Definition of Capital Maintenance in Units of Constant Purchasing Power

Definition of Capital Maintenance in Units of Constant Purchasing Power

Updated on 3 May 2013

Capital Maintenance in Units of Constant Purchasing Power is the maintenance of the constant purchasing power of capital (equity) – with capital being equal to the real value of net assets – for an indefinite period of time at all levels of inflation (low inflation, high inflation and hyperinflation) and deflation in all entities that at least break even in real value – ceteris paribus – in units of constant purchasing power in terms of an index that recognizes all the changes (every change) in the general price level.

Capital Maintenance in Units of Constant Purchasing Power was originally authorised as an option to financial capital maintenance maintenance in nominal monetary units (the 3000 year old, generally accepted, globally implemented, traditional Historical Cost Accounting model) at all levels of inflation (low inflation, high inflation and hyperinflation) and deflation in IFRS in the original Framework (1989), Par 104 (a) which states ‘Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power.’

Capital Maintenance in Units of Constant Purchasing Power is required during hyperinflation in terms of IAS 29 Financial Reporting in Hyperinflationary Economies (IFRS are principles-based standards: the requirement is implied/inferred in IAS 29). Unfortunately IAS 29 has been implemented in terms of the monthly published CPI since its authorization in 1989. This results in the destruction of part of the real value of current year profits by the implementation of the stable measuring unit assumption during the periods that the daily change in the general price level is being ignored under IAS 29 during hyperinflation (from the 1st of the month till the second last day of the month: the monthly CPI is the CPI valid on the last day of the month). [The implications of the difference in the value of the monthly publised CPI and the Daily CPI on the last day of the month need to be analysed]. There are at least 365 different price levels in the general price level during low inflation, high inflation, hyperinflation and deflation. IAS 29 is implemented recognizing only the 12 month-end CPIs during the year during hyperinflation.

Although Capital Maintenance in Units of Constant Purchasing Power is required during hyperinflation in terms of IAS 29,  it, unfortunately, does not result in 100 per cent Capital Maintenance in Units of Constant Purchasing Power during hyperinflation. This is remedied with the implementation of an index that recognizes all changes in the general price level during hyperinflation.

This can be done with (1) the use of the daily US Dollar or other relatively stable foreign currency parallel rate (where a daily parallel rate exists) or (2) a Brazilian-style URV-based daily index that was almost entirely made up of the US Dollar daily exchange rate (not a parallel rate) during hyperinflation or (3) the use of the Daily CPI at initial levels of hyperinflation.

The Daily CPI – available in all countries that issue government capital inflation-indexed bonds, i.e., in 90 per cent of the world economy – which is a lagged daily interpolation of the monthly published CPI, recognizes all changes in the general price level (when the monthly published CPI is recognized as the general price level) during low inflation, high inflation, initial hyperinflation and deflation.

Low inflation is inflation up to 10 per cent per annum. High inflation is inflation from 10 per cent to 26 per cent per annum. Hyperinflation is cumulative inflation of 100 per cent over three years, i.e., 26 per cent per annum inflation for three years in a row.

Judgment and pragmatism have to be used to determine whether (1) the Daily CPI, (2) a daily foreign currency exchange rate (normally the daily US Dollar parallel rate) or (3) a Brazilian-style URV-based daily index (which was almost entirely made up of the USD daily exchange rate) should be used as the general price level during hyperinflation. Judgment has to be used to judge whether the Daily CPI is not, in fact, too far behind real value as determined by the USD parallel rate and the use of the Daily CPI, in fact, would not result in adequate (judgment to be used again) Capital Maintenance in Units of Constant Purchasing Power during hyperinflation.

Pragmatism has to be used when the use of the US Dollar parallel rate is forbidden (illegal) in a country and its use would result in the arrest of company owners and/or directors.

The constant item constant purchasing power concept of capital is implemented under Capital Maintenance in Units of Constant Purchasing Power. Constant items are constant real value non-monetary items as inferred in IFRS which are principles-based standards. The Conceptual Framework (2010), Par 4.59 (a) states ‘Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power.’ Capital is a non-monetary item.

Non-monetary items to be measured in units of constant purchasing power are thus constant real value non-monetary items or simply constant items. They include issued share capital, retained earnings, capital reserves, all other items in equity, trade debtors, trade creditors, all other non-monetary receivables, all other non-monetary payables, all items in the income statement, provisions, etc. They are always and everywhere measured in units of constant purchasing power in terms of an index that recognizes all changes in the general price level, e.g., the Daily CPI during low inflation, high inflation and deflation and the US Dollar parallel rate during hyperinflation.

Non-monetary items that are not constant items are variable real value non-monetary items or simply variable items. They include property, plant, equipment,  quoted and unquoted shares, foreign exchange, etc. They are measured in terms of IFRS excluding the stable measuring unit assumption.

The stable measuring unit assumption is never implemented under Capital Maintenance in Units of Constant Purchasing Power.

Net monetary item gains and losses and net constant item gains and losses are accounted under Capital Maintenance in Units of Constant Purchasing Power.

Nicolaas Smith

Copyright (c) 2005-2013 Nicolaas J Smith. All rights reserved. No reproduction without permission.