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Tuesday, 12 July 2011

Real value erosion under Historical Cost Accounting

Table 2 Real value erosion under Historical Cost Accounting

Table 2 above is an estimate of the state of real value erosion in the SA economy in Aug 2009:  In the 12 month period-ending in August, 2009, inflation actually eroded R1 952.799 billion x 0.064 = R124.9 billion in the real value of the Rand in the SA monetary economy. At the same time the stable measuring unit assumption unnecessarily eroded about R200 billion in the real value of constant real value non–monetary items never maintained constant which are treated as monetary items in the SA constant item economy. About R324 billion in real value was thus eroded in the SA economy in the 12 months to August, 2009 by inflation and unknowingly, unintentionally unnecessarily by the implementation of the very erosive stable measuring unit assumption as it forms part of the traditional Historical Cost Accounting model.

If inflation stays at 6.4% for the next five years and the implementation of the HCA model keeps on unknowingly eroding the real values of constant real value non–monetary items never maintained constant which are treated as monetary items with the very erosive stable measuring unit assumption then a cumulative total of R1 620 billion in real value would be eroded in the SA economy – all else being equal. The cumulative totals of real value erosion under these circumstances for 10, 20 and 30 years would be R3 240 billion, R6 480 billion and R9 720 billion respectively. These are huge values of real value erosion in the SA economy. The part which the HCA model unknowingly, unnecessarily and unintentionally erodes can easily be eliminated completely.

We can see from Table 3 what the difference would be when it is freely decided to measure financial capital maintenance in units of constant purchasing power as authorized in IFRS in the original Framework (1989), Par 104 (a).

The erosion of real value in constant items never maintained constant which are treated as monetary items under the HCA model would stop completely. There would only be real value erosion in the value of the Rand because of inflation. At 6.4% annual inflation only R124 billion in real value would be eroded in the economy as a whole instead of the about R324 billion over a period of 12 months (Aug 2009 values). Over five years the cumulative total of real value erosion would drop from R1 620 billion to R 624 billion, over 10 years from R3 240 billion to R1 249 billion, over 20 years from R6 480 billion to R2 498 billion and over 30 years from R9 720 billion to R3 747 billion.

The HCA model unknowingly erodes existing real values in existing constant real value non–monetary items never maintained constant with the very erosive stable measuring unit assumption. When the stable measuring unit assumption is rejected about R200 billion in existing constant item real values would automatically be maintained constant in all entities that at least break even – ceteris paribus - during every period of 12 months in the SA constant item economy amounting to R1 000 billion over 5 years, R 2 000 billion over 10 years, R4 000 over 20 years and R6 000 billion over 30 years. Boosting the SA real economy with these real values would make a significant difference to growth and employment in the economy over those periods.

Obviously a further reduction of inflation to an annual average of 4% would improve the SA monetary economy even more. Over 30 years it would maintain a further R1 140 billion in the monetary economy on top of the R6 000 to be gained when entities freely switch over to financial capital maintenance in units of constant purchasing power (CIPPA).

There would never more be any erosion of real value in constant real value non–monetary items never maintained constant because of a fundamentally flawed basic model of accounting under which entities simply assume there is no such thing as inflation and never has been, only for the valuation of constant real value non–monetary items when they measure financial capital maintenance in units of constant purchasing power during low inflation (implementing CIPPA). This is exactly the same as stating that there would never more be erosion of the real value of the Rand in the monetary economy at the level of R228 billion per annum (12 x 19 billion) as long as average annual inflation never again reaches 12%. There would be automatic zero per cent real value erosion in constant real value non–monetary items in all entities that at least break even – all else being equal – with financial capital maintenance in units of constant purchasing power (CIPPA) at all levels of inflation and deflation.

Stating that the SARB is responsible for limiting the erosion of the real value of the Rand and other monetary items by inflation to a maximum of 6 per cent or R117 billion per annum is the same as stating that the SARB is responsible for maintaining 94 percent or R1 808 billion of the R1 925 billion total per annum of the real value of the Rand and other monetary items in the SA monetary economy.

It is also the same as stating that the HCA model only maintains 94 % or R3 133 billion per annum of the about R3 333 billion of the existing constant real value of constant real value non–monetary items never maintained constant being treated as monetary items in the SA constant item economy under the Historical Cost paradigm since  the remaining 6% or R200 billion per annum of the real value of constant items never maintained constant is unnecessarily being eroded by the implementation of the stable monetary unit assumption. Implementing CIPPA automatically maintains the real value of the R3 333 billion in existing constant items constant forever in all SA companies at least breaking even – all else being equal – at all levels of inflation and deflation whether these companies own revaluable fixed assets or not.

It is evident from the above why Alan Greenspan stated that low inflation is what sustainable economic growth is built on.


Nicolaas Smith

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