Two per cent inflation also erodes real value

Two per cent inflation also erodes real value

There is a school of thought that the effects of two per cent inflation are not more harmful than zero per cent inflation.  This school of thought is incorrect in two of the three valuation processes in our current HC economy and would also be mistaken in one of the three valuation processes under continuous financial capital maintenance in units of constant purchasing power, i.e., the Constant Item Purchasing Power paradigm during low inflation.  The three valuation processes in our economy under both the HC and CIPP paradigms are the valuation of monetary, variable and constant items.

Variable items are valued in terms of IFRS under both the HC and CIPP paradigms with the stable measuring unit assumption being applied under HCA. The stable measuring unit assumption is never implemented under the CIPP paradigm. The two paradigms are fundamentally different paradigms.

The view that a high degree of price stability of a positive inflation rate of up to two per cent per annum is completely unharmful and that it has no disadvantages compared to absolute price stability is never true in the case of monetary items under any accounting model, either the HCA model or the CIPPA model, since inflation always erodes the real value of monetary items. A high degree of price stability of two per cent per annum in this case erodes two per cent per annum of the real value of money and other monetary items which equates to the erosion of 51 per cent of real value in all current monetary items over the next 35 years. It will over a long enough time period lead to all current monetary items arriving at the point of being completely worthless in economies with continuous two per cent inflation. The five cents coin was recently withdrawn from the South African money supply since it was practically worthless. South Africa has an inflation target of three to six per cent per annum. Swedish rounding whereby the cost of a purchase paid for in cash is rounded to the nearest multiple of the smallest denomination of currency is implemented in a number of countries.

In the case of monetary items we can thus confidently disagree with those who assume that a high degree of price stability of above zero and up to two per cent per annum is unharmful in all respects and that it has absolutely no disadvantages compared to absolute price stability or zero inflation.

The assumption that two per cent inflation is unharmful and that it has no disadvantages compared to zero inflation is acceptable in the case of variable real value non–monetary items valued continuously in terms of IFRS (excluding the stable measuring unit assumption) under the CIPPA model. The nature of the valuing processes in valuing variable real value non–monetary items continuously, for example, at fair value or the lower or cost and net realizable value or market value, etc., in terms IFRS (excluding the stable measuring unit assumption), allows this idea to be justifiable under CIPPA.

The above view is acceptable in this instance, because, in principle, any level of inflation or deflation – high or low – is automatically adjusted for in determining the price of a variable real value non–monetary item at the moment of a transaction in terms of IFRS, excluding valuation in nominal monetary units, under CIPPA.

The above assumption relating to two per cent inflation is acceptable under the HC model with the valuation of variable items in terms of IFRS accept in the case where the stable measuring unit is implemented. It is thus not acceptable per se with reference to variable items under the HC paradigm.

Two per cent inflation erodes two per cent per annum – i.e., 51 per cent over 35 years – of the real value of constant real value non–monetary items never maintained, e.g., retained profits, etc.  under the current HC paradigm. The only constant items generally maintained constant with annual measurement in units of constant purchasing power under the HC paradigm are certain (not all) income statement items, e.g., salaries, wages, rentals, etc. They are, however, paid monthly at the same value after being updated annually. All existing constant real value non–monetary items´ real values would automatically be maintained constant with continuous measurement in units of constant purchasing power at any level of inflation or deflation under the CIPP paradigm for an unlimited period of time in entities that at least break even in real value – ceteris paribus.

We can thus safely disagree in the case of constant real value non–monetary items under the HC paradigm too, that the effects of two per cent inflation is completely unharmful. Two per cent inflation – in fact, any level of inflation or deflation – would be the same as zero inflation as far as the valuation of constant real value non–monetary items under the CIPPA model is concerned.

Nicolaas Smith

Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Absolute price stability in constant items

Absolute price stability in constant items

Constant Item Purchasing Power Accounting is a price–level accounting model where under financial capital maintenance in units of constant purchasing power is implemented at all levels of inflation and deflation.

Continuous financial capital maintenance in units of constant purchasing power was authorized by the IASC Board thirteen years after Harvey Kapnick´s 1976 prediction. The IASC Board approved the original Framework (1989), Par 104 (a), now Conceptual Framework (2010), Par. 4.59 (a), which state:

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

However, the enormous real value eroding effect of implementing the very erosive stable measuring unit assumption when entities choose, also in terms of the original Framework (1989), Par. 104 (a), IASB–approved financial capital maintenance in nominal monetary units (the HCA model) and apply it in the valuing of constant real value non–monetary items never maintained constant, e.g., retained earnings, in low inflationary economies is not generally realized at all. This is clearly verified by the fact that both financial capital maintenance in nominal monetary units (a very popular accounting fallacy) and real value maintaining continuous financial capital maintenance in units of constant purchasing power at all levels of inflation and deflation were approved by the IASB in the original Framework, Par 4.59 (a) in 1989 – in one and the same sentence.

Hundreds of billions of US Dollars is eroded in constant items never maintained constant in the world’s constant item economy per annum by the implementation of the stable measuring unit assumption as part of HCA during low inflation in this manner.

Entities can choose the one or the other and state that they have prepared primary financial statements in terms of IFRS. However, when they choose the traditional HCA model they unknowingly, unintentionally and unnecessarily erode real value on a significant scale in the real or non–monetary economy during low inflation when they implement the very erosive stable measuring unit assumption. When they choose IASB–approved continuous financial capital maintenance in units of constant purchasing power they would maintain the real values of all constant real value non–monetary items during inflation and deflation in companies which at least break even in real value, empowering and enriching those companies, their shareholders and the economy in general with the accompanying benefits to workers and employment for an unlimited period of time – ceteris paribus.

As the Deutsche Bundesbank stated:

‘The benefits of price stability, on the other hand, can scarcely be overestimated, especially as these are, in principle, unlimited in duration and accrue year after year.’

Deutsche Bundesbank, 1996 Annual Report, P 83.

Financial capital maintenance in units of constant purchasing power would result in absolute price stability under complete co-ordination in constant real value non–monetary items for an unlimited period of time in companies that at least break even in real value at all levels of inflation and deflation – all else being equal – without the need for extra capital from capital providers or more retained earnings simply to maintain the existing constant real value of existing constant real value non–monetary capital constant. The IASB predecessor body, the IASC Board, approved absolute price stability in income statement and balance sheet constant real value non–monetary items when they authorized the original Framework (1989), Par 104 (a) approving the option of continuously measuring financial capital maintenance in units of constant purchasing power at all levels of inflation and deflation.

Nicolaas Smith

Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Price-level accounting

Price-level accounting

Entities generally choose to measure financial capital maintenance in nominal monetary units and thus apply the very erosive stable measuring unit assumption as part of the traditional HCA model. They generally value all balance sheet constant items, e.g., owners´ equity, trade debtors, trade creditors, etc. as well as most income statement items, which are all constant items, at Historical Cost. They value them in nominal monetary units as a result of the fact that they assume that changes in the purchasing power of the unstable monetary unit are not sufficiently important to require financial  capital maintenance in units of constant purchasing power during low inflation and deflation.

Entities, in practice, assume unstable money is perfectly stable for this purpose. They, in practice, assume there has never been inflation or deflation in the past, there is no inflation and deflation in the present and there never will be inflation and deflation in the future as far as the valuation of most constant real value non-monetary items is concerned. They only value certain income statement constant items, e.g. salaries, wages, rentals, etc. in real value maintaining units of constant purchasing power annually by means of the annual CPI during low inflation. They then pay these items monthly in fixed nominal amounts, again implementing the stable measuring unit assumption.

IAS 29 Financial Reporting in Hyperinflationary Economies does not require the valuation of non–monetary items in units of constant purchasing power at the time of the transaction or event. IAS 29 simply requires the restatement of Historical Cost or Current Cost financial statements in terms of the period–end monthly published CPI in order to make them ‘more useful’ during hyperinflation. The non–monetary or real economy of a hyperinflationary economy can only be maintained relatively stable by applying the daily parallel US Dollar exchange rate or a Brazilian–style URV daily index to the valuation of all non–monetary items instead of simply restating HC or CC financial statement in terms of the period–end monthly published CPI as required by IAS 29.

The Framework is applicable

The concepts of capital, the capital maintenance concepts and the profit / loss determination concepts are not covered in IAS, IFRS or Interpretations. These concepts were covered in the original Framework for the Preparation and Presentation of Financial Statements (1989), now The Conceptual Framework for Financial Reporting (2010), Chapter 4: The Framework (1989): the remaining text. There are no specific IAS or IFRS relating to these concepts. The Framework is thus applicable as per IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors, Par.11.

Deloitte states:

‘In the absence of a Standard or an Interpretation that specifically applies to a transaction, management must use its judgement in developing and applying an accounting policy that results in information that is relevant and reliable. In making that judgement, IAS 8.11 requires management to consider the definitions, recognition criteria, and measurement concepts for assets, liabilities, income, and expenses in the Framework. This elevation of the importance of the Framework was added in the 2003 revisions to IAS 8.’

IAS 8, Par. 11 states:

‘In making the judgement, management shall refer to, and consider the applicability of, the following sources in descending order: (a) the requirements and guidance in Standards and Interpretations dealing with similar and related issues; and (b) the definitions, recognition criteria and measurement concepts for assets, liabilities, income and expenses in the Framework.’

The valuation of the constant items issued share capital, retained earnings, other items in owners´ equity and other constant  items was thus covered in IFRS in the original Framework (1989), Pa. 104 (a), now the Conceptual Framework (2010), Par. 4.59 (a).

Harvey Kapnick in the Sax Lecture in 1976 correctly predicted the course of the development of International Financial Reporting Standards:

‘Confusion constantly arises between changes in value and changes in purchasing power. The fact is both are occurring and, while there may be an interrelationship, the effects of each should be accounted for separately. Thus, the debate concerning whether value accounting or price–level accounting should prevail is not on point, because in the long run both should prevail. The real changes in value should be segregated from changes resulting only from changes in price levels.’

Harvey Kapnick, Chairman, Arthur Andersen & Company, “Value Based Accounting – Evolution or Revolution”, Sax Lecture, 1976.

Nicolaas Smith

Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Value accounting

Value accounting

On the other hand, there has also been strong awareness in the accounting profession for a very long time that financial reporting is actually about value and not simply about Historical Cost.

‘...it is really values that are the basic data of accounting, and costs are important only because they are the most dependable measures of initial values of goods and services flowing into the enterprise through ordinary market transactions.’

Paton W. A., "Accounting Procedures and Private Enterprise", The Journal of Accountancy, April 1948, p.288.

It is broadly agreed that financial reporting should be value based. By value based it is  meant that variable items cannot always be valued at Historical Cost and are to be valued in terms of specific measurement bases defined in IFRS and US GAAP; for example, market value, the lower of cost and net realizable value, fair value, present value, recoverable value, etc.  

Value accounting has been defined in International Standards since 1976 via International Accounting Standards and IFRS relating to variable items. Value accounting thus clearly prevails in the valuation and accounting of variable items in terms of IFRS.

The real value of monetary items is eroded daily by inflation and increased daily by deflation while it is normally hyper-eroded daily by hyperinflation. The real value of monetary items is eroded by inflation, increased by deflation and hyper–eroded by hyperinflation. The nominal value of monetary items stays the same during the current financial period, i.e., in all active ledger accounts under any accounting model and under any economic environment, but, the real value is automatically adjusted by inflation, deflation and hyperinflation. The real value of monetary items can be halved every 24.7 hours as it happened during hyperinflation in Zimbabwe in 2008. According to Prof. Steve Hanke from John Hopkins University prices halved every 15.6 hours during hyperinflation in Hungary in 1946.  

The net monetary loss or net monetary gain in monetary items caused by inflation, deflation and hyperinflation resulting from holding net monetary item assets or net monetary item liabilities is calculated and accounted in terms of IAS 29 in hyperinflationary economies and in terms of financial capital maintenance in units of constant purchasing power (CIPPA) at all levels of inflation and deflation. They are not calculated and accounted under the traditional Historical Cost Accounting model, although it can be done according to Harvey Kapnick.

‘Computing the gains or losses from holding monetary items can be done and the information disclosed when the books are maintained on a historical–cost basis.’

Harvey Kapnick, Chairman of Arthur Anderson & Company, Value based accounting: Evolution or revolution, Saxe Lecture, 1976, Page 6.  


Nicolaas Smith

Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Basic objective of accounting not realized

Basic objective of accounting not realized

Many people still see financial reporting as simply providing historic economic information. It is not realized that it is a basic objective of general purpose financial reporting to maintain the constant purchasing power of capital.

The reasons for this are:

(1) The Three Popular Accounting Fallacies.

(a)   The stable measuring unit assumption based on the fallacy that changes in the purchasing power of money are not sufficiently important to require financial capital maintenance inunits of constant purchasing power during low inflation and deflation. Changes in the purchasing power of unstable money logically require financial capital maintenance in units of constant purchasing power at all levels of inflation and deflation in terms of a daily rate.

(b)   Financial capital maintenance in nominal monetary units per se during low inflation and deflation originally authorized in IFRS in the Framework (1989), Par 104 (a) and in the FASB´s Concepts Statement No. 5. It is impossible to maintain the real value of capital in nominal monetary units per se during inflation and deflation.

(c) The generally accepted belief that the erosion of companies´ profits and capital is caused by inflation fully supported in IFRS and specifically stated by the FASB. Inflation has no effect on the real value of non-monetary items. Companies´ profits and capital are constant real value non-monetary items. The implementation of the stable measuring unit assumption during inflation erodes the constant purchasing power of owners´ equity that is not being maintained constant by the real value of net assets.

(1)   It is not realized that the stable measuring unit assumption and not inflation erodes the real value of constant items never maintained constant when financial capital maintenance in nominal monetary units (the traditional HCA model) is implemented during low inflationary periods.

(2)   It is not realized that continuous measurement of financial capital maintenance in units of constant purchasing power (CIPPA) in terms of a daily index rate automatically remedies this erosion by the stable measuring unit assumption in all entities that at least break even in real value during low inflation – ceteris paribus- whether they own any revaluable fixed assets or not.

The stable measuring unit assumption as implemented under financial capital maintenance in nominal monetary units, i.e., the HCA model, would already have been stopped by now, if the above were realized.

(3)   Although the principle of financial capital maintenance in units of constant purchasing power during inflation and deflation was authorized in IFRS in 1989, it is not generally implemented during low inflation and deflation because the very erosive effect of the stable measuring unit assumption on the real value of constant items never maintained constant is not recognized as such. It is generally believed that it is inflation doing the eroding in, for example, companies´ invested capital and profits – as  specifically stated in FAS 89 – when this erosion in constant item real value is, in fact, caused by the stable measuring unit assumption. Inflation has no effect on the real value of non–monetary items. Capital and profits are constant real value non–monetary items.

Nicolaas Smith


Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.

IAS 29 made no difference in Zimbabwe

IAS 29 made no difference in Zimbabwe

The implementation of IAS 29 by Zimbabwean listed companies as required by the Zimbabwean Stock Exchange made no difference to the collapse of the Zimbabwean constant item economy during hyperinflationary. Valuing all non–monetary items in restated HC or CC financial statement as required by IAS 29 in terms of the period–end CPI which was published a month or more after the month to which it related when the real value of the Zimbabwe Dollar sometimes halved every day, obviously, made no difference to the collapse of the economy.

Massive increases in the local currency money supply hyper–eroded the real value of only the ZimDollar and ZimDollar monetary items in the Zimbabwean monetary economy during hyperinflation.

Most variable items in Zimbabwe´s variable item economy, especially in the private sector, were valued in terms of the daily unofficial US Dollar parallel rate. The real values of most variable items in the private sector were thus maintained while the unofficial US Dollar parallel rate and finally the Old Mutual Implied Rate (OMIR) were available.

The real values of variable items in the public sector were not maintained in terms of the daily US Dollar parallel rate. The government attempted various periods of price freezes in the private and public sector.

The continued use of the HCA model in the Zimbabwean economy during the financial year unknowingly, unintentionally and unnecessarily eroded Zimbabwe´s constant item economy with the use of the stable measuring unit assumption during hyperinflation, as approved by the IASB and supported by PricewaterhouseCoopers (amongst others). HC financial statements of Zimbabwean companies were then restated in terms of the period–end CPI (while the CPI was still made available in Zimbabwe) to make these restated HC financial statements ‘more useful’. That made no difference to the collapse of the constant item economy.

Brazil rejected the HCA model and the stable measuring unit assumption during 30 years of very high and hyperinflation from 1964 to 1994. Brazil introduced the Historical Cost Accounting model again in 1994. The Brazilian real or non–monetary economy was kept relatively stable with daily indexing of most non–monetary items (variable and constant items) in terms of a daily index supplied by the various governments during that period while they had hyperinflation of up to 2000 per cen per annum in only their monetary unit.  Hyperinflation has no effect on the real value of non–monetary items.

How anyone can use or accept the use of the HCA model during hyperinflation is completely incomprehensible. The use of the HCA model during hyperinflation should specifically be banned by law.

Nicolaas Smith

Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.

HCA should be banned during hyperinflation

HCA should be banned during hyperinflation

IAS 29 Financial Reporting in Hyperinflationary Economies is not a departure from, but an extension to Historical Cost Accounting.

The only way a country with a hyperinflationary economy can maintain its variable item and constant item economies relatively stable during hyperinflation is by continuously measuring all non–monetary items (variable and constant items) in units of constant purchasing power. The real economy would still be affected by the stable measuring unit assumption in constant items never maintained constant at a rate of real value erosion equal to the annual rate of inflation of the hard currency used for determining the parallel rate, normally the US Dollar.

The real economy can be maintained relatively stable during hyperinflation in the local currency monetary unit not by restating Historical Cost or Current Cost financial statements at the end of the reporting period in terms of the period–end monthly published CPI to make them ‘more useful’ as required by IAS 29, but, by applying the daily parallel US Dollar or other hard currency exchange rate, or – as was done in Brazil during the 30 years of very high and hyperinflation from 1964 to 1994 – with daily indexation.

Daily indexation is, in principle, better than applying the daily US Dollar parallel rate. Daily indexation in terms of a Brazilian-style Unidade Real de Valor daily index would keep the real economy more stable: the erosion of the real value of constant items never maintained constant caused by the stable measuring unit assumption as applied to the US Dollar parallel rate is eliminated in the formulation of the index value when the CPI is included in the formula as it was in the case of the URV.

Nicolaas Smith

Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Valuing constant real value non–monetary items

Valuing constant real value non–monetary items

All constant items have always and everywhere (historic and current period constant items) to be measured in units of constant purchasing power in terms of a Daily CPI or other daily rate under financial capital maintenance in units of constant purchasing power (CIPPA) in order to automatically maintain the constant purchasing power of capital constant in all entities that at least break even in real value at all levels of inflation and deflation – ceteris paribus – whether they own any revaluable fixed assets or not in a double-entry accounting model under which the real value of owners´ equity is equal to the real value of net assets. This is not always the case, hence the necessity to calculate the net constant item loss or gain during the current financial period when constant items are not measured in units of constant purchasing power, e.g., in the case of trade debtors and trade creditors as well as other non-monetary payables and receivables treated incorrectly as monetary items by third parties who still implement HCA.

The constant real values of constant items in the constant item economy are automatically maintained constant under Constant Item Purchasing Power Accounting during low inflation and deflation by means of continuous financial capital maintenance in units of constant purchasing power

Annual measurement in units of constant purchasing power is only currently implemented under the HCA model in the case of certain (not all) income statement items, e.g., salaries, wages, rentals, etc. in non–hyperinflationary economies. Once updated annually, these items are normally paid at the same monthly value; i.e., the stable measuring unit assumption is applied in their monthly payments during the financial year.

Financial reporting has to take all three scenarios – occurring simultaneously – into account over time when an entity´s economic activities are accounted daily and financial reports are prepared and presented periodically and accessed or viewed today at the current Daily CPI or other daily rate.

Harvey Kapnick was correct when he stated in the Saxe Lecture in 1976:

‘In the long run both value accounting and price–level accounting should prevail.’

Nicolaas Smith

Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Valuing variable items

Valuing variable items

Variable real value non–monetary items are valued and accounted in terms of IFRS at, for example, fair value, market value, the lower of cost or net realizable value, recoverable value, present value, etc. excluding the stable measuring unit assumption under financial capital maintenance in units of constant purchasing power (CIPPA). These prices change all the time: even minute by minute in many markets, e.g., the prices of foreign currencies, commodities, precious metals, quoted shares, properties, finished goods, services, raw materials, etc. Their historic prices (e.g., of the day before) are updated on a daily basis to the current (today´s) rate in terms of a Daily CPI or other daily rate when they are not valued at the current date (today) in terms of IFRS as qualified.

Under the stable measuring unit assumption it is assumed that changes in the purchasing power of money are not sufficiently important to require capital maintenance in units of constant purchasing power on a daily basis. Another way to state the stable measuring unit assumption is to state that it is assumed that the real value of money is perfectly stable over time. The stable measuring unit assumption is applied to the measurement of certain non-monetary items under HCA. It is never applied under financial capital maintenance in units of constant purchasing power (CIPPA).

Inflation and deflation have no effect on the real value of non-monetary items. Historic variable items are thus not inflation-adjusted or deflation-adjusted daily. Historic variable items are updated daily in terms of a daily index or other daily rate when they are not valued daily in terms of IFRS as qualified.

Nicolaas Smith

Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.

A fact will eventually prevail over an assumption of that fact

A fact will eventually prevail over an assumption of that fact

Under the stable measuring unit assumption it is assumed that changes in the purchasing power of money are not sufficiently important to require capital maintenance in units of constant purchasing power during inflation and deflation.

The 3000-year-old, generally accepted, globally implemented, traditional Historical Cost Accounting model is based on the stable measuring unit assumption.

The fact is that changes in the purchasing power of money are sufficiently important to require capital maintenance in units of constant purchasing during inflation and deflation as authorized in IFRS and implemented under Constant Item Purchasing Power Accounting.

Just as the double-entry accounting model drove out weaker accounting models in the past, so will capital maintenance in units of constant purchasing power (CIPPA) drive out HCA in the future. Financial capital maintenance in units of constant purchasing power (CIPPA) will eventually prevail over financial capital maintenance in nominal monetary units (HCA).

Nicolaas Smith

Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Valuing monetary items

Valuing monetary items

Financial reporting values and accounts unstable monetary items on recognition at their nominal values in nominal monetary units under all accounting models. Monetary items are then valued daily in fixed nominal monetary units (unstable in real value) only during the current financial period under financial capital maintenance in units of constant purchasing power (CIPPA) and the net monetary loss or gain is, logically and necessarily, calculated and accounted

All historical monetary items are inflation-adjusted daily in terms of the current (today´s) Daily CPI thereafter, i.e., once they are reported in historical financial reports, whether for comparison purposes or not. The historical net monetary loss or gain (a constant real value non-monetary item once accounted) is thereafter measured in units of constant purchasing power in terms of the current (today´s) Daily CPI or other daily rate over time.

Low inflation, high inflation, deflation and hyperinflation determine the always current generally unstable real value of the unstable monetary unit (US Dollar, Euro, British Pound, Bolívar, Yen, Yuan, etc.) and other unstable monetary items within each country´s monetary economy.

The real value of money held and other unstable monetary items changes equally (all unstable monetary items are affected evenly) on a daily basis at all levels of inflation and deflation. The change is quantified with the daily publication of the Daily CPI or monetized daily indexed unit of account value during low inflation, high inflation and deflation and the daily US Dollar or other hard currency parallel rate or Brazilian-style daily Unidade Real de Valor during hyperinflation. The daily black market or parallel US Dollar exchange rate or street rate is generally constantly (24/7, 365 days a year) available in a hyperinflationary economy.

The Daily CPI is an internal non-monetary index rate between the unstable real value of a fixed nominal monetary unit and a unit of constant real value within an economy. The daily parallel US Dollar (or other hard currency) exchange rate or a Brazilian–style Unidade Real de Valor daily index rate fulfills this role in a hyperinflationary economy.

The nominal values of bank notes and coins currently (2012) cannot be changed daily on the notes and coins. Inflation and deflation always affect the real value of bank notes and coins and all other monetary items. Inflation-adjusting the total money supply would eliminate the entire cost of inflation or hyperinflation (not actual inflation or hyperinflation) from the monetary economy. This would require complete co-ordination. 20 to 25 per cent of the broad M3 money supply in Chile is inflation-adjusted daily in terms of the Unidad de Fomento according to the Banco Central de Chile. $ 2.68 trillion (2009) of sovereign inflation-linked bonds are inflation-adjusted daily worldwide in terms of country specific Daily Consumer Price Indices.

Months of zero annual inflation are rare and generally not sustained for more than a month of two. During hyperinflation the real value of the very unstable monetary unit and all other very unstable monetary items often changes once per day. Prices can double every 24.7 hours during hyperinflation as happened during severe hyperinflation in Zimbabwe. (Hanke, 2010)

The real values of monetary items inflation-adjusted daily are still affected by inflation and deflation, but by inflation-adjusting or deflation-adjusting them their real values are maintained constant by contract. The capital amounts of inflation-indexed bonds have constant real values over time during inflation. They are, however, not constant real value monetary items in principle. That would only be the case at permanently sustainable zero inflation. Inflation and deflation thus always affect the real values of all monetary items within an economy. The real values of monetary items inflation-adjusted daily are maintained constant by contract.

Nicolaas Smith

Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Accounting is a measurement instrument per David Mosso

Accounting is a measurement instrument per David Mosso

Economic items are valued or measured whenever economic transactions and events are accounted. Financial reporting does not simply report on what took place in the past in nominal historical cost terms. Accounting is not just a scorekeeping exercise of what happened in the past. Financial reporting values everything that happens in the economy on a daily basis.

The three fundamentally different, basic economic items in the economy, namely, monetary items, variable items and constant items, have economic values expressed in terms of unstable money which is also the unstable monetary unit of account. Economic transactions and events involving these three basic economic items are valued and accounted in an organized manner when a double entry accounting model is implemented: journal entries, general ledger accounts, trial balances, cash flow statements, income and expenses in the income statement, assets and liabilities in the balance sheet plus other financial, management and costing reports.

Accounting entries are valuations of the economic items (the debit items and the credit items) accounted.

Financial reporting is the valuing, classifying, recording, summarizing and reporting of economic transactions and events in an entity in terms of the three basic economic items measured in an unstable functional currency at all levels of inflation and deflation. It is the daily valuation and recording of an entity´s economic activities in terms of an unstable functional currency. Under Constant Item Purchasing Power Accounting financial reporting deals with economic values on a daily basis when an entity´s daily economic activities are accounted.

Financial capital maintenance in units of constant purchasing power (CIPPA) is a real net asset valuation of an entity in terms of a Daily Consumer Price Index or daily monetized indexed unit of account, e.g. the Unidad de Fomento, during low inflation, high inflation and deflation or a daily rate, for example the US Dollar parallel rate or a Brazilian-style Unidade Real de Valor daily index rate, during hyperinflation. The real net asset value of an entity is reported in financial terms by means of valuation of the three basic economic items in terms of IFRS, excluding the stable measuring unit assumption, implementing financial capital maintenance in units of constant purchasing power in terms of a daily rate (CIPPA).

Nicolaas Smith

Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.

A financial report relates to one day

A financial report relates to one day

A balance sheet is prepared periodically reporting the real net asset value (not the real market value or the real intrinsic value) of an entity on a specific day, e.g. the end of a month, the end of a quarter, the end of six months, the end of a financial year or sometimes a longer financial period.

A balance sheet under financial capital maintenance in units of constant purchasing power (CIPPA) is a financial report relating to an instant in an entity´s economic life: a report about the real net asset value of an entity on a specific day; i.e., the date of the financial report in terms of the Daily Consumer Price Index or other daily rate on that day when the financial report is accessed or viewed on that day.

The next day and every day thereafter, the real net asset value of an entity is generally different because the daily valuations of variable real value non-monetary items have changed, the entity has created more constant real value in the form of constant real value non-monetary after tax net income or has suffered a constant real value non-monetary net loss or extra capital or other resources have been contributed by shareholders or other third parties. The entity is a going concern and its real net asset value generally changes day after day.

In the event of the real net asset value remaining the same from the one day to the next, the nominal net asset value would generally change during inflation and deflation under financial capital maintenance in units of constant purchasing power (CIPPA) because the stable measuring unit assumption is not implemented under this accounting model. Inflation and deflation change the real value of money, the monetary unit of account, over time.

The real net asset value of the entity as reported in the balance sheet on the date of the balance sheet stays constant in real value (not in nominal value during inflation and deflation) for an indefinite period of time with reference to the date of the financial report. But, the real value of the functional currency (the unstable monetary unit of account) generally changes daily as indicated by the change in the Daily CPI or monetized daily indexed unit of account in a non-dollarized economy at all levels of inflation and deflation. Thus, all items in a historic balance sheet and all historic financial reports have to be valued at the current, i.e. today´s, Daily CPI or other daily rate under financial capital maintenance in units of constant purchasing power (CIPPA).

Nicolaas Smith

Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Valuation of constant items during hyperinflation

Valuation of constant items during hyperinflation

The stable measuring unit assumption is applied in the valuation of constant real value non–monetary items, e.g., salaries, wages, rentals, equity, trade debtors, trade creditors, taxes payable, etc. during hyperinflation when these items are not updated at all or not fully updated during hyperinflation; i.e., when the HCA model is implemented during hyperinflation as mistakenly approved in IAS 29 and mistakenly supported by Big Four accounting firms like PricewaterhouseCoopers.

PricewaterhouseCoopers state the following regarding the use of the HCA model during hyperinflation:

‘Inflation–adjusted financial statements are an extension to, not a departure from, historic cost accounting. IAS 29 seeks to overcome the limitations of historic cost financial reporting in hyperinflationary conditions.’

Financial Reporting in Hyperinflationary Economies – Understanding IAS 29, PricewaterhouseCoopers, 2002, p 5.

IAS 29 states:

‘The financial statements of an entity whose functional currency is the currency of a hyperinflationary economy, whether they are based on a historical cost approach or a current cost approach shall be stated in terms of the measuring unit current at the end of the reporting period. ‘

IAS 29, Par 8.

It is absolutely clear from the above quotes that IFRS approve and PricewaterhouseCoopers support the implementation of the Historical Cost Accounting model and the very erosive stable measuring unit assumption during hyperinflation. That is a fundamental mistake during hyperinflation. HCA should be banned by law during hyperinflation.

Certain (not all) income statement items, e.g., salaries, wages, rentals, etc. are measured as a generally accepted accounting practice in units of constant purchasing power on an annual basis (they are updated annually – not monthly) as part of the traditional Historical Cost Accounting model during low inflation. The Framework states that various measurement bases are used in conjunction in the HCA model during inflation, hyperinflation and deflation.

A constant real value non–monetary item´s legal existence is determined by contract or statute (company law, commercial law, etc.). However, these constant real value non–monetary items are – in practice – treated as monetary items (cash) during the period that they are not measured in units of constant purchasing power in terms of the daily US Dollar or other daily hard currency parallel rate or a daily index rate during hyperinflation.

Salaries, wages, rentals, trade debtors, trade creditors, all other non–monetary payables, all other non–monetary receivables, etc. are not required in IAS 29 to be valued or measured or updated at the date of payment in terms of the period–end monthly published CPI. That is, obviously, not practically possible when the period–end monthly CPI is normally only available one or two months after the month to which it relates during hyperinflation. What is required in IAS 29 is that these constant real value non–monetary items´ nominal Historical Cost or Current Cost values – after payment or after the liability for the payment have been accounted – in HC or CC financial statements at the end of the accounting period be restated in terms of the period–end monthly CPI in order – simply – to make the HC or CC financial statements more useful during hyperinflation. The practical implementation of IAS 29 thus does not generally result in financial capital maintenance in units of constant purchasing power during hyperinflation. That clearly explains the failure of IAS 29, for example, when it was implemented during hyperinflation in Zimbabwe. It did not manage to keep the Zimbabwe real economy relatively stable like daily updating in terms of the daily index supplied by various governments during 30 years of very high and hyperinflation in Brazil did. The complete failure of IAS 29 in Zimbabwe seems to make absolutely no difference to the IASB´s confidence in this failed standard.

When there is no CPI published as happened towards the end of severe hyperinflation in Zimbabwe, constant real value non–monetary item values cannot be determined. It was impossible to implement IAS 29 during severe hyperinflation in Zimbabwe. See reference below. However, these constant items´ real legal or contractual values do not disappear even when they – temporarily – cannot be valued in the local currency. Their legal or contractual constant real non–monetary values still exist even after monetary meltdown of only the local currency. Constant real value non–monetary items are measured at fair value (in nominal monetary units or units of constant purchasing power depending on whether the entity chooses the HCA or CIPPA model) in the opening balance sheet after monetary meltdown in terms of IAS 1.

The IASB authorized an addition to IAS 1 in 2011 to allow for the fair value valuation of all non–monetary items (constant and variable items) in the opening balance sheet of companies applying IFRS after severe hyperinflation and a monetary meltdown. Inflation and hyperinflation have no effect on the real value of non–monetary items. All non–monetary items (constant and variable items) were still there to be fair–valued and included in the opening balance sheet of companies after the monetary meltdown in Zimbabwe in 2008.

No exchangeability with all relatively stable foreign currencies means no exchange rates which means no hyperinflation (no prices being set in the local currency) and vice versa: no exchange rate with any relatively stable foreign currency means no exchangeability which means no hyperinflation (no prices being set in the local currency). No prices being set in the local currency means monetary meltdown: the total money supply (all local currency money and other monetary items stated in the local currency) has no value.

Trade debtors and trade creditors are constant real value non–monetary items and not monetary items as incorrectly stated by the US Financial Accounting Standards Board, the International Accounting Standards Board, PricewaterhouseCoopers and most others except 180 million Brazilians and 10 million Angolans during hyperinflation.

Nicolaas Smith

Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Valuing monetary items during deflation

Valuing monetary items during deflation

The whole money supply would be deflation-adjusted daily under complete coordination and perfect financial capital maintenance in units of constant purchasing power during deflation. It is highly unlikely that this would happen right from the start in any economy which decides to abandon the HCA model while it is in deflation and adopt financial capital maintenance in units of constant purchasing power (CIPPA). Monetary items not deflation-adjusted daily in bank and ledger accounts would continue to be valued in nominal monetary units and the net monetary gain or loss would be calculated and accounted under financial capital maintenance in units of constant purchasing power (CIPPA).

Monetary items not deflation-adjusted daily are valued in nominal monetary units under the HCA model during deflation. Their real values thus increase daily. The net monetary gain or loss is not calculated under HCA during deflation.

Not all inflation-indexed government bonds become deflation-indexed bonds during deflation. US Treasury Inflation-Protected Securities (TIPS) and most euro-denominated sovereign inflation-indexed bonds, for example, contain a clause that states that when the nominal value of the capital amount adjusted for deflation is less than the original nominal amount, the original amount would be repaid. These bonds would thus be nominal bonds and the capital amounts would gain in real value during deflation.

‘The presence of this guarantee, which is beneficial for the investor in the event of deflation, is mainly due to accounting considerations: in a lot of countries, bonds must have a minimum redemption price:’

CNO Inflation-linked bonds, p. 15

This does not apply to the coupon payments. They stay the same in real value during inflation and deflation, i.e., they would be lower in nominal value during deflation, but the same in real value.

 Some countries´ government inflation-indexed bonds do not contain the above clause and thus become deflation-indexed bonds during deflation, i.e., they are real constant value bonds. Their capital amounts and their coupon payments would be constant in real value during inflation and deflation.

 ‘The UK, Canada and Japan, do not guarantee a minimum redemption price for their indexed issues.’

CNO Inflation-linked bonds, p. 15.

Nicolaas Smith

Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.