TIPS would eventually increase in real value during deflation

TIPS would eventually increase in real value during deflation

The statement

“When a TIPS matures, you are paid the adjusted principal or original principal, whichever is greater,”

has the following results:

During inflation in the US

TIPS principal’s nominal value increases with inflation: its real value is thus maintained constant.

During initial deflation in the US with the adjusted (decreased) principal still greater than the original principal

TIPS principal’s nominal value decreases with deflation: its real value would thus be maintained constant during the initial period of deflation.

During subsequent deflation in the US with the adjusted principal less than the original principal

TIPS principal’s original nominal value would be maintained constant during subsequent deflation: its real value would thus increase during subsequent deflation. This would be a costly process for the US government.

UK, Canada and Japan

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

Comité de Normalisation Obligataire 2011: 15

The capital amounts of UK, Canadian and Japanese sovereign inflation-linked bonds would thus maintain their real values constant at all levels of inflation and deflation.

 

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Nicolaas Smith


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

No net monetary losses and gains (in 100 years time)

No net monetary losses and gains (in 100 years time)

 

Constant Item Purchasing Power Accounting (CIPPA) is financial capital maintenance in units of constant purchasing power at all levels of inflation and deflation as authorized by the IASB in IFRS in the original Framework (1989), Par. 104 (a) [now the Conceptual Framework (2010), Par. 4.59 (a)] in terms of a Daily Consumer Price Index.

The stable measuring unit assumption is never implemented under financial capital maintenance in units of constant purchasing power.

Perfect financial capital maintenance in units of constant purchasing power would thus mean the following:

The complete money supply in an economy would be inflation-indexed on a daily basis in terms of the Daily Consumer Price Index with financial capital maintenance in units of constant purchasing power also in terms of a Daily CPI, both with complete co-ordination (everyone doing it).

This would result in no net monetary losses and gains in the entire economy: no cost of inflation. There would still be inflation in the monetary unit but there will be no cost of inflation: all monetary items would be inflation-indexed daily in terms of the Daily CPI in the entire economy.

Why?

Because there is no stable measuring unit assumption under financial capital maintenance in units of constant purchasing power as authorized in IFRS.

There would also be no constant items losses and gains under perfect financial capital maintenance in units of constant purchasing power with complete co-ordination.

Perfect financial capital maintenance in units of constant purchasing power during low inflation would take at least 100 years to come about even in one economy let alone in the world economy.

I implemented a form of financial capital maintenance in units of constant purchasing power in 1996 in Auto-Sueco (Angola) when I implemented accounting-dollarization in terms of the daily US Dollar parallel rate in that company during hyperinflation in Angola.

Brazil also implemented a form of financial capital maintenance in units of constant purchasing power during 30 years of very high and hyperinflation from 1964 to 1994 in terms of their government-supplied Unidade Real de Valor daily index. Brazil then went back to financial capital maintenance in nominal monetary units implementing the stable measuring unit assumption as it forms part of traditional Historical Cost Accounting in 1994 when they introduzed their current Real currency.

A form of financial capital maintenance in units of constant purchasing power was also implemented in Chile from 1967 until 2008 in terms of their Unidad de Fomento, which is a monetized daily indexed unit of account published daily since 1977.  That form of financial capital maintenance in units of constant purchasing power was stopped in Chile when “correción monetaria” was stopped in 2008 ‘to comply with IFRS’. Chile now implements financial capital maintenance in nominal monetary units (HCA) ‘to comply with IFRS’. Chile did not realize in 2008 that financial capital maintenance in units of constant purchasing power had already been authorized in IFRS in 1989.

Chile currently (2012) inflation-indexes 20 to 25 per cent of the country´s entire broad M3 money supply on a daily basis in terms of their Unidad de Fomento according to the Banco Central de Chile.They started this process at a much lower scale in 1967.

More than USD 3.5 trillion in government inflation-indexed bonds are currently (2012) being inflation indexed daily in most countries in the world economy in terms of country specific Daily CPIs.

Financial capital maintenance in units of constant purchasing power during low inflation and deflation was authorized in April 1989 in the original Framework (1989), Par. 104 (a).

We will be very lucky if even just financial capital maintenance in units of constant purchasing power in terms of a Daily CPI during low inflation without complete inflation-indexing of the entire money supply is implemented on a national basis in one complete economy by April 2089.

This will happen during low inflation some time in the future. No-one knows when.

Welcome on the long journey to perfect financial capital maintenance in units of constant purchasing power in terms of a Daily CPI during low inflation and deflation in 100 years time.

Nicolaas Smith

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Lonmin miners´ vote of no confidence in the SA Reserve Bank

Lonmin miners´ vote of no confidence in the SA Reserve Bank

During hyperinflation members of the public generally spontaneously start using the US Dollar as a relatively stable unit of account because their own local hyperinflationary currency loses real value at a very rapid rate. They start pricing everything in terms of the US Dollar.

SA has never been in hyperinflation in the past. It is not in hyperinflation at the moment (2012).
However, during the mine unrest at the Lonmin mine at Marikana near Rustenburg in South Africa, the miners stated on CNN that they wanted an increase to USD 1500 per month.

The SA Reserve Bank´s definition of price stability is stated in an inflation target of three to six per cent per annum. The SA Reserve Bank thus defines prices in South Africa increasing at six per cent per annum as being “stable”. The SARB would state that “price stability is being maintained” at inflation at six per cent per annum.

The miners are not economists, but they have a better sense of what is price stability in practice than the SARB.

Contrary to the SARB the miners obviously do not regard SA prices increasing at six per cent per annum as representing “price stability”. They use the US Dollar as a relatively stable unit of account, not the SA Rand. It is a clear vote of no confidence in the SA Reserve Bank´s monetary policies.

The SARB´s Monetary Policy Committee would now state as it stated in past: “The MPC remains fully committed to its mandate of achieving and maintaining price stability”. Six per cent annual inflation is actually “achieving and maintaining price stability” as far as the SARB is concerned. The miners clearly disagree with the SARB.

The Lonmin miners are good practical economists and I am sure they are good miners too.

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Purchasing power of capital has to be maintained

Purchasing power of capital has to be maintained

“It is essential to the credibility of financial reporting to recognize that the recovery of the real cost of investment is not earnings — that there can be no earnings unless and until the purchasing power of capital is maintained.”

FAS 33

Not a single company in the world economy knows whether it has maintained the purchasing power of its capital over the lifetime of the company.

Financial capital maintenance in units of constant purchasing power in terms of a Daily Consumer Price Index (i.e., Constant Item Purchasing Power Accounting) would automatically  maintain the constant purchasing power of capital constant for an indefinite period of time in all companies that at least break even in real value – ceteris paribus.

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Practical result of abolishing the stable measuring unit assumption

Practical result of abolishing the stable measuring unit assumption

In practice abolishing the stable measuring unit assumption, i.e. correctly accepting and implementing the proven fact that money (the monetary medium of exchange) is never perfectly stable under inflation and deflation within and economy will mean that financial statements as prepared at a specific date (e.g. the year end) will only be valid when consulted on that specific date, i.e. the year end date. When the financial statements are consulted after that date, all values at the stated historical date will be updated in terms the current, i.e. today´s, Daily CPI: the date on which the financial statements are consulted. The amounts of the items stated at the date the financial statements were prepared shall then be historical reference amounts (not values – value can only be perceived in terms of current value, i.e. today´s Daily CPI) as at the date of the financial statements and the Daily CPI at that date always to be updated in terms of the Daily CPI to the current, i.e. today´s, date thereafter.

In digital financial statements the amounts at the date of the financial statements will only be visible as part of the financial statements on that date. Thereafter they will never be part of the financial statements again to be seen as original fixed nominal historical amounts. They will be in memory (and on all original dated hard copy documents) at that date with a historical amount (not value – value can only be perceived in terms of current value, i.e. today´s Daily CPI) and the Daily CPI at that date. When consulted at any time after that date the original historical fixed nominal amounts of their real values measured in terms of the Daily CPI at the historical date will always be updated in terms of the current, i.e. today´s, Daily CPI.

During inflation their real values will remain the same for an indefinite period of time, but their nominal values will generally increase daily in terms of the Daily CPI.

During deflation their real values will remain the same for an indefinite period of time, but their nominal values will generally decrease daily in terms of the Daily CPI.

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Measurement of inventories under financial capital maintenance in units of constant purchasing power

Measurement of inventories under financial capital maintenance in units of constant purchasing power

The difference between financial capital maitenance in nominal monetary units (traditional Historical Cost Accounting) and financial capital maintenance in unit of constant purchasing power, i.e. Constant Item Purchasing Power Accounting (CIPPA), is that the stable measuring units assumption is always implemented under HCA but is never implemented under CIPPA.

The fact that the real value of money (and thus the monetary medium of exchange) was and is never perfectly stable on a sustainable basis within an economy during inflation and deflation is reflected in an entity in the way the three basic economic items, i.e., monetary, variable and constant items, are measured /valued  (for example variable items in terms of daily fair value and constant items in terms of daily constant purchasing power) over time under financial capital maintenance in units of constant purchasing power.

The reason for and the advantage of financial capital maintenance in units of constant purchasing power in terms of a Daily CPI is the fact that the constant purchasing power of equity (capital) is automatically maintained constant for an indefinite period of time in all entities that at least break even in real value at all levels of inflation and deflation – ceteris paribus.

Everything is done (and accounted daily) and all historical financial information is stated at the current, i.e. today´s, real value which generally changes every day. The concept of a nominal Historical Cost or a nominal historical value is abolished because the stable measuring unit assumption is never implemented under financial capital maintenance in units of constant purchasing power. Tomorrow today´s real values will be historical reference amounts and must be valued (measured) at tomorrow´s real value, e.g. tomorrow´s market price, Daily Consumer Price Index, etc.

Financial capital maintenance in units of constant purchasing power is authorized in IFRS in the Conceptual Framework (2010), Par. 4.59 (a) and includes Historical Cost as a measurement basis, but excludes the stable measuring unit assumption.

Since both financial capital maintenance in units of constant purchasing power (CIPPA) as well as financial capital maintenance in nominal monetary units (HCA) are authorized in the Conceptual Framework (2010), Par. 4.59 (a) it means that IFRS are implemented under two paradigms, namely the HC paradigm and the Constant Item Purchasing Power paradigm.

IAS 2 Inventories, Par. 9 Measurement of Inventories states:

‘Inventories shall be measured at the lower of cost and net realisable value.’

An inventory item measured at Historical Cost in terms of IAS 2 shall be measured in terms of the current, i.e. today´s, Daily Consumer Price Index and continuously updated day after day thereafter because there is no stable measuring unit assumption under financial capital maintenance in units of constant purchasing power.

Par. 10 Cost of Inventories states:

‘The cost of inventories shall comprise all costs of purchases, costs of conversion and other costs incurred in bringing the inventories to their present location and condition.’

All historical costs of purchases, historical costs of conversion and other historical costs incurred in bringing the inventories to their present location and condition shall be measured in terms of the current, i.e. today´s, Daily Consumer Price Index and continuously updated day after day thereafter because there is no stable measuring unit assumption under financial capital maintenance in units of constant purchasing power.

Par. 23 Cost Formulas states:

‘The cost of inventories of items that are not ordinarily interchangeable and goods or services produced and segregated for specific projects shall be assigned by using specific identification of their individual costs.’

The above individual historical costs shall be measured in terms of the current, i.e. today´s, Daily Consumer Price Index and continuously updated day after day thereafter because there is no stable measuring unit assumption under financial capital maintenance in units of constant purchasing power.

Par. 25 states:

‘The cost of inventories, other than those dealt with in paragraph 23, shall be assigned by using the first-in, firts-out (FIFO) or weighted average cost formula.’

The cost of inventories, other than those dealt with in IAS 2, paragraph 23, assigned using the first-in, firts-out (FIFO) or weighted average cost formula shall be measured in terms of the current, i.e. today´s, Daily Consumer Price Index and continuously updated day after day thereafter because the stable measuring unit assumption is never implemented under financial capital maintenance in units of constant purchasing power.

Par. 34 Recognition as an expense states:

‘When inventories are sold, the carrying amount of those inventories shall be recognised as an expense in the period in which the related revenue is recognised.’

When inventories are sold, the carrying amount of those inventories shall be measured in terms of the current, i.e. today´s, Daily Consumer Price Index and continuously updated day after day thereafter and shall be recognised as an expense in the period in which the related revenue is recognised because the stable measuring unit assumption is never implemented under financial capital maintenance in units of constant purchasing power.

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What to do with the world´s accumulated Historical Cost Accounting loss

What to do with the world´s accumulated Historical Cost Accounting loss

Entities preparing their financial statements based on the historical cost basis generally do not know whether they have maintained the constant purchasing power of their equity constant over time.

The test would be to measure every item in current equity in units of constant purchasing power as from the date each item was contributed or came about over the entity´s lifetime and then to compare that total value with the company´s current net asset value measured in real value, i.e. no item in current net assets to be stated at historical cost, but at fair value.

This would be required to be done by an entity adopting financial capital maintenance in unit of constant purchasing power as authorized in IFRS in the Conceptual Framework (2010), Par. 4.59 (a) instead of financial capital maintenance in units of nominal monetary units, the traditional HCA model.

In most entities this would result in an enormous accumulated Historical Cost Accounting loss to be accounted as part of equity.

The net effect would be an enomous increase in the nominal value of equity (measured in units of constant purchasing power over the entity´s lifetime to date) together with and enormous accumulated Historical Cost Accounting loss, but resulting in the same current net equity real value being equal to the current real value of net assets before and after the above calcultions are made.

It is thus advisable to rather simply value current net assets in real value and state that as the constant real value of current equity to be maintained constant as from here on foreward by means of financial capital maintenance in units of constant purchasing power.

It is very doubtful that tax authorities would accept the sudden calculation of enormous accumulated Historical Cost Accounting losses which would represent the erosion of equity by the stable measuring unit assumption (HCA) over the lifetime of the entity to date under the Historical Cost paradigm.

In countries which allow the write-off of profits against accumulated losses over five years, for example, it would mean that no taxes would be paid by entities over the next five years in the case of an entire country adopting financial capital maintenance in units of constant purchasing power as from the same date. No country would accept not receiving any taxes from the corporate sector for five years.

This could be overcome in two ways:

1. The accumulated HCA loss not being allowed for tax purposes. It would thus remain on entities´ balance sheets over many years till it is written off against future profits. The net constant real value of equity would be correct and be maintained constant correctly by means of financial capital maintenance in units of constant purchasing power. This option would be costly in terms of accounting time spent on the calculations. It would reveal the real cost today of having implemented HCA over the lifetime of an entity.
2. Do not value past additions to equity in units of constant purchasing power and do not calculate the current HCA accumualted loss. Value current equity at the real value of current net assets and implement financial capital maintenance in units of constant purchasing as from the current date foreward. This option would have no extra costs, but would hide the accumulated cost of having implemented the HCA model over the lifetime of the entiy.

The second option is obviously the better choice.

So, the answer to the question: what to do about the world´s accumulated HCA loss is: just ignore it J in time-honoured accounting fashion.

However, it is actually required to stop the hundreds of billions of US Dollars (2012) in real value eroded each and every year by the implementation of the stable measuring unit assumption (HCA) in the world´s constant item economy during inflation and hyperinflation.

I do realize that may only happen a hunderd or more years from now (2012). Individual companies (even countries) are free to start anytime they like. It was authorized in IFRS in 1989.

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Unacceptable items in IFRS

Unacceptable items in IFRS

1. IAS 29 Financial Reporting in Hyperinflationary Economies.

It was duely implemented in Zimbabwe for at least the last six years during hyperinflation in that country: it had zero effect in the Zimbabwean hyperinflationary economy during those six years.

2. The IASB definitions of monetary items in IAS 21 and IAS 29.

All items paid or received in money are not monetary items. All economic items – monetary and non-monetary items – are generally paid or received in money as the monetary medium of exchange. A non-monetary item always paid or received in money does not transform that non-monetary item into a monetary item. It remains a non-monetary item always paid or received in money, e.g., salaries and wages.

3. The exclusion of measurement in units of constant purchasing from the FASB´s  and IASB´s joint list of possible basic measurement bases.

Measurement in units of constant purchasing power is a basic measurement basis continously applied in the world economy. Salaries, wages, rentals and many other items are generally measured in units of constant purchasing power on an annual basis in most of the world economy.

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BASIC MEASUREMENT BASES

Monetary items

1. Measurement in terms of the general price level index.

This requires the calculation and accounting of net monetary losses and gains only as long as the stable measuring unit assumption (HCA) is mistakenly still being applied. It is an absolute fact that the monetary unit of measure is not perfectly stable.

Variable real value non-monetary items

2. Fair value and related bases excluding the stable measuring unit assumpiton as stated in the FASB and IASB list (below) of nine measurement bases.

Constant real value non-monetary items

      3. Units of constant purchasing power.

The following is the FASB and IASB list of basic measurement bases which mainly apply to variable items:

“Measurement Bases

“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 a general price level index nor

(ii)                 measurement (of constant items) in units of constant purchasing power

are considered by either the FASB or the IASB as possible basic measurement bases.

The IASB does, however, require the calculation of net monetary losses and gains only during hyperinflation in terms of IAS 29 Financial Reporting in Hyperinflationary Economies.

The inexplicable omission of these two basic measurement bases is obviously a mistake on the part of the FASB and IASB.

Most salaries and wages and tens of thousands of other items have been and are currently measured in units of constant purchasing power on an annual basis in the world economy during at least the last 100 years.

It is impossible to explain how units of constant purchasing power can be omitted by both the FASB and IASB as a basic measurement basis.

The only possible explanation is to state that to err is human.

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