Measurement in units of constant purchasing power excluded from IASB and FASB measurement bases list

Measurement in units of constant purchasing power excluded from IASB and FASB measurement bases list

The FASB and IASB spent several years discussing measurement around the world during the Measurement Chapter of their Joint Conceptual Framework Project.

After several years of discussions around the world they published the following joint list of possible basic measurement bases:

MeasurementBases

"The Boards agreed to the following set of nine measurement basis candidates:

1. Past entry price

2. Past exit price

3. Modified past amount

4. Current entry price

5. Current exit price

6. Current equilibrium price

7. Value in use

8. Future entry price

9. Future exit price.”

It can be seen from the above FASB and IASB list that neither

(i)                  measurement (of monetary items) in terms of the Daily Consumer Price Index nor

(ii)                 measurement in units of constant purchasing power

are considered by both the FASB and the IASB as possible basic measurement bases to be included on their list.

Measurement in units of constant purchasing power is thus currently (2012) excluded as a possible basic measurement basis by both the FASB and IASB.

It is to be noted that financial capital maintenance in units of constant purchasing power as an alternative to HCA (see above) automatically maintains the existing constant purchasing power of capital constant for an indefinite period of time in all entities that at least break even in real value – ceteris paribus – at all levels of inflation and deflation.

The omission of measurement in units of constant purchasing power from the FASB´s and IASB´s joint list of possible basic measurement bases is thus noted with concern. It is difficult to come up with a plausible explanation why both the FASB and the IASB exclude measurement in units of constant purchasing power as a possible basic measurement basis.

The fact that financial capital maintenance in units of constant purchasing power is authorized in IFRS in the Framework since 1989 would normally result in it automatically being included in a list of possible basic measurement bases. However, after several years of international discussion both the FASB and IASB do not regard measurement in units of constant purchasing power as a possible basic measurement basis.

A healthy and robust discussion and publication of different viewpoints and research are good for the ongoing development of the understanding of the basic concepts of accounting / financial reporting at the FASB, IASB and elsewhere.

However, excluding measurement in units of constant purhasing power from the current (2012) list of possible basic measurement bases is not compatible with the development of high quality international accounting standards.

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FORGET INFLATION!?

FORGET INFLATION!?

MONETARY ITEMS

Definition

Monetary items are units of local currency held and items with an underlying monetary nature being substitutes of the former.

MEASUREMENT BASIS

The measurement basis used to measure monetary items over time under financial capital maintenance in units of constant purchasing power as authorized in IFRS in the Conceptual Framework (2010), Par. 4.59 (a) is the following:

Measurement in terms of the Daily Consumer Price Index.

This requires the calculation and accounting of net monetary losses and gains only while third party entities you deal with still implement Historical Cost Accounting and apply the stable measuring unit assumption.

ADVANTAGE OF DAILY INFLATION-ADJUSTMENT OF ALL MONETARY ITEMS

Inflation-adjustment on a daily basis of the entire money supply under full co-ordination will eliminate the entire cost of inflation (not actual inflation) from the entire economy. In practice (maybe in 100 years´ time) this will result in no-one being concerned about the actual rate of inflation since monetary item balances will maintain their real values over time.

Chile currently (2012) inflation-adjusts 20 to 25 per cent of its entire broad M3 money supply on a daily basis in terms of their Unidad de Fomento which is a monetized daily indexed unit of account used in the country since 1967 according to the Central Bank of Chile.

At least USD 3 trillion is currently (2012) being inflation-adjusted on a daily basis in terms of country-specific Daily Consumer Price Indices in the world economy. USD 798 billion is today (29-07-2012)  being inflation-adjusted on a daily basis in terms of the US Daily CPI in the US economy.

Yes, under complete inflation-adjustment of the entire money supply with complete co-ordination (everyone doing it) we can forget about inflation. Unfortunately that may only happen in 100 years´ time.

We are still a long way away from that. However, I have no doubt that it will happen one day.

We had a form of it in Angola in 1996 in Auto-Sueco (Angola), the company where I worked. We had it during hyperinflation of 3200 per cent per annum because I implemented accounting-dollarization as from 1 January 1996 in the company. We updated all our trade debtors, new car, new truck, spare parts prices and workshop service rates daily in term of the daily US Dollar black market or parallel rate.

We stopped our fear of hyperinflation with daily updating of all non-monetary items.

Low inflation countries can do the same with daily inflation-adjusting the entire money supply and the implementation of financial capital maintenance in units of constant purchasing power in terms of a Daily CPI as authorized in IFRS.

This will take a very long time to come about, but I am sure we will all eventually do it.

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IASB unanimously support a research programme on financial reporting in high-inflation and hyperinflationary economies

IASB unanimously support a research programme on financial reporting in high-inflation and hyperinflationary economies

At its May 2012 meeting the International Accounting Standards Board unanimously supported initiating a research programme focusing initially on, amongst other items, financial reporting in high-inflation and hyperinflationary economies.

This is an important decision as far as financial capital maintenance in units of constant purchasing power (Constant Item Purchasing Power Accounting which is implemented   at all levels of inflation and deflation) is concerned.

In the 2011 Agenda Consultation comment letter request document the IASB stated the following:

‘Inflation accounting (revisions to IAS 29 Financial Reporting in Hyperinflationary Economies)

IAS 29 provides guidance on the preparation of financial statements in a functional currency that is suffering from hyperinflation.  Concerns have been raised from some countries whose economies suffer from high inflation, but which are not hyperinflationary. Those concerns are that the effects of high inflation on an entity’s financial results are not adequately reflected in IFRS financial statements. A research paper was prepared on this issue and submitted to the IASB by the Federación Argentina de Consejos Profesionales de Ciencias Económicas. A future project could use this research paper to consider revisions to IAS 29 to include guidance for entities whose functional currency is that of an economy subject to high inflation, but not to hyperinflation.’

The Federación Argentina de Consejos Profesionales de Ciencias Económicas submitted a research report to the IASB in 2010 entitled IFRS ‘X’ INFLATION.  The IASB made the FACPCE´s reseach report available to me on my request.

In an unsolicited comment letter in Jan 2012 I pointed out to the IASB that inflation has no effect on the real value of non-monetary items and I comprehensively amended the FACPCE´s proposal to IFRS ‘X’ CAPITAL MAINTENANCE IN UNITS OF CONSTANT PURCHASING POWER.

Both IFRS X’ INFLATION and the amended version IFRS ‘X’ CAPITAL MAINTENANCE IN UNITS OF CONSTANT PURCHASING POWER are available in full in the ebook CONSTANT ITEM PURCHASING POWER ACCOUNTING per IFRS here.

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Acknowledgements

I wish to thank the following people and entities for helping me in this project either directly or indirectly:

David Mosso, Vice Chairman (retired) at the Financial Accounting Standards Board (1978-1987) and Chairman (retired) at the US Federal Accounting Standards Advisory Board (1997-2006) for reading an abstract of my work and for his comment: ‘Good work.’

Prof. Robert Shiller from Yale University for his clarifications to me regarding the formula for calculating the Unidad de Fomento in Chile.

Prof. Rachel Baskerville from The School of Accounting and Commercial Law at the Victoria University in Wellington, New Zealand for taking the time in 2010 to confirm the authorization of a third concept of capital maintenance in IFRS with her colleague Prof. Kevin Simpkins, the Chairman of the New Zealand Accounting Standards Review Board and for her statement: ‘‘There is much to be gained from moving away from reporting on the basis Financial Capital Maintenance in Nominal Monetary Units.’

Sir David Tweedie, Ex-Chairman of the International Accounting Standards Board, and Prof. Geoffrey Whittington, ex-member of the IASB, for their valued input in 2005 regarding that year’s version of the manuscript.

The South African Institute of Chartered Accountants for their valued exchange of ideas regarding the project in 2008.

Prof. Geoff Everingham, Emeritus Professor of Accounting at the University of Cape Town, for his valued exchange of ideas regarding the project in 2008.

Without SAICA´s and Prof. Everingham’s input in 2008 the project would not be where it is today.

Prof. Steve Hanke from the Cato Institute and John Hopkins University for his detailed assistance regarding currency boards to me prior to 2005 and his assistance with the definition of severe hyperinflation more recently.

Dr Gustavo Franco, Ex-Governor of the Banco Central do Brazil for his contribution to confirm that trade debtors and trade creditors are non-monetary items which have to be measured in units of constant purchasing power during inflation and hyperinflation.

Ron Lott, FASB Research Director and Kevin McBeth, FASB Project Manager for clearing up my doubts regarding the treatment of capital maintenance during the IASB and FASB´s Joint Conceptual Framework Project.

Dr Cemal KUCUKSOZEN, the Ex-Head of the Accounting Standards Department at the Capital Markets Board of Turkey in Ankara, for reading the 2005 version of the manuscript and for his comments including: ‘Theoretically, I totally agree with you. But, as you know, there is a trend towards acceptance of International Accounting Standards and IFRS issued by the IASB all over the world. In this regard, we can change over to Real Value Accounting when there is a change in IAS / IFRS toward Real Value Accounting or there is a trend toward Real Value Accounting all over the world.’ Constant Item Purchasing Power Accounting was called Real Value Accounting in 2005.

Prof. Dr Aylin POROY ARSOY from the Uludag University in Turkey for her information regarding her article where she and Prof. Dr Umit GUCENME state in 2005 that inflation has no effect on the real value of non-monetary items.

Dr Fermín del Valle, Chairman of the Special Commission created by the Federación Argentina de Consejos Profesionales de Ciencias Económicas (FACPCE) in 2009, for making FACPCE´s 2010 research paper to the IASB regarding the replacement of IAS 29 available to me in 2012.

Prof. Stephen Zeff from Rice University for his detailed assistance with inflation accounting to me in 2008.

The Canadian Institute of Chartered Accountants for providing copies of IAS 6 and IAS 15.

April Pitman, Technical Manager at the IASB for liaising with FACPCE regarding my access to their 2010 research paper.

Graham Terry, Vice President at The South African Institute of Chartered Accountants for his assistance in getting my article Financial Statements, Inflation & The Audit Report published in Accounting SA, SAICA´s accounting journal, in 2007.

Riana Julies, editor at Accounting SA, SAICA´s accounting journal for publishing my article Financial Statements, Inflation & the Audit Report in 2007 after I initially stated that I doubted very much that it would be published.

Prof. Ignacio Rodríguez from the Escuela de Administración, Pontificia Universidad Católica de Chile for clarifying the use of the Unidad de Fomento in Chile to me in 2011.

Prof. Ignacio Velez-Pareja from the Universidad Tecnologica de Bolivar, Department of Finance and International Business in Colombia for his extensive discussions with me in 2009 regarding the effect of inflation.

Robert Burgess, Resident IMF Representative in South Africa in 2007 and Norbert Funke from the IMF for their assistance in dealing with my questions regarding stabilization programs in high inflation situations during Zimbabwe’s hyperinflation.

Miguel Octavio, the owner of the Venezuelan blog The Devil’s Excrement and the commentators on his blog for sharing their experience of hyperinflation under President Hugo Chávez in Venezuela.

Banco Central de Chile for supplying me with detail of the extent of daily inflation-adjustment of the money supply in Chile.

Banco Central do Brasil for supplying me with detail regarding daily indexing of non-monetary items during 30 years of hyperinflation in Brazil.

Statistics South Africa for clarifications to me regarding the CPI in South Africa.

Motley Fool, the owner of the Fool’s Paradise blog for bringing the Unidad de Fomento to my attention in 2011.

Newzimbabwe.com Forum members for sharing with me the daily developments during the last two years of Zimbabwe’s period of hyperinflation under President Robert Mugabe and Gideon Gono, governor of the Reserve Bank of Zimbabwe.

Terry Clague, Publisher for Business, Management & Accounting books at Routledge Publishers for his assistance in my attempt to get published and his comment: ‘The quality of the book is not in question.’

Jonathan Norman, Publisher at Gower Publishing for his role in my attempt to get published and his comment: ‘You make a convincing case for the book.’

Juta Academic Publishers in Cape Town for offering me a publishing contract in 2005. Unfortunately we could not agree on terms at the time.

Harriet, my daughter, for her enduring support for the project.

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

Preface - Part 1

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I developed the theoretical basis for Constant Item Purchasing Power Accounting (CIPPA) over the last 16 years since I worked in Angola’s hyperinflationary economy from 1994 to 1997. This project started in Angola’s hyperinflationary economy in 1996. I went to Angola from Portugal in October, 1994 to work at Auto-Sueco (Angola), the Volvo distributor in that country. After 15 months of living and working in a hyperinflationary economy and being responsible for the financial reporting in the company, I convinced Mr Tomáz Jervell, the President of Auto-Sueco, our holding company in Portugal, that I should do our accounting in Angola in US Dollars as from 1 January, 1996. I started writing the book in 1996 about how I accounting-dollarized our daily business operations and daily accounting in Luanda.

The book had many major revisions during the last 16 years. The first title was Zero Inflation. Other titles included Real Value, Maintaining the Wealth of Nations and RealValueAccounting.Com. I think the basic concepts will not change much as from 2012.

The book is the result of my research regarding the effects of the stable measuring unit assumption in accounting and the economy. I first wrote everything about Constant Item Purchasing Power Accounting, including the name.

I realized very early on that measurement in units of constant purchasing power should be used at all levels of inflation and deflation. I identified the split of non-monetary items in variable and constant items by 2005 which made the use of the CIPPA model acceptable to the accounting profession and business community during low and high inflation and deflation. I only realized that it is not inflation but the stable measuring unit assumption eroding companies´ capital and invested profits during 2009.

I named the model Constant Item Purchasing Power Accounting because (a) I identified the split of non-monetary items in variable and constant items and (b) to differentiate CIPPA from the inflation accounting model Constant Purchasing Power Accounting (CPPA) required by International Accounting Standard IAS 29 Financial Reporting in Hyperinflationary Economies only during hyperinflation.  CIPPA is used at all levels of inflation and deflation.

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CONSTANT ITEM PURCHASING POWER ACCOUNTING per IFRS 

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Measurement of constant items

Measurement of constant items

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1 Definition 

A constant item is a non-monetary item with a constant real value over time that is not generally determined in a market on a daily basis within an entity.

Constant real value non-monetary items are fixed in terms of real value while their nominal values change daily in terms of a Daily CPI or other daily index under financial capital maintenance in units of constant purchasing power (CIPPA).

2 Measurement

Measurement of constant items is the generally accepted accounting practice of determining the monetary amounts at which constant items are to be recognised, valued, carried and accounted on a daily basis in the economy under all levels of inflation and deflation. This involves the selection of the particular basis of measurement. Constant items can only be measured in units of constant purchasing power during inflation and deflation because the stable measuring unit assumption is not applied in their measurement. Constant items are always and everywhere valued in terms of IFRS in units of constant purchasing power by applying the Daily CPI or a monetized daily indexed unit of account at the current (today’s) rate under financial capital maintenance in units of constant purchasing power (CIPPA) during low and high inflation and deflation. Constant items would always and everywhere be valued on a daily basis in terms of a relatively stable foreign currency parallel rate or a Brazilian-style Unidade Real de Valor index rate during hyperinflation.

Financial capital maintenance in nominal monetary units (HCA) and its IFRS–authorized alternative – financial capital maintenance in units of constant purchasing power (CIPPA) – would be one and the same accounting model at permanently sustainable zero inflation. This is proof that financial capital maintenance in units of constant purchasing power (CIPPA) is the logical next step in our fundamental model of accounting.

The IASB defined monetary items in IAS 29 incorrectly as money on hand and items to be paid in money or to be received in money. Most variable real value non–monetary items as well as constant real value non–monetary items are generally received or paid in money as the generally accepted monetary medium of exchange. The fact that the IASB defines non–monetary items as all items in the income statement and all other assets and liabilities in the balance sheet that are not monetary items, after having defined monetary items incorrectly, leads to the wrong classification of some constant real value non–monetary items, notably trade debtors and trade creditors, as monetary items by, for example, PricewaterhouseCoopers in their publication Understanding IAS 29. This results in the net monetary gain or loss generally being calculated incorrectly by companies implementing IAS 29 in hyperinflationary economies.

The definition of non–monetary items as being all items that are not monetary items is a generic definition. It is thus premised by the IASB that there are only two fundamentally distinct items in the economy: monetary and non–monetary items and that the economy is divided into two parts: the monetary and non–monetary economy. IAS 29 and other IFRS are based on this premise of only two fundamentally different items in the economy. This is a false premise.

It is not true that there are only two basic economic items as defined in IFRS. There are three fundamentally different basic economic items in the economy:

1 Monetary items

2 Variable real value non–monetary items

3 Constant real value non–monetary items

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Foreign exchange is not a monetary item

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A foreign currency is not a monetary item since its real value is not affected by local inflation and deflation. A unit of foreign currency is not a monetary item in the local economy because it is not a unit of local currency held or an item with an underlying monetary nature being a substitute for a unit of internal currency held in the local economy.

Money has three functions:

1 Unstable medium of exchange

2 Unstable store of value

3 Unstable unit of account

The local currency is the monetary unit in the local economy. A foreign currency like the US Dollar or the Euro is generally a medium of exchange in any economy outside the US and the European Monetary Union, respectively. Most businesses and individuals would accept the US Dollar or the Euro as a means of payment; that is, as a medium of exchange because they normally can easily exchange the foreign currency amounts they would receive in transactions at their local banks for local currency.

A relatively stable foreign currency is also a store of value in a foreign economy. The US Dollar and the Euro are foreign currencies with daily changing market values in economies outside the US and the EMU respectively. They are generally accepted world–wide as a relatively stable store of value. People know there are normal daily small changes in their foreign exchange values.

The USD and the Euro are, however, not national units of account in non-dollarized economies outside the US and EMU, respectively. You do not normally do your accounting in US Dollars or Euros for tax purposes during low inflation and deflation in non-dollarized economies outside the US and EMU, respectively. You normally do your accounting in local currency values during low inflation and deflation in non-dollarized economies. The USD and the Euro are not functional currencies in non-dollarized economies outside the US and EMU, respectively. A foreign currency like the USD or the Euro is only a medium of exchange and a store of value in non-dollarized economies outside the US and EMU, respectively. Their real values are not affected by local inflation outside the US and EMU, respectively. They are not monetary items in non-dollarized economies outside the US and EMU, respectively.

Foreign currencies are variable real value non–monetary items. They have variable real values which are determined in the foreign exchange markets daily.

The US Dollar, for example, is only a functional currency outside the United States of America in countries like Ecuador, Panama and Zimbabwe which have dollarized their economies. They use the US Dollar as their functional currency. They do not have their own local currencies.

It just appears very strange to say that the US Dollar or the Euro is not a monetary item in SA, for example. Theoretically speaking that is correct because an economic item is only a monetary item in a non–dollarized economy when it is affected by local inflation. The Euro is only a monetary item within the European Monetary Union (EMU) and the USD is only a monetary item within the US economy. The real value of the US Dollar in the US is only affected by US inflation.

The man and woman in the street, however, regard anything that is a medium of exchange as ‘money’ in very limited applications. Cigarettes are often used as a medium of exchange in prisons. Shells have been used way back in history as a medium of exchange.

The man and woman in the street in SA certainly regard the USD and the Euro as money in SA. Foreign exchange would be classified within the SA economy as a variable real value non–monetary item stated at its current market value (today) and not the same as the SA Rand, that is, not as a monetary item under financial capital maintenance in units of constant purchasing power (CIPPA).

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Valuing variable items at HC does not erode their real values

Valuing variable items at HC does not erode their real values

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The real values of variable items are not eroded by the stable measuring unit assumption when entities value these items at their original nominal HC values before the date that they are actually sold or exchanged during inflation and deflation. They would be valued at their current market values on the date of exchange or sale in an open economy. During hyperinflation all non–monetary items (variable and constant real value non–monetary items) are required to be restated in terms of IAS 29 to make these restated HC or Current Cost period–end financial reports – supposedly – more useful by applying the period–end monthly published CPI. A hard currency parallel rate – normally the US Dollar parallel rate – or a Brazilian–style URV daily index is applied on a daily basis when a country wishes to stabilize its real economy during hyperinflation.

Variable items´, e.g., land and buildings´, real values are not being unknowingly eroded by the HCA model as a result of the implementation of IFRS since they exist independently of how we value them. Entities can value land and buildings in the balance sheet at their historical cost 50 years ago, but, when these assets are sold in the market today they would be transacted at the current market price in an open market. The real values of variable items are also not being eroded uniformly at, e.g., a rate equal to the annual inflation rate because of valuing them at original nominal HC. Inflation has no effect on the real value of non–monetary items.

Where real losses are made in dealing with variable items in the economy, these losses are the result of supply and demand or business or private decisions, e.g., selling at a bad price, obsolescence, stock market crashes, credit crunches, other impairments, etc. They do not result from the implementation of the HC accounting model. These losses and impairments are treated in terms of IFRS.

A house is a variable real value non–monetary item. Let us assume a house in Port Elizabeth, South Africa is fairly valued in the PE market at say R 2 million on 1 January in year one. With no change in the market a year later but with annual inflation at 6 per cent in SA, the seller would increase his or her price to R2.12 million – all else being equal. The house’s real value remained the same. The depreciating monetary value of the house expressed in the depreciating Rand medium of exchange – all else being equal – was updated to compensate for the erosion of the real value of the depreciating Rand in the internal SA market by 6 per cent annual inflation. It is clear that inflation does not affect the house’s variable non–monetary real value – all else being equal.

However much inflation rises, it can only erode the SA Rind’s real value at a higher rate and over a shorter period of time. As inflation rises the price of the house would rise to keep pace with inflation or value erosion in the real value of the Rand – all else being equal. The real value of the property will be updated as long as the house is valued as a variable real value non–monetary item at its market price, a measurement base dictated by IFRS and also practiced in all open markets.

The house’s real value is not a constant real value non–monetary item. It is only assumed in this example that only inflation changes with all else being equal. This is not normally the case in the actual property market. The house is a variable real value non–monetary item.

When a property was valued at Historical Cost in the not so distant past in a company’s balance sheet it may have stayed at its original HC of, for example, R 100 000 for 29 years (2010) since January, 1981 in the company’s balance sheet. When it is eventually sold in 2010 for R 1.4 million we can see that inflation did not erode the property’s variable real non–monetary value – all else being equal. Inflation only eroded the real value of the depreciating Rand, the depreciating monetary medium of exchange, over the 29 year period – all else being equal. This would be taken into account by the buyer and seller at the time of the sale in a free and open market. The selling price quoted in terms of the depreciating Rand would be increased to compensate for the erosion of the real value of the depreciating Rand by inflation. R1.4 million in 2010 was the same as R100 000 in January, 1981 – all else being equal.

As the two academics from Turkey state:

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

Guceneme and Arsoy 2005: 9

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Nicolaas Smith

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