Historical Cost Debate

Historical Cost Debate

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The Historical Cost Debate is the debate over the last 100 years or so about the use of Historical Cost for accounting purposes. The entities realized a long time ago that financial reports based on Historical Cost for all economic items do not fairly represent a company’s results and operations. As a result of this debate the pure Historical Cost accounting model was improved and changed dramatically during this time, so much so, that today we have a huge volume of IFRS where under variable real value non–monetary items are not all valued at HC, but at, e.g., fair value or the lower of cost and net realizable value or market value or recoverable value or present value, etc. This debate has thus been a very valid and successful debate regarding the valuation of variable real value non–monetary items. IFRS mainly refer to variable items.

Unfortunately, the stable measuring unit assumption is still an IFRS–approved option that is used for the valuation of most constant items (excluding annual measurement of salaries, wages, rents, etc. in units of constant purchasing power) during inflation and deflation. Fortunately, the option of measuring financial capital maintenance in units of constant purchasing power during inflation and deflation (CIPPA) was approved in IFRS in the original Framework (1989), Par. 104 (a).

Entities value variable items in terms of IFRS when they implement both the traditional HCA model and when they measure financial capital maintenance in units of constant purchasing power during inflation and deflation applying CIPPA. The stable measuring unit assumption is implemented under HCA. It is not to be implemented under financial capital maintenance in units of constant purchasing power (CIPPA). The net monetary loss or gain is calculated and accounted whenever monetary items are not inflation-adjusted daily during the current financial period under financial capital maintenance in units of constant purchasing power. The net constant item loss or gain is calculated whenever constant items are not maintained constant during the current accounting period under financial capital maintenance in units of constant purchasing power (CIPPA).

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Nicolaas Smith

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

Measurement bases

Measurement bases  

Measurement bases used in the valuation of variable items in terms of IFRS include – but are not limited to – the following:

Market value

Fair value

Historical Cost

Net realisable value

Present value

Recoverable value

Current cost

Carrying value

Residual value

Value in use

Settlement value

Replacement cost

Examples of variable items         

Property

Freehold land

Buildings

Leasehold improvements

Plant

Equipment

Equipment under finance lease

Investment property

Other intangible assets

Capitalised development items

Patents

Trademarks

Licences

Investments in associates

Joint ventures  

Available–for–sale investments  

Quoted and unquoted shares

Inventories

Raw materials

Work–in–progress

Finished goods

Foreign exchange

Commodities

Precious metals

Nicolaas Smith Copyright

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

Inflation

Inflation

Inflation is always and everywhere a monetary phenomenon.

Milton Friedman

              

Inflation is a sustained increase in the general price level of goods and services within an economy over a period of time. During inflation an entity pays more money for the same real value. Inflation is generally accepted to refer to annual inflation. All prices are normally quoted in terms of unstable money. During inflation each unit of the unstable monetary unit buys fewer goods and services. Inflation has no effect on the real value of non–monetary items.

                

Inflation erodes real value evenly in money and other monetary items. Under the Historical Cost paradigm under which the stable measuring unit assumption is implemented, there are, consequently, real hidden monetary costs to some and real hidden monetary benefits to others from this erosion in purchasing power in unstable monetary items that are assets to some while – a the same time – liabilities to others, e.g., the capital amount of a monetary loan. Under the HC paradigm the debtor generally gains during inflation since he, she or it (a company) has to pay back the nominal value of the loan, the real value of which is being eroded by inflation. The debtor pays back less real value during inflation. The creditor loses out because he, she or it receives the nominal value of the loan back, but, the real value paid back is lower as a result of inflation. Efficient lenders attempt to recover this loss in real value by charging interest at a rate they hope will be higher than the inflation rate during the period of the loan.

              

Capital inflation-indexed government bonds overcome this problem for lenders.

Nicolaas Smith

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

Measurement of variable items

Measurement of variable items

Measurement in the case of variable items is the process of determining the monetary amounts at which variable items are to be recognised, valued, carried and accounted on a daily basis in an economy under all levels of inflation and deflation. This involves the selection of particular bases of measurement.

Variable items are valued daily in terms of IFRS, excluding the stable measuring unit assumption, under financial capital maintenance in units of constant purchasing power (CIPPA). 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 CPI or a monetized daily indexed unit of account during low and high inflation and deflation and in terms of a daily hard currency parallel rate or Brazilian – style Unidade Real de Valor daily index rate during hyperinflation because there is no stable measuring unit assumption under financial capital maintenance in units of constant purchasing power at all levels of inflation and deflation (CIPPA).

Variable items in the non–monetary or real economy are valued at, for example, fair value or the lower of cost and net realizable value or recoverable value or market value or present value, etc. in terms of IFRS excluding the stable measuring unit assumption.

The real values of variable items exist independently of being valued at their original nominal Historical Cost values in terms of IFRS. Valuing a variable item at its original Historical Cost in fixed nominal monetary units during its entire lifetime does not erode its real value because it would be valued at its current market value whenever it is finally exchanged or sold in the future. Any variable item valued at HC, when not being revalued, would be continuously updated in terms of a Daily Consumer Price Index or other daily index rate since the stable measuring unit assumption is not applied under financial capital maintenance in units of constant purchasing power (CIPPA).

Originally all items in financial statements – monetary, variable and constant real value non–monetary items – were valued at Historical Cost before there were any GAAP, IAS or IFRS, since money – the monetary unit of account – was generally assumed to be stable in real value over time: the infamous stable measuring unit assumption. Today, the traditional Historical Cost Accounting model maintains this very erosive and very economically destabilizing assumption for the valuation of all income statement items, all balance sheet constant items and certain variable items, e.g., inventories which are measured at the lower of cost and net realisable value. Under financial capital maintenance in units of constant purchasing power (CIPPA) any item originally valued at HC in terms of IFRS (e.g. an inventory item) is then updated daily in terms of the Daily CPI or other daily index rate while it is not valued daily thereafter.

The IASB only makes a distinction between monetary and non–monetary items. The stable measuring unit assumption allows the IASB to side–step the split between variable real value non–monetary items and constant real value non–monetary items in the practical application of IFRS under the HC paradigm. Both constant and variable real value non-monetary items are however inferred in IFRS under the Constant Item Purchasing Power paradigm. Financial capital maintenance in units of constant purchasing power (CIPPA) as authorized in the original Framework, Par. 104 (a) is implemented under the CIPP paradigm.

Variable items may hold their values in terms of purchasing power under HCA as a result of the ways in which they are valued in terms of IFRS in which their nominal values are adjusted at the time of exchange or disposal to allow for the many factors that determine their real values – including inflation, deflation and hyperinflation. For example: fair value, market value, net realizable value, present value and recoverable value all adjust for inflation, deflation and hyperinflation – in the real value of the monetary unit – as part of the specific valuation process.

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 2006).

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 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 measured 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 has 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 generally does not result in financial capital maintenance in units of constant purchasing power during hyperinflation. That explains the complete failure of IAS 29 when it was implemented during hyperinflation in Zimbabwe. It did not manage to keep the Zimbabwe real economy relatively stable like daily measurement 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, values measured in terms the CPI cannot be determined. It was impossible to implement IAS 29 during severe hyperinflation in Zimbabwe.

The Zimbabwe government last published an official Zimbabwe dollar inflation index in July 2008. This, combined with the complexities of not having a stable currency due to the phenomenon described above, meant that there were severe limitations to accurate financial reporting in the period from August 2008. During this period the Institute of Chartered Accountants in Zimbabwe set up a technical subcommittee to address these challenges, as it was impossible to apply IAS 29 “Financial Reporting in Hyperinflationary Economies” without a general price index, or IAS 21 “Exchange Rates” without a single spot rate.

Whiley 2010

However, these constant items´ legal or contractual values (labour contracts, company registrations) do not disappear even when the accounting items – temporarily – cannot be valued. The companies act and labour laws governing labour contracts, etc. are still valid during hyperinflation, severe hyperinflation, monetary meltdown and thereafter. The accounting concept that the constant purchasing power of capital is equal to the real value of net assets always applies. Their legal or contractual constant real non–monetary values still exist even after monetary meltdown of only the local currency. They are valued in terms of IAS 1 in the opening balance sheet after monetary meltdown applying the principle that the constant purchasing power of capital is equal to the real value of net assets.

The IASB authorized an addition to IAS 1 in 2011 to allow for the fair value valuation of non–monetary 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 sheets of companies after the monetary meltdown in Zimbabwe in 2008.

No exchangeability with any relatively stable foreign currency means no exchange rate 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 (only local currency money and only other monetary items stated in the local currency) has no value. This does not include any non-monetary item, variable or constant real value non-monetary item.

Nicolaas Smith

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

Non–monetary real value does not disappear with a monetary meltdown

Non–monetary real value does not disappear with a monetary meltdown

Only ZimDollars and other monetary items (loans, etc.) expressed in the ZimDollar had no value after the monetary meltdown. The real values of all non–monetary items (variable and constant real value non–monetary items) still existed after the monetary meltdown while the real value of ZimDollar money and monetary items terminated. All non–monetary items (constant and variable items) still had economic real values despite the lack of a CPI and despite the monetary meltdown of the ZimDollar.

Variable items, e.g., finished goods for sale, are generally valued in terms of the daily US Dollar parallel rate during hyperinflation. A variable item is sold at a lower price when a seller does not know the current street rate and sells it at the previous level of the parallel rate. This unnecessary real loss is not caused by the implementation of the stable measuring unit assumption. The seller did not assume the local hyperinflationary currency was stable in real value. The seller was simply not properly informed regarding the current level of the daily US Dollar parallel rate at the time of the sale.

Finished goods and all other variable real value non–monetary items still exist after monetary meltdown. They are then priced / valued / measured at fair value in terms of IAS 1 in the opening balance sheet in the new relatively stable currency adopted as the functional currency after monetary meltdown.

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 2006).

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 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 measured 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 has 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 generally does not result in financial capital maintenance in units of constant purchasing power during hyperinflation. That explains the complete failure of IAS 29 when it was implemented during hyperinflation in Zimbabwe. It did not manage to keep the Zimbabwe real economy relatively stable like daily measurement 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, values measured in terms the CPI cannot be determined. It was impossible to implement IAS 29 during severe hyperinflation in Zimbabwe.

The Zimbabwe government last published an official Zimbabwe dollar inflation index in July 2008. This, combined with the complexities of not having a stable currency due to the phenomenon described above, meant that there were severe limitations to accurate financial reporting in the period from August 2008. During this period the Institute of Chartered Accountants in Zimbabwe set up a technical subcommittee to address these challenges, as it was impossible to apply IAS 29

“Financial Reporting in Hyperinflationary Economies” without a general price index, or IAS 21 “Exchange Rates” without a single spot rate.

Whiley 2010

However, these constant items´ legal or contractual values (labour contracts, company registrations) do not disappear even when the accounting items – temporarily – cannot be valued. The companies act and labour laws governing labour contracts, etc. are still valid during hyperinflation, severe hyperinflation, monetary meltdown and thereafter. The accounting concept that the constant purchasing power of capital is equal to the real value of net assets always applies. Their legal or contractual constant real non–monetary values still exist even after monetary meltdown of only the local currency. They are valued in terms of IAS 1 in the opening balance sheet after monetary meltdown applying the principle that the constant purchasing power of capital is equal to the real value of net assets.

The IASB authorized an addition to IAS 1 in 2011 to allow for the fair value valuation of non–monetary 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 sheets of companies after the monetary meltdown in Zimbabwe in 2008.

No exchangeability with any relatively stable foreign currency means no exchange rate 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 (only local currency money and only other monetary items stated in the local currency) has no value. This does not include any non-monetary item, variable or constant real value non-monetary item.

Nicolaas Smith

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

Hyperinflation has no effect on the real value of non–monetary items

Hyperinflation has no effect on the real value of non–monetary items

Hyperinflation only erodes the real value of the monetary unit extremely rapidly. Hyperinflation has no effect on the real value of non–monetary items. All non–monetary items (variable and constant real value non–monetary items) maintain their real values during hyperinflation when they are measured in units of constant purchasing power daily in terms of a daily parallel rate (a black market or street rate) normally the daily official or unofficial US Dollar or other unofficial hard currency parallel exchange rate or an official Brazilian–style daily URV non–monetary index normally almost totally based on the daily US Dollar exchange rate as Brazil did during 30 years of very high and hyperinflation.

The stable measuring unit assumption (HCA) – not hyperinflation – unknowingly, unnecessarily and unintentionally erodes the real value of constant real value non–monetary items not maintained constant as fast as hyperinflation erodes the real value of the local currency and other monetary items, e.g., loans stated in the local currency, because all economic items (monetary, variable and constant items) in the hyperinflationary economy are measured in terms of the hyperinflationary monetary unit. A monetary meltdown erodes all real value only in the monetary economy; i.e., in the local currency money supply.

Hyperinflation is not always stopped with first a period of severe hyperinflation in the final stage and then a complete monetary meltdown. Hyperinflation was successfully overcome by various countries, e.g., Turkey, Brazil and Angola, without dollarization or a monetary meltdown.

Brazil actually grew their non–monetary economy in real value during 30 years of very high and hyperinflation of up to 2000 per cent per annum from 1964 to 1994 and never had severe hyperinflation followed by a complete monetary meltdown at the end. Brazil stopped its hyperinflation with the Real Plan in 1994. Brazil managed to have years of positive Gross Domestic Product growth during those 30 years of very high and hyperinflation because the various governments during those three decades supplied the population with a daily non–monetary index based almost entirely on the daily US Dollar exchange rate with their monetary unit. It was used to update most non–monetary items (variable and constant real value non–monetary items), e.g., goods, services, equity, trade debtors, trade creditors, salaries payable, wages payable, taxes payable, etc., in the hyperinflationary economy daily.

Brazil would not have been able to maintain its non–monetary or real economy relatively stable with actual real GDP growth during hyperinflation if it had applied restatement of HC or CC financial statements in terms of the period–end monthly published CPI as required in IAS 29 Financial Reporting in Hyperinflationary Economies during that period. IAS 29 does not require continuous daily measurement of all non–monetary items in terms of a daily index during hyperinflation. IAS 29 does not require continuous daily updating of all non-monetary items in terms of the US Dollar parallel rate or a Brazilian–style URV daily index rate. IAS 29 simply requires restatement of Historical Cost and Current Cost financial statements during hyperinflation applying the monthly Consumer Price Index at the end of the reporting period (monthly, quarterly, six monthly or annual) – generally available a month or two months after the current month – to make these financial statements more useful. It is not the intention of IAS 29 to, and in its current form it cannot, stop the continuous daily rapid erosion of the real value of constant real value non–monetary items never maintained constant as Brazil did for 30 years of high and hyperinflation generating positive economic growth.

This daily very rapid erosion of constant real value non-monetary items never maintained constant is caused, not by hyperinflation, but, by the implementation of the stable measuring unit assumption (HCA) during hyperinflation. Applying the monthly CPI a month or two months after the current month is very ineffective during hyperinflation as far as the constant real non–monetary value of salaries, wages, rentals, equity, trade debtors, trade creditors, etc., positive economic growth, economic stability in the real or non–monetary economy, the maintenance of internal demand and the continuous daily maintenance of the real value of all non–monetary items during hyperinflation are concerned. All non–monetary items (variable and constant items) have to be updated daily in terms of the parallel US Dollar rate or a Brazilian–style URV daily index rate in order to maintain the real economy relatively stable during hyperinflation in the local currency monetary unit. That would be financial capital maintenance in units of constant purchasing power (CIPPA) during hyperinflation.

When the stable measuring unit assumption is implemented under HCA or financial capital maintenance in nominal monetary units also originally authorized in IFRS in the Framework (1989), Par. 104 (a), it is assumed, in practice, that there was, is and never ever will be inflation, deflation or hyperinflation as far as the valuation of constant real value non–monetary items are concerned. It is assumed, in principle, that money was, is and will always in the future be perfectly stable at all levels of inflation, hyperinflation and deflation.

Various accounting authorities are requesting a fundamental review of IAS 29. See IFRS X Capital Maintenance in Units of Constant PurchasingPower.  

David Mosso state:

Neither IFRS 29 nor FAS 89 is complete in the sense of a single authoritative standard.

Mosso 2011

Severe hyperinflation is defined by the IASB as a period at the end of completely uncontrolled hyperinflation when exchangeability between the hyperinflationary monetary unit and most relatively stable foreign currencies does not exist. The wording of the IASB definition thus confirms that at least one exchangeability has to exist for prices to be established in the hyperinflationary monetary unit; i.e., for severe hyperinflation to exist. Severe hyperinflation is only present when there is still exchangeability with at least one relatively stable foreign currency in order for prices to continue to be set in the hyperinflationary monetary unit in terms of this final exchangeability. The one exchange rate that lasted till the end of severe hyperinflation in Zimbabwe was the Old Mutual Implied Rate (OMIR).

The ratio of the Old Mutual share price in Harare to that in London equals the Zimbabwe dollar/sterling exchange rate.

Hanke and Kwok 2009: 8

Hyperinflation (severe or not) stops the moment exchangeability between the local hyperinflationary currency and all foreign currencies does not exist.

Zimbabwe’s hyperinflation came to an abrupt halt. The trigger was an intervention by the Reserve Bank of Zimbabwe. On November 20, 2008, the Reserve Bank’s governor, Dr. Gideon Gono, stated that the entire economy was “being priced via the Old Mutual rate whose share price movements had no relationship with economic fundamentals, let alone actual corporate performance of Old Mutual itself” (Gono 2008: 7–8). In consequence, the Reserve Bank issued regulations that forced the Zimbabwe Stock Exchange to shut down. This event rapidly cascaded into a termination of all forms of non–cash foreign exchange trading and an accelerated death spiral for the Zimbabwe dollar. Within weeks the entire economy spontaneously “dollarized” and prices stabilized.

Hanke and Kwok 2009: 9–10

There was severe hyperinflation in Zimbabwe while there was exchangeability (prices could still be set in the ZimDollar) with at least one relatively stable foreign currency – the British Pound in this case as it was made possible via the OMIR. When this last exchangeability stopped it was not possible to set prices in the ZimDollar anymore and severe hyperinflation stopped: no exchangeability means no hyperinflation. That was a monetary meltdown. The entire ZimDollar money supply had no value as from that date on.

Nicolaas Smith

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

Monetary meltdown

Monetary meltdown

A monetary meltdown takes place when a hyperinflationary local currency monetary unit stops having exchangeability with all foreign currencies, normally after first a period of hyperinflation and then a period of severe hyperinflation. It happened in Zimbabwe on 20 November 2008.

The monetary economy (the total real value of the fiat money supply) can disappear completely from one day to the next. It happened three times during three months towards the end of hyperinflation in Yugoslavia. It happened at the end of hyperinflation in Zimbabwe in 2008, terminating severe hyperinflation in that country. Zimbabwe did not try hyperinflation again like Yugoslavia which has the distinction of having wiped out the real value of its entire monetary economy three times in three months. In Zimbabwe the economy dollarized spontaneously after a decision by the Reserve Bank of Zimbabwe to close the Zimbabwe Stock Exchange. That stopped the Old Mutual Implied Rate being the final exchange rate of the Zimbabwe Dollar with a foreign currency: the British Pound.

The Zimbabwean economy dollarized spontaneously after that because it was a sufficiently open economy right next to the stable South African, Botswana and other stable economies in the Southern Africa region. Those stable economies supplied the Zimbabwean economy with essential goods and services during and after hyperinflation.  Zimbabwe then had the opportunity to slowly recover from total monetary meltdown and the devastating effect of implementing the very erosive stable measuring unit assumption – the Historical Cost Accounting model – during hyperinflation as supported by the IASB and Big Four accounting firms like PricewaterhouseCoopers.. The implementation of the HCA model during hyperinflation is mistakenly accepted in International Financial Reporting Standards and mistakenly supported by Big Four accounting firms like PricewaterhouseCoopers. Zimbabwe spontaneously adopted a multi–currency dollarization model using the US Dollar, the Euro, the South African Rand, the British Pound and the Botswana Pula as relatively stable foreign currencies in the Zimbabwean economy in 2008.

The variable real value non–monetary item economy (fixed assets, land, property, plant, equipment, inventory, etc.) cannot disappear completely from the one day to the next because of wrong monetary policies. ‘Inflation is always and everywhere a monetary phenomenon.’ Inflation and hyperinflation have no effect on the real value of non–monetary items. After monetary meltdown in Zimbabwe the fixed assets, land, properties, plant, equipment, raw materials, finished goods, etc., were still there. The variable item economy can be destroyed by natural disasters like earth quakes and tsunamis and by man–made events like war, but not by hyperinflation.

The constant item economy (owners´ equity, trade debtors, trade creditors, salaries, wages, rentals, etc.) also cannot be eroded by inflation and hyperinflation because inflation and hyperinflation have no effect on the real value of non–monetary items – both variable and constant real value non–monetary items. However, the very erosive stable measuring unit assumption (i.e., the HCA model or financial capital maintenance in nominal monetary units during inflation and hyperinflation) erodes the constant real non–monetary value of constant items not maintained constant during inflation and hyperinflation, e.g., trade debtors, trade creditors, salaries, wages, rentals, that portion of shareholder´s equity never maintained constant by the real value of net assets under HCA, all other non–monetary payables and receivables, etc., at a rate equal to the annual rate of inflation or hyperinflation.

Severe hyperinflation is the final stage of a devastating hyperinflationary spiral only in the local currency monetary unit with a continuously super–increasing rate of hyperinflation reaching millions per cent per annum when exchangeability of the hyperinflationary monetary unit becomes limited to very few or just one single relatively stable foreign currency.

Hyperinflation and severe hyperinflation need exchangeability with at least on foreign currency. With no exchangeability there is no local currency and no hyperinflation, in this case, no severe hyperinflation.

The real value of the entire money supply can be eliminated like in the case of the Zimbabwe Dollar on 20 November, 2008, not as a result of hyperinflation, but as a result of a monetary meltdown after a period of severe hyperinflation.

As of 14 November 2008, Zimbabwe’s annual inflation rate was 89.7 Sextillion per cent (89,700,000,000,000,000,000,000%).

Hanke 2010

In Zimbabwe the Zimbabwe Dollar finally had exchangeability only with the British Pound via the Old Mutual Implied Rate (OMIR) as derived from continued trade in Old Mutual shares on the Zimbabwe Stock Exchange even during severe hyperinflation. A monetary meltdown took place in Zimbabwe on 20 November, 2008 when the ZSE was closed by government regulation and the Zimbabwe Dollar stopped having exchangeability with the British Pound (the last foreign currency it had exchangeability with) via the OMIR.

Nicolaas Smith

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

Valuing monetary items during hyperinflation

Valuing monetary items during hyperinflation

Monetary items are valued at their nominal monetary HC values during the current accounting period under HCA during hyperinflation too. The real value of money and other monetary items is eroded at the rate of hyperinflation which can be anything from 100 per cent per over three years (i.e., 26 per cent per annum for three years in a row) to 89.7 Sextillion per cent (89,700,000,000,000,000,000,000 per cent) in the case of Zimbabwe in 2008. (Hanke 2010)

Net monetary losses and gains have to be calculated and accounted during hyperinflation as required by IAS 29 Financial Reporting in Hyperinflationary Economies under HCA. IAS 29 is an extension to and not a departure from HCA. This is in total contradiction to what is done during low inflation under HCA.

The net monetary loss or gain from holding net monetary item assets or net monetary item liabilities has to be calculated and accounted during hyperinflation under HCA in terms of IAS 29, but not during low inflation of up to, for example, 15 per cent per annum.

Hyperinflation is defined by the IASB as 100 per cent cumulative inflation over three years. That is 26 per cent annual inflation for three years in a row. At 26 per cent annual inflation for three years in a row companies have to calculate and account the cost of hyperinflation and write it off against profit, but, not at 15 per cent or 6 per cent inflation. At 22 per cent annual inflation for three years or 81.6 per cent cumulative inflation over three years an economy would not be in hyperinflation. However, 81.6 per cent of the real value of the monetary unit, all other monetary items as well as the real value of all constant items not maintained constant (treated as monetary items) of  listed and unlisted companies would be wiped out over the short period of three years. The economy would not be in hyperinflation and the HCA model would be implemented.

SA, for example, had been going along at 12 per cent average annual inflation or 40 per cent cumulative inflation over three years for at least the last 15 years before 2000, continuously implementing the HCA model.

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 when the economy changes over from inflation to 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:

Comité de Normalisation Obligataire 2011: 15  CNO_Indexed_Bonds_-Final_15.7.2011-2-2.pdf

This normally 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 capital deflation-indexed bonds during deflation, i.e., they are real constant real 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.

Comité de Normalisation Obligataire 2011: 15   CNO_Indexed_Bonds_-Final_15.7.2011-2-2.pdf

     

Nicolaas Smith

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