Introduction to Capital Maintenance in Units of Constant Purchasing Power

Introduction

 

Historical Cost Accounting is the globally implemented, generally accepted, traditional, basic accounting model used by entities to prepare their financial reporting. It was originally authorized in IFRS in 1989 as an optional (not required) accounting model at all levels of inflation and deflation (including during high inflation and hyperinflation) in the original Framework for the Preparation and Presentation of Financial Statements, Par. 104 (a) which states:

 

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

 

HCA is thus not required by IFRS. It is an optional nominal financial capital maintenance basic accounting model. The other optional financial capital maintenance concept authorised in IFRS at all levels of inflation and deflation (including during high inflation AND HYPERINFLATION) is financial capital maintenance in units of constant purchasing power.

 

The exact wording of the original Framework (1989), Par. 104 (a) is maintained in the current Conceptual Framework (2010), Par. 4.59 (a).

 

Three concepts of capital maintenance authorised in IFRS

 

There are thus three concepts of capital and three concepts of capital maintenance authorised in IFRS since 1989 although both the original Framework (Par. 107) and the Conceptual Framework (Par. 4.62) mistakenly state:

 

‘The principle difference between the two capital maintenance concepts is the treatment of the effect of changes in the prices of assets and liabilities of the entity.’

 

the exact same wording maintained here too between the Framework (1989) and the Conceptual Framework (2010).

 

Capital concepts authorised in IFRS since 1989

 

The following three concepts of capital can be identified in the Conceptual Framework, Par. 4.57:

 

1. Physical capital. See Par. 4.57 and 4.58
2. Nominal financial capital. See Par. 4.59 (a)
3. Constant purchasing power financial capital. See Par. 4.59 (a)

 

Capital maintenance concepts authorised in IFRS since 1989

 

The three concepts of capital identified in Par. 4.57 give rise to the following three concepts of capital maintenance during all levels of inflation and deflation, including during high inflation and hyperinflation:

 

1. Physical capital maintenance concept. Optional at all levels of inflation and deflation. The Current Cost Accounting model is prescribed in IFRS when the physical capital maintenance concept is implemented. See Par. 4.56

 

2. Financial capital maintenance in nominal monetary units. (HCA) Authorised in IFRS, but not prescribed. Optional at all levels of inflation and deflation, including during high inflation and hyperinflation. See Par. 4.59 (a)

 

3. Financial capital maintenance in units of constant purchasing power. Authorised in IFRS, but not prescribed. Optional at all levels of inflation and deflation, including during high inflation and hyperinflation. See Par. 4.59 (a)

 

Constant real value non-monetary items inferred in IFRS

 

In terms of the Conceptual Framework (2010), Par. 4.59 (a), financial capital maintenance can be measured in units of constant purchasing power. There are thus actual economic items with constant real values over time.

 

Inflation erodes the real value of only monetary items over time.

 

‘Inflation is always and everywhere a monetary phenomenon.’

 

Milton Friedman

 

´The purchasing power of non monetary items does not change in spite of variation in national currency value.’

 

Gucenme U and Arsoy A P 2005 Changes in financial reporting in Turkey, Historical development of inflation accounting 1960 – 2005 Academy of Accounting Historians 2005 Research Conference 6-8 Oct 2005 Ohio State University Columbus Ohio USA

 

Low inflation, high inflation, hyperinflation and deflation thus affect the real value of only monetary items over time. Low inflation, high inflation, hyperinflation and deflation have, consequently, no effect on the real value of non-monetary items over time (and never had in the past and never will have in the future).

 

The above-mentioned economic items with constant real values over time are thus not monetary items. Consequently, they are non-monetary items with constant real values over time. They are thus constant real value non-monetary items or constant items.

 

When the stable measuring unit assumption is never implemented, i.e., under capital maintenance in units of constant purchasing power, these constant items have permanently fixed constant real values over time at all levels of inflation and deflation, including during high inflation and hyperinflation.

 

When, however, the stable measuring unit assumption is implemented, i.e., under traditional Historical Cost Accounting, and these constant items are not maintained constant in real value over time (because of the implementation of the stable measuring unit assumption – HCA - , not inflation), then the constant real non-monetary values of these constant items are eroded by the stable measuring unit assumption – HCA - (not by low inflation, high inflation or hyperinflation) over time at a rate equal to the annual rate of low inflation, high inflation or hyperinflation (because they are measured in terms of depreciating money, i.e., the depreciating monetary unit of account - and low inflation, high inflation and hyperinflation erode the real value of only money over time) and increased at a rate equal to the annual rate of deflation by the stable measuring unit assumption (not by deflation).

 

Examples of constant items are salaries, wages, rentals, pensions, borrowing costs, fees, royalties, employment benefits, interest received, interest paid, bank charges, issued share capital, retained income, retained losses, reserves, all other items in shareholders´ equity, provisions, trade debtors, trade creditors, taxes payable, taxes receivable, all other non-monetary payables and all other non-monetary receivables, all items in the income statement, etc.

 

Definition: Constant real value non-monetary items are non-monetary items with constant real values over time.

 

Variable real value non-monetary items inferred in IFRS

 

Consequently, non-monetary items that are not constant real value non-monetary items are variable real value non-monetary items or variable items. They have variable real values over time generally determined by supply and demand in free markets.

 

Definition: Variable items are non-monetary items with variable real values over time generally determined in terms of demand and supply.

 

Examples of variable items are property, plant, equipment, inventories, foreign exchange, quoted and unquoted shares, goodwill, patents, copy right, trade marks, intellectual property rights, etc.

 

Non-monetary items

 

Definition: Non-monetary items are all items that are not monetary items.

 

Non-monetary items are sub-divided in:

 

1. Variable real value non-monetary items
2. Constant real value non-monetary items

 

Monetary Items

 

The definition of monetary items thus determines whether an item is a monetary or non-monetary item. When the definitions of monetary items need improvement as they currently do in IFRS in IAS 29, Par. 12:

 ‘Monetary items are money held and items to be received or paid in money,’

 

and IAS 21, Par. 8:

 

´Monetary items are units of currency held and assets and liabilities to be paid in a fixed or determinable number of units of currency.’  

 

then some monetary and non-monetary items would be mis-classified. This would result in the doubtful calculation and accounting of the net monetary item loss or gain and the net constant item loss or gain only under capital maintenance in units of constant purchasing power if the current definitions of monetary items in IFRS were to be followed. The overall net effect of such mis-classification on the financial statements would be nil: the net loss or gain would in any case be calculated and accounted, as either a net monetary item loss or gain, or a net constant item loss or gain only under capital maintenance in units of constant purchasing power since it is normally constant items (e.g., trade debtors and trade creditors) that are incorrectly treated as monetary items. It is, however, necessary to classify items correctly as monetary, constant or variable items.

 

Net monetary item losses and gains and net constant item losses and gains are not required (net constant item losses and gains are not even identified under HCA) to be calculated and accounted (although net monetary losses and gains can be calculated and accounted under HCA according to Harvey Kapnick in the 1976 Sax Lecture by the ex-Chairman of Arthur Andersen) under the Historical Cost Accounting model as a result of the implementation of the stable measuring unit assumption.  It is assumed, in practice,  that money is perfectly stable for the purpose of the measurement of constant items and constant items treated as monetary items (e.g., trade debtors and trade creditors, etc.) under HCA during low inflation, high inflation and deflation while under hyperinflation the measures in IAS 29 are required, but Pricewaterhousecoopers very correctly states:

 

‘Inflation-adjusted financial statements are an extension to, not a departure from, historic cost accounting.’

 

PricewaterhouseCoopers 2006 Understanding IAS 29 p 5

 

IAS 29 simply requires the restatement of Historical Cost or Current Cost financial statements in terms of the measuring unit current at the end of the reporting period to make them more meaningful. IAS is not a departure from Historical Cost Accounting, even during hyperinflation of hundreds of billions percent per annum.

 

‘The Measuring Unit Principle:

The unit of measure in accounting shall be the base monetary unit of the most relevant currency. This principle also assumes the unit of measure is stable, that is, changes in its general purchasing power are not considered sufficiently important to require adjustments to the basic financial statements.’

 

Walgenbach, Dittrich and Hanson 1973 p 429

 

The implementation of the stable measuring unit assumption under the Historical Cost Accounting model, consequently leads to the erosion of the real value of constant real value non-monetary items never maintained constant during low inflation, high inflation, hyperinflation and deflation; e.g., that portion of an entity´s equity never maintained constant by the real value of its net assets over time - probably amounting to the unnecessary erosion of real value in the world’s capital investment base amounting to hundreds of billions of US Dollar per annum in the world economy. Replacing the Historical Cost Accounting model by adopting constant real value maintaining capital maintenance in units of constant purchasing power in terms of a daily index would automatically maintain the constant purchasing power of equity constant for an indefinite period of time in all entities that at least break even in real value – all else being equal – at all levels of inflation and deflation, including during high inflation and hyperinflation, whether these entities own any revaluable fixed assets or not. This would maintain hundreds of billions of US Dollar per annum in the world economy for as long as the current level of world inflation maintains.

 

Definition of Monetary items

 

Monetary items constitute the money supply.

 

Examples are local currency bank notes and coins and the local currency capital amounts of home loans, car loans, commercial loans, business loans, student loans, government bonds, commercial bonds, capital market investments, money market investments, notes payable, notes receivable, etc.

 

Three economic items

 

From the above it is absolutely clear that there are not just the generally accepted two economic items in the economy, namely monetary and non-monetary items, but three basic, fundamentally different economic items in the economy and that the economy is made up of three basic, fundamentally different parts as follows:

 

Three basic, fundamentally different economic items

 

1. Monetary items
2. Variable real value non-monetary items (variable items)
3. Constant real value non-monetary items (constant items)

 

Three parts of the economy

 

1. Monetary economy
2. Variable item economy
3. Constant item economy

 

Measurement under capital maintenance in units of constant purchasing power

 

Daily measurement required

 

Daily measurement of all items are required under capital maintenance in units of constant purchasing power since constant items like trade debtors and trade creditors can pay or be paid on any day of the month. The Daily Consumer Price Index is used for this purpose during low inflation, high inflation and deflation and the daily US Dollar parallel rate during hyperinflation. Most countries (representing about 95 percent, or more, of the world economy) issue capital inflation-indexed government bonds. These bonds trade on a daily basis and are priced in terms of a Daily CPI which is a one or two month lagged daily interpolation of the monthly published CPI available in all these countries.

 

Chile has been using an index, the Unidad de Fomento (UF), to index non-monetary and some monetary items since 1967. It has been published daily since 1977. Chile currently inflation-indexes 25 per cent of its money supply daily.

 

During hyperinflation, populations spontaneously start using the daily US Dollar parallel rate to index variable items.

 

Value date

 

The value date under capital maintenance in units of constant purchasing power is the current value of the daily index, that is, today´s value. Everything in a company and economy is always presented, accessed, valued, measured, treated, shown and printed in terms of the current, that is, today´s Daily CPI or daily US Dollar parallel rate (during hyperinflation). It changes every day. Financial statements are not printed on hard copy: they are kept in digital format and updated daily: they change every day in nominal value, but they stay the same in real value.

 

A person quickly learns during hyperinflation that the value date is today: everybody uses the current, today´s, value of the US Dollar parallel rate to price variable items: it changes every day during hyperinflation. On some days it changes more than once a day.

 

Financial statements are thus stated at the measuring unit current at the end of the accounting period, only at the end of the accounting period: on that day. The next day (and at all future dates) all items in the financial statements are updated in terms of the new Daily CPI or the new daily USD parallel rate (during hyperinflation). The real values in the financial statements stay the same, but their daily nominal values change daily- the same for all values in the economy.

 

Constant items

 

Constant items are the easiest to measure under capital maintenance in units of constant purchasing power in terms of a daily index. They are always and everywhere (current period and historical constant items) measured in terms of the Daily CPI at today´s rate. When they are not measured daily as decribed – during the current financial period, then the net constant item loss or gain is calculated and accounted in the income statement. Net constant item losses and gains are constant items once accounted and measured in units of constant purchasing power daily thereafter - like all constant items.

 

Variable items

 

Variable items are valued daily in terms of IFRS, e.g., at fair value, net realisable value, recoverable value, present value, etc., excluding the stable measuring unit assumption, i.e., excluding nominal historical cost. Nominal historical cost is only valid during zero inflation – an economic environment never achieved on a sustainable basis in the past and aparently not soon to be achieved in the future. When variable items are not valued daily in terms of IFRS, as qualified, they are updated (only monetary items can be inflation-adjusted – inflation only affects monetary items) daily in terms of the Daily CPI till they are again measured daily in terms of IFRS, as qualified. Impairment, losses and gains in variable items are treated in terms of IFRS, as qualified.

 

Monetary items

 

Monetary items are always and everywhere (historical and current period monetary items) inflation-adjusted on a daily basis. When they are not inflation-adjusted during the current accounting period, then the net monetary loss or gain is calculated and accounted.

 

Inflation-adjusting the entire money supply on a daily basis in terms of the Daily CPI compensates for (nullifies) the effect of low inflation, high inflation and deflation, and in terms of the Daily USD parallel rate, nullifies the effect of hyperinflation. However, this does not remove actual low inflation, high inflation, hyperinflation and deflation. This means that the monetary economy and constant item economy can be maintained stable with an IFRS. Normally it is seen that the stability of the monetary economy is the responsibility of the Central Bank. In fact it is not. It is the responsibility of the accounting profession to implement capital maintenance in units of constant purchasing power in terms of a daily index correctly under complete co-ordination (everyone doing it). No central bank intervention is actually required to stop the effect of the erosion of the real value of monetary items from the monetary economy. It can be done by accountants with an IFRS: with capital maintenance in units of constant purchasing power in terms of a daily index. Central bank intervention is only required to eliminate actual inflation and deflation. Correct accounting can compensate for (nullify) its effect in the economy.

 

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Nicolaas Smith

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