of the real value of Retained Income equal to the annual average value of Retained Income times the average annual rate of inflation. This value is easy to calculate in the case of each and every company in South Africa with Retained Income. It is also possible to calculate this value for all companies in the world economy with Retained Income.


It is broadly known that the destruction of the internal real value of the monetary unit of account is a very important matter and that inflation thus destroys the real value of all variable real value non–monetary items when they are not valued at fair value, market value, present value, net realizable value or recoverable value.


But, everybody suddenly agrees, in the same breath, that for the purpose of valuing Retained Income – a constant real value non–monetary item – the change in the real value of money is not regarded as important to update the value of Retained Income in the financial statements. Everybody suddenly then agrees to destroy hundreds of billions of Dollars in real value in all companies´ Retained Income balances all around the world.


Yes, inflation is very important!


All central banks and thousands of economists and commentators spend huge amounts of time on the matter. Thousands of books are available on the matter. Financial newspapers and economics journals dedicate thousands of columns to the fight against inflation.


But, when it comes to constant real value non–monetary items, it doesn’t seem as if inflation is important. We happily destroy hundreds of billions of Dollars in Retained Income real value year in year out.


However, when you are operating in an economy with hyperinflation (perhaps only Zimbabwe at the moment with 3 713% inflation), then we all agree that you have to update everything in terms of International Accounting Standard IAS 29 Financial Reporting in Hyperinflationary Economies. You have to update variable AND constant real value non–monetary items.


But, ONLY as long as your annual inflation rate has been 26% for three years in a row adding up to 100% – the rate required for the implementation of IAS 29.


Once you are not in hyperinflation anymore, for example, 15% annual inflation for as many years as you want, then you are not allowed to update constant real value non–monetary items any more. Then you must destroy their real value again – at 15% per annum. Or 7.0% per annum in the case of South Africa (April 2007).


For example:


Shareholder value permanently  destroyed by the implementation of the Historical Cost Accounting model in Exxon Mobil's Retained Income during 2005 exceeded $4.7bn for the first time. This compares to the $4.5bn shareholder real value permanently destroyed in 2004 in this manner. (Dec 2005 values).


The application by BP, the global energy and petrochemical company, of the stable measuring unit assumption in the accounting of their Retained Income resulted in the destruction of at least $1.3bn of shareholder value during 2005. (Dec 2005 values).


Royal Dutch Shell Plc, a global group of energy and petrochemical companies, permanently destroyed $2.974 billion of shareholder value during 2005 as a result of the application of the stable measuring unit assumption in the accounting of their Retained Income. (Dec 2005 values).


Should this value be reflected in the financial statements?


Maybe it should.


Nicolaas Smith”


Footnotes

¹ International Accounting Standards Committee, (1995), International Accounting Standard 1995, London, IASC, Page 502


² Paul H. Walgenbach, Norman E. Dittrich and Ernest I. Hanson, (1973), Financial Accounting, New York: Harcourt Brace Javonovich, Inc. Page 429.

http://www.accountancysa.org.za/resources/ShowItemArticle.asp?ArticleId=1235&issue=857

This article was first published in Accountancy SA (September 2007, pg 38). Accountancy SA is published by the South African Institute of Chartered Accountants. www.accountancysa.org.za

The understanding of the global, economy–wide erosion of banks´ and companies´ capital and profits (equity) during low inflation caused by the implementation of the stable measuring unit assumption is an ongoing process. In 2007 I, like almost everyone else, still believed that inflation eroded the real value of non–monetary items. Since then I have realized that I made a mistake by believing what everyone else believes and state with regard to the erosive effect of inflation on the real value of non–monetary items. I realized since then that inflation is in fact always and everywhere only a monetary phenomenon, as the late Milton Friedman so eloquently stated. I realized since then that inflation can only erode the real value of money and other monetary items – nothing else. I realized since then that inflation has, in fact, no effect on the real value of non–monetary items as so correctly stated by Prof Dr. Ümit GUCENME and Dr. Aylin Poroy ARSOY from Uludag University, Bursa, Turkey:

Purchasing power of non monetary items does not change in spite of variation in national currency value.”

The theme of this project is thus not inflation–accounting. Inflation accounting is an accounting model to be applied only during very high and hyperinflation. Inflation accounting is specifically defined in IAS 29 Financial Reporting in Hyperinflationary Economies and required by IFRS only during hyperinflation.

The theme of this project is financial capital maintenance in units of constant purchasing power accounting during low inflation and deflation (as implemented via the Constant Item Purchasing Power Accounting model) as authorized in IFRS in the original Framework (1989), Par 104 (a). Stated differently: the theme of this project is the rejection of the stable measuring unit assumption, i.e. the rejection of the generally accepted, globally implemented, traditional Historical Cost Accounting model, during low inflation and deflation . HCA is also authorized in IFRS in the exact same original Framework (1989), Par 104 (a). The rejection of the stable measuring unit assumption is authorized in IFRS since financial capital maintenance in units of constant purchasing power during low inflation and deflation (CIPPA) is authorized in IFRS as an alternative to financial capital maintenance in nominal monetary units, i.e. the Historical Cost Accounting model under which the stable measuring unit assumption is implemented.

Non–monetary items are subdivided in variable real value non–monetary items and constant real value non–monetary items as published in the above Accountancy SA article. Only constant real value non–monetary items are updated under financial capital maintenance in units of constant purchasing power (CIPPA) to maintain their existing constant real non–monetary values constant during low inflation and deflation in order to measure financial capital maintenance in units of constant purchasing power instead of in nominal monetary units. That is what this project is about. Variable real value non–monetary items are valued in terms of IFRS or GAAP in a manner that takes into account all elements – including inflation – which determine the variable real value non–monetary item’s real value at the date of valuation during low inflation and deflation. Monetary items are always valued at their original nominal monetary values under all accounting models and under all economic environments. Constant real value non–monetary items are also valued in terms of IFRS in units of constant purchasing power when financial capital maintenance is measured in units of constant purchasing power during low inflation and deflation by implementing the CIPPA model.

This project is about the existing real values of constant real value non–monetary items – e.g., banks´ and companies´ shareholders´ equity – automatically being maintained constant forever in all entities that at least break even – ceteris paribus – during low inflation and deflation by continuously implementing the real value maintaining financial capital maintenance in units of constant purchasing power model (CIPPA) as approved in the IFRS in the original Framework (1989), Par 104 (a).

This project is about knowingly indexing or updating or measuring in units of constant purchasing power only constant real value non–monetary items by implementing the CIPPA model during low inflation and deflation as approved in IFRS in the original Framework (1989), instead of unknowingly, unintentionally and unnecessarily eroding their real values on a massive scale with the implementation of the very erosive stable measuring unit assumption as it forms part of the traditional HCA model when financial capital maintenance is measured in nominal monetary units during inflation.

This project is about knowingly choosing to measure financial capital maintenance in banks and companies in real value maintaining units of constant purchasing power during low inflation and deflation as approved in IFRS instead of in real value eroding nominal monetary units as a result of the choice to implement the very erosive stable measuring unit assumption during low inflation also authorized in IFRS in the same original Framework (1989), Par 104 (a).

This project is about rejecting the stable measuring unit assumption and instead adopting IFRS–approved real value maintaining constant purchasing power units as the measurement basis for only constant real value non–monetary items including banks´ and companies´ shareholders´ equity and not only for income statement constant real value non–monetary items, e.g. salaries, wages, rentals, etc during non–hyperinflationary conditions.

This project is about stopping the implementation of the Historical Cost Accounting model which unknowingly, unintentionally and unnecessarily erodes hundreds of billions of US Dollars per annum of existing constant real value in existing constant real value non–monetary items (bank´s and companies´ capital) in the constant item economy because the traditional HCA model is chosen when the very erosive stable measuring unit assumption is implemented during inflation instead of the IFRS–approved real value maintaining CIPPA model.

The Historical Cost Mistake is the implementation of the very erosive stable measuring unit assumption as part of the traditional HCA model during inflation.

This project is about knowingly, automatically maintaining hundreds of billions of US Dollars per annum of existing constant real non–monetary value in the real economy for an unlimited period of time in all entities that at least break even complying with IFRS instead of unknowingly, unintentionally and unnecessarily eroding that value year in year out as is unknowingly being done at the moment with the implementation of the stable measuring unit assumption during inflation.

This project is about abandoning the very erosive traditional HCA model and adopting the real value maintaining CIPPA model in low inflationary and deflationary economies as authorized in IFRS in the original Framework (1989), Par 104 (a).


Nicolaas Smith

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