Comment letter to the IASB regarding Draft Discussion Paper: Capital Maintenance
Rachel Knubley
IASB
cc Peter Clark
Dear Ms Knubley,
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
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.
Copyright (c) 2005-2013 Nicolaas J Smith. All rights reserved. No reproduction without permission.
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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
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