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

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