Safest long-term investment

An inflation-linked bond will therefore be the safest investment option for a long-term investor looking to limit the uncertainty associated with the future real value of his capital. 

The market for inflation-linked bonds 

The market capitalisation of inflation-linked bonds is less than 10 percent of the market for government bonds and is dominated by the UK and the US. Linkers issued by authorities in these two countries make up almost 60 percent of the world market.

The authorities in a number of countries with a considerable economic output, including China, India and Russia, have not issued inflation-linked bonds. The same is the case in many smaller countries, and large developed markets in the benchmark index such as Japan and Germany have only small and relatively illiquid markets for inflation-linked bonds (see appendix).

In some markets, tax and regulatory conditions may affect the structural demand for, and therefore the supply of, inflation-linked bonds.

In a situation where there is a growing probability of deflation, inflation-linked bonds could have markedly different characteristics in different countries, as the underlying rules vary. Linkers are not identical across markets and are therefore difficult to view as a global asset class.

The combination of a long investment horizon, no short-term liquidity needs and a patient owner generally make the fund well-suited to bearing different types of systematic risk.

 Experience from the financial crisis in 2008 showed, however, that in periods of financial instability we cannot count on the same level of liquidity in the market for inflation-linked bonds. Tradability in these situations is lower, and we therefore bear a higher liquidity risk than for investments in nominal government bonds. 

 Linkers may, however, have a role in the operational management of the fund when it is possible to secure an attractive real return and inflation expectations are considered moderate.

Capital maintenance in units of constant purchasing power is an objective of Accounting / Financial Reporting

The entity concept is only possible together with the capital concept. Capital being independent from the owner(s) of capital is only possible with double-entry accounting and this is not referring to Historical Cost Accounting.

The above concept of capital assumes that the constant purchasing power of capital is being maintained constant over time during inflation and deflation because capital is equal to the real value of net assets. This assumption is not part of HCA because HCA simply assumes money is perfectly stable as far as the measurement of monetary items and constant real value non-monetary items are concerned, i.e., the stable measuring unit assumption is implemented and net monetary losses and gains are not accounted under HCA. Net monetary losses and gains are accounted and the stable measuring unit assumption is never implemented under ideal Capital Maintenance in Units of Constant Purchasing Power.

If the constant purchasing power of capital were not maintained 100 percent constant and if its real value were completely eroded by the stable measuring unit assumption during hyperinflation, it would lead to the end of the existence of the entity - all else being equal - only in the case of entities with net assets made up of only monetary items and constant real value non-monetary items, e.g., trade debtors, other non-monetary receivables, etc. never maintained constant under HCA. Entities with net assets made up of variable real value non-monetary items (e.g., property, plant, equipment, inventory, shares, foreign exchange, etc.) would continue existing even when the real value of the entire local money supply is completely eroded by hyperinflation as in the case of Zimbabwe on 20 November 2008.

Capital maintenance in units of constant purchasing power is thus essential for the entity.

Double-entry accounting is not essential for business, for example in a business with no organised accounting. Double-entry accounting is not essential for the exchange of goods and services. A contract - implied or not - is essential for exchange (business). The measurement bases underlying the contract are generally implied or stated / agreed / assumed in the contract.

Double-entry accounting is essential for the existence of an entity with capital. The economic items constituting the entity need to be valued from time to time. Measurement bases thus need to be adopted by the entity besides the ones used in exchange contracts for variable real value non-monetary items.

The entity has to adopt a measurement basis for the measurement of monetary items and constant real value non-monetary items, e.g., all items in equity, trade debtors, trade creditors, all other non-monetary receivables, all other non-monetary payables, provisions, all items in the income statement, etc. Under HCA the measurement basis adopted for this purpose is the stable measuring unit assumption, i.e., changes in the purchasing power of the monetary unit of account are not considered sufficiently important to implement measurement in units of constant purchasing power in terms of an index that recognises all - normally daily - changes in the general price level. HCA thus simply ignores the fact that money is not stable in real value. HCA also ignores the net monetary losses and gains that result from the choice of financial capital maintenance in nominal monetary units.

The stable measuring units assumption is never implemented under ideal CMUCPP in terms of an index that recognises all - normally daily - changes in the general price level for the purpose of measuring constant real value non-monetary items and net monetary losses and gains in monetary items are accounted.

Measurement bases are adopted by an entity with capital for the valuation of the entity items via the capital maintenance concept adopted. The Conceptual Framework states this in another way, namely that the accounting model is decided by the capital maintenance concept and measurement bases adopted.

One of the objectives of accounting / general purpose financial reporting on a logical or scientific basis is thus the adoption of measurement bases that would ensure capital maintenance in units of constant purchasing power in terms of an index that recognises all - normally daily - changes in the general price level during inflation and deflation. This can only be achieved via the adoption of Capital Maintenance in Units of Constant Purchasing Power in terms of an index that recognises all - normally daily - changes in the general price level for both physical and financial capital maintenance. It is the only possible choice on a logical or scientific basis. HCA, i.e., financial capital maintenance in nominal monetary units being the traditional accounting model only came about because of generally accepted social and economic practice over the last 3000 years.

Maintaining the constant purchasing power of capital constant during inflation and deflation is generally impossible under traditional HCA, i.e., under financial capital maintenance in nominal monetary units - all else being equal. Entities increase their nominal equity under HCA (hoping to maintain the real value of their nominal capital in this way) with increases in capital and with retained earnings which are then again not maintained constant in real value over time which again needs new capital or retained earnings which again are not maintained constant, etc., etc., etc., ... in a never ending process during inflation. In general, no entity in the world knows whether it has in the past maintained or is currently maintaining the real value (constant purchasing power) of its capital constant. This calculation is generally not done or required to be done in entities.

Capital Maintenance in Units of Constant Purchasing Power in terms of an index that recognises all - normally daily - changes in the general price level would automatically maintain the constant purchasing power of capital constant under complete co-ordination  in all entities that at least break even in real value - all else being equal - for an indefinite period of time at all levels of inflation and deflation.

The objectives of accounting / general purpose financial reporting on a logical or scientific basis are thus:

1. Capital Maintenance in Units of Constant Purchasing Power in terms of an index that recognises all - normally daily - changes in the general price level.

2. “The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity.” Conceptual Framework, OB2  

Accounting / general purpose financial reporting is not normally implemented on a logical or scientific basis on the international accounting standard-setting level. International accounting standard-setting is highly politicised. (Bunting 2013)

However, accounting / general purpose financial reporting on a logical or scientific basis is not forbidden or illegal in most of the world economy. CMUCPP is authorised in IFRS on an optional basis at all levels of inflation and deflation [CF 4.59 (a)] for whoever wishes to choose it in terms of an index that recognises all - normally daily - changes in the general price level.

No-one chooses it because it is not prescribed in IFRS: it is optional.

If the IASB were to require a daily index in IFRS, it would stabilise the non-monetary economy in every entity or country or monetary union which implements it at all levels of inflation and deflation under complete co-ordination.

If a daily index had been prescribed in IAS 29 in 1989, the Zimbabwean economy would never have imploded in 2008. Brazil had a relatively stable non-monetary economy during the 30 years of high inflation and hyperinflation of up to 2000 percent per annum from 1964 till 1994 as the result of Capital Maintenance in Units of Constant Purchasing Power in the form of daily indexation or daily monetary correction (daily price-level accounting) in terms of various government supplied daily indices.

Nicolaas Smith

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

IASB completely unaware of its social responsibility

Countries like Belarus and Venezuela - both in hyperinflation - are not the best examples of modern democracies. The president of Belarus describes himself as the last dictator in Europe.

The president of Belarus is also the only person with the power to authorise sweeping accounting changes that would stabilise Belarus´s economy. Sweeping changes like the adoption of a Daily Index with IAS 29 Financial Reporting in Hyperinflationary Economies which is not actually being implemented in the country although Belarus signed up to implement IFRS.

The only reason Venezuela´s non-monetary economy is not stable today, is because IAS 29 is being implemented in terms of a monthly CPI. Brazil had a relatively stable non-monetary economy during the 30 years of very high and hyperinflation from 1964 to 1994 because of the use of government-supplied daily indices with Capital Maintenance in Units of Constant Purchasing Power in the form of indexation or monetary correction which was also widely used in other Latin American countries during that period in the form of price-level restatement in terms of a daily index. IAS 29 requires Capital Maintenance in Units of Constant Purchasing Power. Unfortunately IAS 29 has been implemented since its inception in 1990 in terms of the monthly published CPI.

IAS 29 does not prescribe the use of the monthly published CPI. It is generally accepted to implement IAS 29 in terms of the monthly CPI, but it is not prescribed in IAS 29.  IAS 29 simply requires restatement in terms of the general price level. The Daily CPI is based on the general price level since it is simply a lagged, daily interpolation of the monthly published general price level CPI. IAS 29 can thus currently be implemented in terms of a Daily CPI or another Daily Index, for example, a Brazilian-style Unidade-Real-de-Valor-based Daily Index that was almost entirely made up of the US Dollar daily exchange rate - by any country with the political will to use a Daily Index with IAS 29 to stabilise its hyperinflationary economy.

In short: if the IASB were to add the two words “Daily Index” to IAS 29, it would immediately stabilise the Venezuelan non-monetary economy over a short period of time. It would also stabilise the Belarus non-monetary economy whenever Belarus would actually implement such a revised version of IAS 29. An IAS 29 requiring a Daily Index would thus currently stabilise Venezuela´s non-monetary economy, but not in the case of Belarus because Belarus is not actually implementing IAS 29 as per my American accredited source in Belarus.

According to my source: "the government has not recognized the existence of hyperinflation in the country."

If the IASB were to add the two words “Daily Index” to the future IFRS regarding Financial Reporting in High Inflationary Economies, it would stabilise the non-monetary economies of all countries with inflation in excess of 10 percent per annum or 26 percent cumulative inflation over three years.

Stable non-monetary economies would be a great benefit to the people of Venezuela and Belarus and of countries with high inflationary economies.

The IASB can thus with two words do what now would be required to be done by the last dictator in Europe and by the newly elected president in Venezuela.

Unfortunately the IASB is currently completely unaware of this social responsibility it has to the people of high inflationary and hyperinflationary economies to - where it could it should - authorise standards that would automatically stabilise a non-monetary economy because the IASB itself does not understand the stabilising effect in the non-monetary economy of  Capital Maintenance in Units of Constant Purchasing Power as required in IAS 29, but with requiring a Daily Index instead of the monthly published CPI . The power to automatically stabilise high inflationary and hyperinflationary economies thus lies in the hands of the IASB because most of these countries implement IFRS. All that is required is the addition of two words. All the rest of the requirements and authorisations are already in place in IFRS.

This is not something new. It was widely implemented in Latin America from the early 1960´s to the mid 1990´s.

The IASB “are hoping to publish the Conceptual Framework discussion paper” regarding capital maintenance “next month.”

Nicolaas Smith

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

IFRS are based on a fallacy

Maintaining the constant purchasing power of capital in nominal monetary units is impossible during inflation (including during low inflation) when net assets include constant real value non-monetary items not measured in units of constant purchasing power and monetary items not inflation-adjusted - both in terms of an index which recognizes all changes in the general price level (normally a Daily Index).

It is generally assumed that capital maintenance means that the real value (constant purchasing power) of capital is maintained constant over time.

It is generally impossible to maintain the constant purchasing power of capital constant in nominal monetary units during inflation. The statement in IFRS in the Conceptual Framework, par. 4.59 (a) that “Financial capital maintenance can be measured in nominal monetary units” is thus a fallacy. IFRS are thus based on a fallacy which came about through social and economic practice over the last 3000 years. It may take another 200 years to undo that practice.

Nicolaas Smith

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

Constant purchasing power maintenance

‘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 1979: 24

The above statement clearly excludes a financial concept of capital such as invested money, i.e., Historical Cost Accounting or financial capital maintenance in nominal monetary units, from being part of what bestows credibility on financial reporting.

Capital is equal to the real value of net assets.

However, the Conceptual Framework states:

‘Under a financial concept of capital, such as invested money or invested purchasing power, capital is synonymous with the net assets or equity of the entity.’

Conceptual Framework, par. 4.57

The CF mistakenly implies that under a financial concept of capital, such as invested money or invested purchasing power, capital is synonymous with the nominal net assets or equity of the entity.

This is obviously a mistake to be corrected in IFRS.

It is thus generally impossible to maintain the constant purchasing power of capital with Historical Cost Accounting, i.e., under financial capital maintenance in units of constant purchasing power per se.

However, “A financial concept of capital is adopted by most entities in preparing their financial statements.’

Conceptual Framework, par. 4.57

The CF assumes a nominal financial concept of capital - the traditional model in the world economy - since capital maintenance in units of contant purchasing power is only prescribed in IFRS (in IAS 29) in “exceptional circumstances.” CF par. 4.63.

Thus most entities do not maintain the purchasing power of their capital constant during low inflation, (high inflation and hyperinflation). It is very obvious during high inflation and hyperinflation. Financial capital maintenance in nominal monetary units is thus a fallacy since it is impossible - in general - to maintain the real value of capital constant in nominal monetary units per se during inflation. IFRS should not be based on generally accepted accounting fallacies.

The opening constant purchasing power of capital can be maintained constant in entities that at least break even in real value - all else being equal - with measurement in units of constant purchasing power in terms of the measuring unit current at the end of the reporting period during hyperinflation, i.e., with restatement as currently applied in IAS 29 in terms of the month-end CPI - because opening capital is a balance sheet item, i.e., it has an unlimited lifetime: it is not time dependent. Current year profits and losses are time-dependent. When they are not maintained - during the reporting period - in terms of every change in the general price level, then 100% of their constant purchasing power are not being maintained constant, e.g., currently in Venezuela and Belarus. The same has always happened during low inflation (all levels of inflation).

Current year results at the end of the reporting period pass to equity. Their constant purchasing power cannot be maintained 100% during the reporting period unless all changes in the general price level are recognized which is  impossible with restatement in terms of the month-end CPI as it is currently implemented under IAS 29. IAS 29 had no relevance in Zimbabwe.

Thus, what is important is constant purchasing power maintenance and not just capital maintenance. The two concepts are in fact the same under ideal capital maintenance in units of constant purchasing power. The two are the same only with measurement in units of constant purchasing power when all changes in the general price level are recognized - which does not happen under IAS 29 in terms of the month-end CPI. A Daily Index - as used very successfully from 1964 to 1994 in Brazil and in other Latin American countries during that period - is thus required.

Capital maintenance in units of constant purchasing power in terms of a Daily Index is not something new. It was widely used in Latin America in the period mentioned above. The very successful and wide use of daily indices over 30 years in Latin America was - very unfortunately (see Zimbabwe) ignored by the IASC - the IASB´s predecessor body - with the authorization of IAS 29 in 1989. The IASB plans to undertake research to determine whether to revise IAS 29.

Nicolaas Smith

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

Comment letter to the IASB regarding Draft Discussion Paper: Capital Maintenance

Comment letter to the IASB regarding Draft Discussion Paper: Capital Maintenance

Rachel Knubley

IASB

cc Peter Clark

Dear Ms Knubley,

Re: Draft Discussion Paper: Capital Maintenance

In my opinion the issues associated with capital maintenance are best dealt with in the Conceptual Framework.

Attached please find Appendix A with my detailed comments.

Yours sincerely,

Nicolaas Smith

Appendix A: Comment letter to the IASB regarding  Draft Discussion Paper: Capital Maintenance

A The Conceptual Framework states:

Scope

The Conceptual Framework deals with:

(d) concepts of capital and capital maintenance.

Purpose and status

The purpose of the Conceptual Framework is:

(a) to assist the Board in the development of future IFRSs and in its review of existing IFRSs;

The issues associated with capital maintenance are thus best dealt with in the Conceptual Framework.

B The Draft Discussion Paper states:

2. Most entities adopt a financial concept of capital maintenance.

In my opinion it would be more useful to state:

Most entities adopt a financial concept of capital maintenance, namely

(a) financial capital maintenance in nominal monetary units (Historical Cost Accounting) during low inflation, high inflation and deflation and

(b) financial capital maintenance in units of constant purchasing power as prescribed in IAS 29 Financial Reporting in Hyperinflationary Economies during hyperinflation.

C The Draft Discussion Paper states:

2.  However, the existing Conceptual Framework does not prescribe a particular model of capital maintenance.

The Conceptual Framework does not prescribe a particular model of capital maintenance, but IAS 29 does - as indicated in the Draft Discussion Paper, par. 3.

The Conceptual Framework, par. 4.65 states:

At the present time, it is not the intention of the Board to prescribe a particular model other than in exceptional circumstances, such as for those entities reporting in the currency of a hyperinflationary economy.

Restatement of HC or CC financial statements in terms of the measuring unit current at the end of the reporting period as prescribed in IAS 29 and implemented in terms of the monthly published CPI is a form of financial capital maintenance in units of constant purchasing power, i.e., one of the concepts of capital maintenane referred to in the Draft Discussion Paper as follows:

3. The concepts of capital maintenance are used in IAS 29 Financial Reporting in Hyperinflationary Economies.

It is to be noted that

IFRS Staff Paper Agenda ref 20 IFRS Interpretations Committee Meeting 22-23 January 2013 Applicability of IAS 29 to financial statements prepared under the concept of financial capital maintenance in constant purchasing power units

states:

Par. 10 Under current IFRS, there is no particular guidance on how to prepare financial statements stated in constant purchasing power units.

The above statement is obviously wrong as indicated in par. 3 in the Draft Discussion Paper.

There are thus important issues associated with capital maintenance to be dealt with.

D The Draft Discussion Paper states:

4. The IASB note that the concepts of capital maintenance are most relevant for entities operating in high inflation economies.

That is not correct.

The concepts of capital maintenance are most relevant for entities operating in hyperinflationary economies - when relevance is considered simply in terms of the percentage of real value eroded per annum (a) by the stable measuring unit assumption in the constant real value of constant real value non-monetary items never or not fully maintained constant and (b) by inflation in the real value of only monetary items not inflation-adjusted.

‘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 S H and Kwok A K F 2009 On the Measurement of Zimbabwe’s Hyperinflation Cato Journal 29 2

IAS 29 in terms of the monthly CPI was implemented during the last 8 years of hyperinflation in Zimbabwe (except during the last few months of severe hyperinflation when it could not be implemented because no CPI was available) with no positive effect at all. IAS 29 had no relevance in Zimbabwe: the Zimbabwean economy imploded on 20 November 2008.

The concepts of capital maintenance are most relevant for entities operating in low inflation economies when the absolute value of real value eroded per annum (a) by the stable measuring unit assumption in the constant real value of constant real value non-monetary items never or not fully maintained constant and (b) by inflation in the real value of only monetary items not inflation-adjusted, is considered.

It is generally impossible to maintain the real value (constant purchasing power) of capital constant with measurement in nominal monetary units per se during inflation and deflation.

‘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 1979: 24

Capital is equal to the real value of net assets.

E The Draft Discussion Paper states the principles related to the concepts of capital and capital maintenance as they appear in the Conceptual Framework. The CF only indicates the two broad categories of capital concepts and capital maintenance concepts: physical and financial.

However, the CF, Par. 4.59 (a) also states:

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

Financial capital maintenance in nominal monetary units (HCA) is fundamentally different from financial capital maintenance in units of constant purchasing power. The stable measuring unit assumption is implemented and net monetary losses and gains are not accounted under HCA while the stable measuring unit assumption is never implemented and net monetary losses and gains are accounted under ideal financial capital maintenance in units of constant purchasing power.

IAS 29 in terms of the monthly CPI is not ideal FCMUCPP since IAS 29 results in the erosion by the stable measuring unit assumption and inflation (see above) of current period results during the 353 different daily general price levels during the year when IAS 29 does not recognize these (at least) 353 different daily general prices level changes. IAS 29 can also have no positive effect at all. See Zimbabwe above. IAS 29 has been implemented recognizing only the 12 month-end CPI´s. IAS 29 does not prescribe the use of the month-end CPI. It simply requires restatement in terms of the general price level. The Daily CPI is a lagged, daily interpolation of the general price level monthly published CPI. The general price level can change more than once - even hourly - during hyperinflation (Hanke and Kwok 2009, p 359). This erosion is remedied with a daily index (e.g. the Daily CPI or a Brazilian-style Unidade Real-de-Valor-based daily index) as was used very successfully in Brazil during the 30 years of very high and hyperinflation from 1964 till 1994 as well as widely implemented in other Latin American countries during that period all using a form of capital maintenance in units of constant purchasing power in the form of indexation or monetary correction or price-level restatement.The latter described in detail by the Central Bank of Chile.

There are thus three concepts of capital and three concepts of capital maintenance authorised in IFRS.

Three concepts of capital

The concepts of capital in the Conceptual Framework (2010), Par. 4.57 give rise to the following three concepts of capital during inflation and deflation:

(i) Physical capital. Par. 4.57 & 4.58.

(ii) Nominal financial capital. Par. 4.59 (a).

(iii) Constant item purchasing power financial capital. Par. 4.59 (a).

Three concepts of capital maintenance

The concepts of capital in Par. 4.57 give rise to the following three concepts of capital maintenance during inflation and deflation:

(i)  Physical capital maintenance. Optional during inflation and deflation. The Current Cost Accounting model is prescribed in IFRS when the physical capital maintenance concept is implemented. Par. 4.61.

(ii)  Financial capital maintenance in nominal monetary units (HCA). Authorized in IFRS but not prescribed—optional during inflation and deflation. Par. 4.59 (a).  

(iii)  Financial capital maintenance in units of constant purchasing power. Authorized in IFRS, but not prescribed—optional during inflation and deflation. Par. 4.59 (a).

Conclusion: In my opinion the issues associated with capital maintenance are best dealt with in the Conceptual Framework.

Nicolaas Smith

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

__________________________________________________________________________________

10 June 2013

Dear Mr Smith

Thank you very much for your email and accompanying comments.

We are hoping to publish the Conceptual Framework discussion paper next month. The purpose of the discussion paper is to seek input on the issues discussed in the paper. The IASB will consider their preliminary views on how to deal with capital maintenance in the light of comments received on the discussion paper. Consequently, I would encourage you to submit a comment letter on the discussion paper once it is published.

Once again, thank you for your interest in our work.

Regards

Rachel Knubley

________________________________________________________________________