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Friday 12 August 2011

Net constant item loss or gain – a new accounting item.

Net constant item loss or gain – a new accounting item 
Updated on 16-8-11

Financial capital maintenance in units of constant purchasing power (CIPPA) with no stable measuring unit assumption requires the following:

1.    All monetary items – historical and current period monetary items – would be inflation–adjusted in terms of a Daily Index or monetized daily indexed unit of account like the Unidad de Fomento (UF) published daily by the Central Bank of Chile. This would result in the complete elimination of the cost of inflation; i.e. there would be no net monetary loss or gain, only under complete coordination, as well as with all money in the banking system which may never be the case. There is always money outside the banking system even if all deposits and other monetary items in the banking system were inflation–indexed, as partially done in Chile since 1967 with the UF. There would thus always be net monetary losses and gains to be calculated and accounted only in the monetary economy. Inflation has no effect on the real value of non–monetary items.

Complete coordination in an economy would most probably not be that easy to achieve right from the start. Banks cannot be forced to inflation–adjust all monetary items in the banking system when entities do not yet understand all the benefits of financial capital maintenance in units of constant purchasing power. Chilean banks operate profitably with inflation–adjusting a significant portion of deposits from clients since 1967. They inflation–index, for example, mortgages and car loans, which include their profit margins, to clients in terms of the UF.

However, entities may start financial capital maintenance in units of constant purchasing power, as authorized in IFRS, without any inflation–adjustment of monetary items at all. They may be motivated by the invisible hand of self–interest, shareholder pressure or more financial crises caused by continuously undercapitalized banks and companies. They may wish to immediately benefit from automatically maintaining the constant purchasing power of their own shareholders´ equity constant forever as long as they break even during inflation and deflation – ceteris paribus – whether they own any revaluable fixed assets or not. (See CIPPA increases a company´s net asset value.) [Link this to the blog article.]

There is much to be gained from moving away from reporting on the basis of Financial Capital Maintenance in Nominal Monetary Units.

           Prof Rachel Baskerville, Associate Professor of Accounting at the School of Accounting and Commercial Law at the Victoria University of Wellington, New Zealand in her publication 100 Questions (and Answers) about IFRS, March 15th, Question 38, 2010 on the Social Science Research Network. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1526846

The full cost of inflation – net monetary loss – would be recognized by these entities in their operations. It would be calculated and accounted in financial reports prepared under CIPPA. Under partial inflation–adjustment of monetary items in the banking system – e.g. in Chile – the net monetary loss or gain would be calculated and accounted for the part not inflation–indexed. This is presently not being done in Chile because entities in Chile implement the HCA model under which net monetary losses and gains are not calculated and accounted.

The calculation and accounting of net monetary losses and gains are required under CIPPA because there is no stable measuring unit assumption under financial capital maintenance in units of constant purchasing power.

The constant purchasing power of capital can only be automatically maintained by the real value of net assets in entities that at least break even during inflation and deflation – ceteris paribus – whether they own any revaluable fixed assets or not per se under financial capital maintenance in units of constant purchasing power.

Under HCA the cost of inflation in the monetary economy is not calculated and accounted because the books are not being balanced in real terms but in illusionary nominal monetary terms. The concept of capital being equal to net assets is also applied under HCA, but, in nominal monetary terms.

Entities, on the one hand, apply the stable measuring unit assumption under HCA in the valuation of their own shareholders´ equity in their own financial reports in nominal monetary units under which they may not take into account unreported hidden reserves for fixed assets not revalued. On the other hand, they always value third parties´ shareholders´ equity taking into account unreported hidden reserves for fixed assets not revalued, e.g. in the share price of listed companies which they value at market value in terms of IFRS, as well as in their valuations of unlisted companies. With regard to their own shareholders´ equity, they implement financial capital maintenance in nominal monetary units as authorized in IFRS and by the FASB which is a very popular accounting fallacy not yet extinct because it is impossible to maintain the real value of capital in nominal monetary units per se during inflation and deflation.

This means that under HCA only entities with revaluable fixed assets (revalued or not) with an updated real value equal to 100% of the updated constant real value of shareholders´ equity maintain the real value of their capital under the concept of capital is equal to net assets during inflation and deflation. This may only be the case in hotel, hospital and other property–intensive groups. CIPPA maintains the constant purchasing power of capital constant forever in all entities that at least break even during inflation and deflation – ceteris paribuswhether they own any revaluable fixed assets or not. This requires the calculation and accounting of net monetary losses and gains as well as net constant item losses and gains because the books are being balanced in real terms; i.e. the stable measuring unit assumption is not applied.

This also means that, under HCA, the portion of shareholders´ equity never covered by sufficient revaluable fixed assets (revalued or not) is currently  unnecessarily, unintentionally and unknowingly being eroded at a rate equal to the annual rate of inflation; not by inflation, but, by the implementation of the stable measuring unit assumption during inflation.

The erosion is equal to the annual rate of inflation because economic items are valued in terms of money which is the legal monetary unit of account and inflation erodes the real value of only money and other monetary items. Inflation has no effect on the real value of non–monetary items. Shareholders´ equity is a constant real value non–monetary item. This unnecessary erosion in constant item real value amounts to hundreds of billions of US Dollars per annum in the world´s constant item economy.

Financial capital maintenance in units of constant purchasing power (CIPPA) would stop that forever and would instead maintain hundreds of billions of US Dollars per annum in the world´s shareholders´ equity investment base for an unlimited period of time.

2.    Variable items are valued and accounted in terms of IFRS. Variable item revaluation losses and gains are treated in terms of IFRS. Variable items when not valued daily in terms of IFRS would be updated in terms of a Daily Index or a monetized daily indexed unit of account because there is no stable measuring unit assumption under financial capital maintenance in units of constant purchasing power.

Selling prices of items in shops and restaurants, etc. are not updated on a daily basis during low inflation and deflation. They are not historical prices. They are set every day in a free market.  Keeping them the same during a period is a marketing strategy. Selling prices depend on demand and supply. McDonalds´ prices would not be updated daily in terms of a Daily Index or a monetized daily indexed unit of account. They would be updated daily under hyperinflation in terms of the daily US Dollar parallel rate or a daily Brazilian–style index rate under Constant Purchasing Power Accounting (CPPA). That happened at McDonalds in Harare, Zimbabwe; i.e., the daily updating, not the implementation of CPPA.

3.    Constant items would always and everywhere be measured in units of constant purchasing power in terms of a Daily Index or monetized daily indexed unit of account. This would eliminate the total cost of the stable measuring unit assumption (currently hundreds of billions of US Dollars per annum) from the constant item economy only in the unlikely case of complete coordination right from the start of changing over to financial capital maintenance in units of constant purchasing power.

Constant items within an entity with no third parties involved would always and everywhere be measured in units of constant purchasing power. This would include all items in shareholders´ equity, provisions, all items in the income statement, accounts payable, all other non–monetary payables, etc.

A new accounting item, net constant item loss (or gain) would be calculated and accounted where trade debtors and other non–monetary receivables initially do not agree to measurement in units of constant purchasing power in terms of a Daily Index or monetized daily indexed unit of account. The loss is not a net monetary loss because it is not caused by inflation in the real value of a monetary item, but, by the application of the stable measuring unit assumption causing a loss in the real value of a constant item. The calculation and accounting of the net constant item loss or gain is required because there is no stable measuring unit assumption under financial capital maintenance in units of constant purchasing power: the books would – for the first time – be balanced in real terms.


Nicolaas Smith

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

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