Brazil should go back to banning Historical Cost Accounting

Brazil should go back to banning Historical Cost Accounting is the same as stating that Brazil should go back to Capital Maintenance in Units of Constant Purchasing Power or price-level restatement or indexation or monetary correction in terms of a daily index. It would have a very positive effect on Brazil´s currency. See "Can Brazil´s currency be saved."

Brazil effectively banned Historical Cost Accounting from 1964 till March 1994 and instead implemented CMUCPP in terms of a daily index when it used daily indexation or monetary correction in terms of a daily index during the above thirty years of very high inflation and hyperinflation. Brazil unnecessarily re-introduced HCA with the adoption of the Real after it very successfully stopped hyperinflation with daily indexation (the Unidade Real de Valor) and the Real Plan in 1994.

Most Latin American countries used CMUCPP in terms of a daily index during that period as well as afterwards. Chile only stopped in 2008 in order to "comply with" IFRS. Chile did not realise that CMUCPP in terms of a daily index at all levels of inflation and deflation (including during low inflation) had originally been authorised in IFRS in the Framework (1989), Par. 104 (a) - now the Conceptual Framework (2010), Par. 4.59 (a), which states "Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power."

Re-introducing CMUCPP in terms of a daily index with its current "monetary stability" upper limit of 6.5% inflation would stabilise Brazil´s constant real value non-monetary item economy currently during low inflation, like it stabilised its entire non-monetary economy (both its variable real value non-monetary item economy and its constant item economy) and some of its monetary economy during those 30 years of high and hyperinflation from 1964 to 1994.

Brazil is a co-author of a 2010 proposal to the IASB under the chairmanship of the Argentinean Accounting Federation for the requirement of Capital Maintenance in Units of Constant Purchasing Power or price-level restatement at annual inflation of 10% or cumulative inflation of 26% over three years.

I suggest Brazil implements CMUCPP in terms of a daily index now at their 6.5% "price stability" level. It would stabilise its constant item economy over a short period of time. Brazil has 30 years of experience of daily indexation.

Inflation-indexing its entire money supply on a daily basis - as Chile has been doing for some time to at least 25% of its money supply - would eliminate the cost of and gain from low inflation of up to 6.5% inflation (or whatever other higher rate) from the entire Brazilian money supply. It would not eliminate inflation, but it would be inflation with no cost or gain.

Brazil (as well as Argentina, Chile and Mexico) already agreed to Capital Maintenance in Units of Constant Purchasing Power (price-level restatement) at 10% annual inflation or 26% cumulative inflation over three years.

Starting now at 6.5% inflation would benefit the Brazilian economy - and consequently its currency - greatly.

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

High inflation in India

High inflation in India

GDP (PPP)		2012 estimate
-	Total	$4.711 trillion[7] (3rd)
-	Per capita	$3,851[7] (129th)
GDP (nominal)		2012 estimate
-	Total	$1.947 trillion[8] (10th)
-	Per capita	$1,592[7] (140th)

Wikipedia

Population
-	2011 census	1,210,193,422[6] (2nd)

Wikipedia

Low inflation is inflation from 0.00001 to 9.99% per annum. High inflation is from 10 to 25.99% per annum or 26% cumulative inflation over three years. Hyperinflation is cumulative inflation of 100% over three years, i.e., annual inflation of 26% for three years in a row (for everyone in the world excluding Prof. Steve Hanke and a handful of other academics who steadfastly ignore the IFRS definition of hyperinflation followed by millions of accountants worldwide).

Indian year-on-year inflation during 2013

January  11.62%
February 12.06%
March     11.44%
April      10.24%
May       10.68%
June      11.06%

The Argentinean Accounting Federation, in collaboration with the Brazilian, Chilean and Mexican accounting authorities, proposed a new IFRS to the IASB namely Financial Reporting in High Inflationary Economies in 2010 in which they proposed a form of Capital Maintenance in Units of Constant Purchasing Power (restatement) in terms of the monthly published CPI similar to what is unsuccessfully used in IAS 29. 

I amended that proposal in January 2012 to use the Daily CPI since comprehensive CMUCPP is only possible with a Daily CPI and not a monthly CPI as unsuccessfully used in IAS 29 Financial Reporting in Hyperinflationary Economies. IAS 29 had absolutely no effect during 8 years of full implementation during Zimbabwe´s hyperinflation because of the use of the monthly CPI - something the IASB refuses to admit.

The IASB now (August 2013) still has to decide first whether it is going to have a research project to decide whether it should have a full-scale project to develop an IFRS for Financial Reporting in High Inflationary Economies. The IASB is currently in a "period of rest" (as they state it) after the first quarter of a century of setting IFRSs.

If the IFRS Financial Reporting in High Inflationary Economies with comprehensive CMUCPP (restatement) in terms of a Daily CPI as from the inflation thresholds as suggested in the Argentinean Proposal, namely as from annual inflation of 10% per annum or from 26% cumulative inflation over three years, were already authorized, then India would CURRENTLY be REQUIRED in terms of IFRS to implement the new IFRS (comprehensive CPMCPP) in terms of a Daily CPI. 

This would stabilize the Indian constant real value non-monetary economy over a very short period of time as India would be required to abandon the Historical Cost Accounting model and with it the stable measuring unit assumption, never to go back to it again.

India does not need the currently draft-only IFRS Financial Reporting in High Inflationary Economies to stabilize its constant real value non-monetary item economy in terms of a Daily CPI because capital maintenance in units of constant purchasing was authorized 24 years ago at all levels of inflation and deflation (including during low and high inflation) as an option to Historical Cost Accounting in IFRS in the original Framework (1989), Par. 104 (a) [now the Conceptual Framework (2010), Par. 4.59 (a)] which states: "Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power." 

India is thus currently authorized in IFRS to implement comprehensive CMUCPP in terms of a Daily CPI and therewith to stabilize its constant real value non-monetary item economy over a short period of time. India would never do it no matter what the enormous benefits would be simply because India is NOT REQUIRED to do it: it is AN OPTION in IFRS to India and India would not make that option.

Technical Issue: India does not issue government capital inflation-indexed bonds and thus does not currently have an official Daily CPI like all countries which do issue sovereign capital inflation-adjusted bonds. That is a very small technical issue. A Daily CPI can be set up in a few hours using the generally accepted Chilean Unidad de Fomento formula for that purpose (Shiller 1998). 

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

Serbian Daily CPI

Serbian Daily CPI

Addition to the Daily CPI links:

Serbian Daily CPI - see the Daily CPI links on the right on my main blog (not available on the SA blog).

I would appreciate it very much if anyone who has knowledge of the links to other countries´ Daily CPIs could be so kind as to send them to me at

realvalueaccounting@yahoo.com

to make as many as possible of these country Daily CPI links available here on one site.

All countries that issue government capital inflation-indexed bonds calculate and publish Daily CPIs. It is normally done by the central bank or the national statistics institute.

Thanking you in advance.

Nicolaas Smith




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Automatic capital maintenance under CMUCPP

Automatic capital maintenance under CMUCPP

You do not maintain the real value (constant purchasing power) of your capital constant simply by measuring it in units of constant purchasing power by multiplying it by the rate of increase in inflation during the accounting period in isolation. You do it automatically by implementing Capital Maintenance in Units of Constant Purchasing Power in terms of a Daily Index, for example, the Daily CPI during low inflation. 

This is possible because of double-entry accounting: for every credit (capital) there is an equivalent debit (e.g., trade debtor/inflation-adjusted monetary item/property). It is thus possible for capital maintenance to be automatic: it is automatic in NOMINAL (NOT REAL) VALUE under HCA and it is automatic IN REAL VALUE under CMUCPP, generally only in terms of a Daily Index. 

CMUCPP in terms of a Daily Index automatically maintains the constant purchasing power of capital constant for an indefinite period of time in all entities that at least break even in real value - ceteris paribus - at all levels of inflation and deflation. 

For example: When you have all your capital invested in a constant item, e.g., trade debtors, your capital is automatically maintained constant in real value over time during inflation and deflation because both the capital and the trade debtors are constant real value non-monetary items and both are always and everywhere measured in units of constant purchasing power in terms of a Daily Index. So it is automatic constant purchasing power capital maintenance.

When all your capital is invested in a variable real value non-monetary item, for example, a property in the middle of the financial district in London, then you would also have automatic constant purchasing power capital maintenance because you would measure your equity in units of constant purchasing power in terms of the Daily CPI in the UK (see link on the right side-bar) and the property would - generally - at least maintain its real value  in the always updated London property market. 

When all your capital is invested in a monetary item, for example, Treasury Inflation-Indexed Bonds (TIPS) in the American market, then the constant purchasing power of your capital would also automatically maintain its constant purchasing power over time. TIPS are inflation-adjusted daily in terms of the US Daily CPI (see link on the right side-bar). 

The requirement under CMUCPP in terms of a Daily Index that an entity has to break even in real value - ceteris paribus - ensures that capital maintenance is always automatic in real value (constant purchasing power) under this IFRS-authorized accounting model.

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

Differences in the three capital maintenance concepts

Differences in the three capital maintenance concepts

To form a company, you need capital. 

The company is a new legal entity even if you own 100% of the capital. You are a legal entity. You are not the company. The company is a new, separate legal entity. There are thus two legal entities or legal persons.

The company has to maintain its capital otherwise it will stop existing.

A long time ago in the past everybody believed that the real value of money is perfectly stable. They did not understand that inflation destroys the real value of money over time. 

So they thought that they were maintaining the real value of capital by simply doing their accounting in nominal monetary units. They used Historical Cost Accounting. 

Today the whole world still uses Historical Cost Accounting (except during hyperinflation  when a flawed form of CMUCPP is implemented, namely IAS 29), that is, traditional accounting: doing accounting in nominal monetary units, but, everybody knows that inflation destroys the real value of money over time.

During low inflation accountants know that inflation is destroying the real value of money, but, they assume that changes in the real value (purchasing power) of money are not sufficiently important to implement Capital Maintenance in Units of Constant Purchasing Power in terms of the Daily CPI. 

Everybody in low inflation economies worldwide thus implements traditional Historical Cost Accounting. That is (1) Financial Capital Maintenance in nominal monetary units. 

As you can see, it is impossible to maintain the real value of your capital in nominal monetary units over time during inflation and deflation. Companies bluff themselves that they overcome this problem by assuming that money is perfectly stable during low inflation and deflation. What they do is they do not declare all their profits in dividends to the owners of the capital. They retain profits hoping to maintain the real value of their capital. No-one knows for sure if the do or not.

Under financial capital maintenance in nominal monetary units (Historical Cost Accounting) a company - in theory - only maintains it capital when its nominal capital at the end of the accounting period is at least equal to its nominal capital at the start  - excluding contributions from and distributions to the shareholders.

You can see that is only true in theory. In reality it is not true. But, all accountants have been doing HCA like that for the last 3000 years, so they think it must be correct. You can see that it is not. However, it is very difficult to change something that all accountants worldwide have been doing for the last 3000 years. I think it will take about another 200 years to stop accountants doing Historical Cost Accounting while we have inflation and deflation. 

(2) Financial Capital Maintenance can also be measured in units of constant purchasing power in terms of a Daily CPI.

There are three basic economic items in the economy. They are all three stated in monetary units: they thus all have monetary values, but, they are not all monetary items. 

The three basic economic items are:

(i) Monetary items. 

(ii) Constant real value non-monetary items 

(iii) Variable real value non-monetary items

Monetary items constitute the money supply. If an item forms part of a country´s money supply as stated by the country´s central bank, then it is a monetary item. 

All items that are not monetary items are non-monetary items. 

Non-monetary items are split in two:

Constant real value non-monetary items  and

Variable real value non-monetary items.

Constant items are non-monetary items with constant real values over time. Examples are salaries, wages, rentals, interest paid, interest received, issued share capital, retained profits, retained losses, capital reserves, all other items in equity, provisions, all items in the income statement, trade debtors, trade creditors, all other non-monetary payables, all other non-monetary receivables, etc.

Constant items are always and everywhere measured in units of constant purchasing power only under Capital Maintenance in Units of Constant Purchasing Power in terms of a Daily CPI. 

Variable items are non-monetary items with variable real values over time. Examples are property, plant, equipment, quoted and unquoted shares, foreign exchange, inventory, raw materials, finished goods, patents, trademarks, etc. 

Under HCA variable items are measured in terms of International Financial Reporting Standards including the stable measuring unit assumption, that is, including nominal Historical Cost.

Under CMUCPP variable items are measured in terms of International Financial Reporting Standards excluding the stable measuring unit assumption, that is, excluding nominal Historical Cost.

How do you solve the problem of (1) the real value of monetary items being destroyed by inflation and (2) the real value of constant items being destroyed by the stable measuring unit assumption.

Inflation is always and everywhere a monetary phenomenon (Milton Friedman). Inflation only destroys the real value of monetary items not inflation-adjusted in terms of a daily index. Inflation has no effect on the real value of non-monetary items. Implementing the stable measuring unit assumption during inflation destroys the real value of constant items never maintained constant in real value. 

You can maintain the real value of monetary items during inflation by inflation-adjusting them in terms of the Daily CPI during low inflation. 

You maintain the real value (constant purchasing power) of constant items by measuring them in units of constant purchasing powe in terms of a daily index: that is, you DO NOT implement the stable measuring unit assumption. 

The stable measuring unit assumption is the assumption that money is perfectly stable. 

You measure, for example, capital in units of constant purchasing power by never implementing the stable measuring unit assumption; that is, you never assume money is perfectly stable. 

You measure capital of 100 in units of constant purchasing power over a year by multiplying it with the increase in inflation during that year. If inflation were 10% during the year, you multiply the 100 by 1.1 and you get 110. Now your capital is stated in units of constant purchasing power: the real value stays the same, but the nominal value changes daily in terms of the Daily CPI. At the end of the year the nominal value would be 110, but, the real value would be the same as the 100 at the BEGINNING of the year. Thus the REAL value remains the same over time (100 in BEGINNING of the year terms), but, the nominal value will change daily with daily inflation.

When this is done with all constant real value non-monetary items in the economy in terms of the Daily CPI, the constant real value non-monetary item economy would be stable.

When all monetary items are inflation-adjusted daily in terms of the Daily CPI during low inflation, then the monetary economy would be stable. There would still be inflation, but no cost of or gain from inflation.


Physical Capital Maintenance is maintaining the physical capital of a company in terms of physical units of output.

For example: if you have a factory that produces 1 million bricks per annum, you have maintained your physical capital (with on-going general maintenance during the year, preventative maintenance, replacement of old machinery, etc.) if the physical factory machines at the end of the year still have the capacity to produce 1 million bricks per annum. Physical capital maintenance is very different from financial capital maintenance. 

1. Financial capital maintenance in nominal monetary units 

2. Financial capital maintenance in units of constant purchasing power

3. Physical capital maintenance in physical units of output. 

Financial capital maintenance in units of constant purchasing power is fundamentally different from financial capital maintenance in nominal monetary units. Financial capital maintenance in nominal monetary units (HCA) implements the stable measuring unit assumption while the stable measuring unit assumption is never implemented under financial capital maintenance in units of constant purchasing power in terms of a daily index. 

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

Where Venezuela is heading

Demystifying the burning process

The term "burning money" has become very common in Zimbabwe. It refers to the selling of Foreign Currency originally by Real Time Gross Settlement (RTGS) or Inter-Account Transfers, and now, through the use of cheques.

20.11.0808:29am

by MISA

[This was published in The Zimbabwean on 20 November 2008, the last day of hyperinflation of  89,700,000,000,000,000,000,000.00 percent per annum.

This is where Venezuela may be heading. Why be productive if you can multiply your salary six times by simple arbitrage.  Top people in Venezuela are getting fabulously rich from arbitrage. They are not going to stop the party. Why have an economy? There is absolutely no logical reason to have a productive economy when you can get fabulously rich from arbitrage. 

This will definitely destroy what is left of the Venezuelan economy.]

The rates have risen so high that it takes less than US$1 to pay the whole of the civil service. As evidenced by the ever winding cash queues at banks, a good number of Zimbabweans are participating directly or indirectly in the "burning process".

Most of the money in circulation comes from the sale of Old Mutual Shares and other dually listed counters. People sell the shares, use the money to buy hard currency and then repurchase shares on the Johannesburg Stock Exchange (JSE) or the London Stock Exchange (LSE). This process can earn one more than 1000 per cent return per week on investment.

For example, on November 11, 2008 the Old Mutual Implied Rate (OMIR) was at Z$22.39 quadrillion per US dollar, while the Cheque Rate was Z$500 trillion per US dollar.

This means one US dollar in the hands of a person with an Old Mutual share was worth 44.78 times more than dealers were paying for a dollar "burnt" using the Cheque Rate. In Zimbabwe, a cheque takes up to four days to clear. However, if one has "enough clout" they can request same-day value and the money clears the same day it is deposited.

Owners of the famed "pots", who sell shares, can get their money on the same day, allowing them to instantly start writing cheques.

The whole process fuels itself. After someone "burns" money, they get a lot of quadrillions they can't use because most people are no longer accepting cheque payments. They then buy shares.

Most businesses are using money in their banks to buy shares and in turn, ordinary people are not selling shares because they cannot use the proceeds in any way. This creates an

artificial Bull-run on the Zimbabwe Stock Exchange.

The whole process creates a very unnatural situation where those trading in the dually listed shares are benefiting while the rest of the country is crying foul.

Ordinary people who sell foreign currency are also benefiting. If someone sold a dollar on November 11, they would have got Z$500 trillion. The cash rate for the same day was Z$350,000.00 for one US dollar. They only need to go and queue for the Z$500 000 being given by banks, then use the money to buy 1 US dollar on the flourishing parallel

market.

The whole process is destroying the economy as most of the money in bank accounts is artificial. There is no-longer any incentive to work, because people make more from burning. Companies have money in their accounts that they can no longer use to make payments as the money cannot compete with proceeds from the burning process. Pricing of goods is no longer possible in Zimbabwe dollar terms.

Can companies rely on the OMIR when billing their clients or converting Financial Statements to US dollars? The OMIR is based on the "No Arbitrage Assumption" that the value of Old Mutual Shares is the same wherever the share trades, and one cannot make a risk-free-profit by buying and selling the share in a different currency. We have shown that this is very possible.

There are a number of possible solutions:

* Dollarising the trade in shares of dually listed companies. If these shares are traded in hard currency, this does away with the arbitrage opportunities addressed above.

* Dollarising the whole economy or using a more stable regional currency such as the rand.

The Zimbabwean 20 November 2008

[The Governor of the Zimbabwe Reserve Bank closed the Zimbabwe Stock Exchange on that day (20 November, 2008) which stopped trading in Old Mutual shares which provided the OMIR (Old Mutual Implied Rate) which was the last exchange rate of the Zimbabwe Dollar with the British Pound. No exchange rate completely ended the real monetary exchange value of the Zimbabwe Dollar. The economy was already at a very advanced stage of spontaneous Dollarization.

Let us wait and see what is going to happen in the Venezuelan economy. We have an excellent example to follow in what happened in Zimbabwe.]

Arbitrage during hyperinflation can be a good thing only if coupled to capital investment

Arbitrage during hyperinflation can be a good thing if coupled to capital investment

Widespread - generally illegal - arbitrage between an official forex and a parallel rate normally appears spontaneously as a result of the invisible hand of self-interest, especially in hyperinflationary countries. It was widespread in the form of "buring money" in Zimbabwe at the height of severe hyperinflation and it is now becoming widespread in Venezuela.

Arbitrage is a crude form of quantitative easing during hyperinflation. 

When the wealth created via "buring money" in Zimbabwe or illegal arbitrage currently in Venezuela without an underlying productive process, is simply used for expenses (consumption without production), then it is simply a temporary self-destructive snowball that will eventually consume the economy and may lead to Dollarization and the economic shackles that come with it.

If the wealth created via the above arbitrage were to be applied as capital investment - for example, in the source capital of new companies - which is then automatically maintained constant in purchasing power with the implementation of Capital Maintenance in Units of Constant Purchasing Power in terms of a daily index (IAS 29 Financial Reporting in Hyperinflationary Ecomies in terms of a Daily Index), the daily USD parallel rate in the case of Venezuela, then it could over time lead to economic stability and GDP growth.

The sense of easy money that illegal arbitrage during hyperinflation engenders unfortunately works against developing the economic discipline and good governance required for such capital investment to come about. It did not come about in Zimbabwe and it will not come about in Venezuela.

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

Difference between the transaction and capital maintenance approach to measuring income

Difference between the transaction and capital maintenance approach to measuring income

"Two approaches to measuring income are commonly discussed in the accounting literature: the transaction approach and the capital maintenance approach. Under the transaction approach, income is calculated by analyzing the effects of revenue and expense transactions during a period. Any change in the value of the enterprise that is not a result of a transaction is not reflected in the enterprise's net income. Income from continuing operations under current GAAP is based on the transaction approach."

Pj Sorn 

The capital maintenance approach is also called the balance sheet approach of measuring income.

The constant purchasing power of capital is automatically maintained constant in real value under Capital Maintenance in Units of Constant Purchasing Power in terms of a Daily Index (e.g., the Daily CPI during low and high inflation and the daily USD parallel rate during hyperinflation) for an indefinite period of time in all entities that at least break even in real value - ceteris paribus - at all levels of inflation and deflation with the stable measuring unit assumption never being implemented; i.e., monetary items always and everywhere inflation adjusted daily and constant real value non-monetary items always and everywhere measured in units of constant purchasing power in terms of a daily index, both under complete coordination (everyone and everything - computer programs - always doing it). 

Under CMUCPP, as defined above, income calculated under the transaction approach as well as the capital maintenance approach would be exactly the same. 

Capital maintenance was and is only and issue under Historical Cost Accounting because it is impossible to maintain the constant purchasing power or real value of capital constant under financial capital maintenance in nominal monetary units (HCA) although the IASB states misleadingly in IFRS in the Conceptual Framework (2010), Par. 4.59 (a) that "Financial capital maintenance can be measured in nominal monetary units". The IASB misleads people in the above that the real value of capital can be maintained constant under HCA per se. That is generally impossible during inflation and deflation. Yes, financial capital can be maintained constant IN NOMINAL VALUES in nominal monetary units, but, not - generally - its real value (constant purchasing power).

Since the constant purchasing power of capital is automatically maintained constant under CMUCPP in terms of a daily index - as defined above, income is thus calculated in terms of the transaction approach; i.e., by analyzing the effects of revenue and expense transactions during a period.

Nicolaas Smith

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

Capital Maintenance: A Neglected Notion  — Oscar S. Gellein

Fall 1987

Accounting Historians Journal - Volume 14 No 2

Capital Maintenance: A Neglected Notion

Oscar S. Gellein

RETIRED MEMBER, FINANCIAL ACCOUNTING STANDARDS BOARD

CAPITAL MAINTENANCE: A NEGLECTED NOTION

Abstract: This paper traces in descriptive fashion some of the developments of thought about capital maintenance during this century. The adverse consequences of neglecting the subject are mentioned after a basic review of the concepts. Contrasts among the theories from the United Kingdom and Ireland, Canada, Australia and other countries are also made.

Introduction

To have income is to have an increment of capital; to have a loss is to have lost some capital. Capital maintenance and income are interdependent building blocks of financial ac-counting. All other notions either derive from or build on those foundation stones. Despite that mutual dependency, they have not had equal attention in the development of financial reporting in the United States. Neglect of capital maintenance in the development of income theory has not been without penalty to financial reporting. This paper traces some developments of thought about capital maintenance during the twentieth century. The paper is largely descriptive of the issues. Attention is not directed to strengths and weaknesses of arguments that have been made about the issues. Sterling et al [1981] have done that well. Some brief comments are made about adverse consequences of the neglect of capital maintenance .

Some simple thoughts about capital maintenance and in-come are offered first. The substance of financial accounting for a business enterprise concerns investment in assets looking towards a return of and on the investment. Investment in that sense refers to the act of giving up assets in exchange for other assets to be used in producing a return on the investment. Return of the investment refers to the receipt of assets equivalent to the assets relinquished in making the investment. Return on the investment is income, that is, the receipt of assets in excess of the return of investment.
Capital maintenance concerns the division of the aggregate return into its two components: return of and on investment.

Financial accounting cannot, of course, assure that capital is maintained. It can only report whether the aggregate return includes any income or, if it does not, that there has been a loss of capital. Capital maintenance refers therefore to a threshold — on one side is income; on the other, a loss. An increment of capital is income; a decrement is loss.

Financial accounting is not very tidy in the use of terms. Investment refers to the act of acquiring an asset. Investment also is used to refer to certain kinds of assets so acquired, such as, stocks, bonds, mortgages, and the like.

Capital also is used to mean several things. The most fundamental use is in characterizing an element of the accounting equation, in which capital appears as the excess of assets over liabilities. Capital also is used to characterize a kind of asset and a kind of expenditure. So capital is used to identify a kind of element on the right side of the balance sheet and an element on the left side. Anthony [1983] has recom-mented that the term capital be confined to the left side to characterize resources. In a capital maintenance context the same ambivalence exists. One view holds that assets themselves (or perhaps net assets), including similarly useful assets, constitute capital. An opposing view is that a measure of the wealth (or financial well-offness) represented by the assets of the enterprise is the capital.

Capital Maintenance Issues

To identify issues about capital maintenance, some ele-mental matters are considered first. An individual makes an investment of $1,000 in a monetary instrument (whatever its form). Suppose that the aggregate return is $1,200. To deter-mine the income one first determines the amount required to maintain capital. The amount of cash invested, $1,000, surely is a candidate. Suppose, however, that the inflation rate currently is 10 percent. Is $1,000 adjusted for 10 percent inflation, that is $1,100, also a candidate? Suppose further that the return is $ 1,200 but that the price of the asset in which the investment was made has increased to $1,150 at the same time that the inflation rate is 10 percent. Is $1,150 also a candidate for the amount of capital to be maintained? Income would be $200, $100, and $50, respectively, for the three candidates.

Turn now to business income. New complications are in-evitable. Note first, however, that the fundamental notion of capital maintenance is much the same as for an individual investor. The business is an investor in assets. There is a sought after return on the investment. Income (if any) of the business therefore is the portion of the aggregate return that exceeds the amount deemed to be a return of investment. Income is any-thing left over after capital is maintained.

The characteristics of a business give rise to issues in determining the capital that were not present in the situation for an individual investor. A business invests in and deploys a mix of assets. Some are monetary, some are nonmonetary subject to amortization over varying service lives. Some expire unexpectedly because of technological supersession. Further, a business ordinarily is leveraged to some extent. The leveraging involves short-term debt, long-term debt often for significant amounts, and may involve preferred stock.

Finally, a business is impersonal in the sense that it is a constructed alter ego of individual owners with residual inter-ests in the business — a proprietary view. Or, the business may be viewed as free standing with its own capital and its own income — the entity view.

Capital — Physical or Financial

The unique characteristics of a business produce a set of issues concerning capital maintenance that may be added to the issues highlighted earlier for an individual investor, that is, the consequences of inflation and of changes in specific prices.

The argument that capital is physical in nature had its roots in the proprietary view of a business. The proprietary view focusses on the residual interest in identifying the capital sought to be maintained. The argument is made that residual interests often are concerned about and interested in a sustained level of income from the mix of assets comprising the business as an operating unit. Accordingly, the capital to be maintained is the operating capability or capacity of the business. The argument supports the conclusion that the capital is a physical phenomenon.

Maintenance of financial capital stands in opposition to maintenance of physical capital. The financial capital view assumes that capital is a financial manifestation of wealth and, accordingly, that the physical characteristics of assets are not an appropriate focus to determine income. Those who hold that view may disagree about the attribute (invested cost, current cost, realizable value, etc.) used to measure wealth, but they agree that capital is a financial phenomenon. At this point it is noted, without elaboration, that the system of accrual accounting practiced currently in the United States is based essentially on maintenance of financial capital.

Before commenting on some world-wide developments concerning the nature of capital, brief observations are made about implications of the proprietary and entity views of a business enterprise.

The entity view raises some unique questions bearing on the nature of capital. One concerns the role of creditors and the return to them in measuring capital. One view is that creditors and equity interests (preferred as well as residual) should be treated alike in accounting for the capital of the business enterprise. One possible consequence is that there should be an accounting for the “cost” of equity capital as an expense similar to the accounting for interest paid to creditors. One might argue, of course, that returns to creditors and returns to owners would be treated alike also if neither is treated as a cost, but rather that both are treated as distributions of entity income.

The most pervasive capital maintenance issue is whether capital is financial or physical. Consideration of that issue has been sporadic in the United States. Indeed, as mentioned ear-lier, capital maintenance was a neglected issue in the United States for almost all of the first three quarters of the current century. The issue was addressed somewhat earlier in other countries of the world. Since the principal effects of the choice between financial capital and physical capital concern changes in prices of assets, differences in the timing and degrees of inflation in various countries have influenced differences in the timing of attention to the subject.

Theordore Limperg of the Netherlands is credited with being the principal originator of the physical capital notion. Limperg, accountant and self-taught business economist, entered the profession of accountancy in its formative years in the Netherlands. He also was a professor of business economics at Amsterdam University. Limperg’s thinking and theories dominated business economics and accountancy in the Netherlands for more than forty years, beginning about 1920. [van Sloten, 1981].

Central features of Limperg’s general theory of business income were the derived conclusions that (a) in normal cir-cumstances, where the business is profitable, cost of replace-ment is the recordable amount for the means of production and (b) profit is the disposable accretion to wealth of those depen-dent on the production process. The second of those conclusions has become the building block for the view that operating capability, a physical quality, is the capital threshold for de-termining business income.

Limperg’s influence on accounting in the Netherlands car-ried over into practices followed by a few well-known Dutch companies, including N. V. Philips Gloeilampen fabricken, Koninklijke Wessanen N. V., and the Group, comprising AKU and KZO. A study conducted by the Economic Institute of the Free University, Amsterdam in 1968 shows, however, that re-placement value accounting was not the prevailing practice in Netherlands. Various aspects of replacement value accounting were reflected, however, in the financial statements by a sig-nificant minority of the companies tudied [Burgert, 1972].

Holding Gains and Losses

Determination of income for a period by comparing capital at the beginning of the period with capital at the end of the period ceased, as a practical matter, at least in the United States, very early in the history of public financial reporting. Accrual accounting in which periodic income is determined by deducting invested (historic) costs from revenues assumes that the costs deducted measure the capital used up during the period. Articulation of the income statement with the opening and closing balance sheets presumably provides the test as to whether the invested capital has been maintained.

In that context, a physical capital approach would call for the matching of replacement costs of operating capability with revenues. Since operating capability in an environment of changing technology is not susceptible to direct measurement, surrogates are necessary. The usual assumption is that replacement costs of productive assests in use generally will serve as a satisfactory surrogate.

In a replacement cost system that articulates through dou-ble entry accounting, changes in replacement costs of specific assets necessarily give rise to credits or debits offsetting the recorded changes in replacement costs. Those offsetting credits and debits have come to be called holding gains and holding losses — gains if costs have increased, losses if they have declined. To label cost increases as gains and decreases as losses may seem twisted, depending on the perspective. From a capital maintenance perspective, a cost increase is a gain because of the advantage gained in using an asset for which the actual outlay was less than the outlay for that asset would have been today, and vice versa for a cost decrease. In short, gains and losses measure opportunities forgone.

The controversy about whether capital is financial or physical focusses principally on the accounting for holding gains and losses. They are income credits or charges for financial capital purposes, since they manifest changes in wealth in financial terms. They are capital adjustments for physical capital purposes, since they manifest changes in the measure of operating capability, rather than a change in operating capability itself.

Standard Setting Developments United States

As mentioned earlier, little attention was given to capital maintenance in the United States during the first seventy-five years of this century. In 1976 the Financial Accounting Stan-dards Board exposed for public consideration a Discussion Memorandum concerning a conceptual framework for financial accounting and reporting. Among the issues dealt with were the attributes (historical costs, current costs, and others) of financial statement elements. Capital maintenance necessarily was an issue to be addressed if attributes other than historical cost are studied. In 1979 the FASB issued Statement of Financial Accounting Standards No. 33 requiring certain companies to report certain information supplementally about current costs of assets and constant dollar measurements. The Statement contained a discussion of financial capital views and physical capital views, but did not contain an expression of the Board’s preference, although the earlier Exposure Draft did contain an expression of the Board’s preference for financial capital. The matter has not had further Board attention. The recent decision to withdraw the requirement of Statement No. 33 probably means indefinite postponement of standard-setting attention to capital maintenance in the United States.

United Kingdom

In January 1976 the Chancellor of the Exchequer and Secretary of State for Trade and Industry of the British government appointed a committee to inquire into inflation ac-counting. The committee, commonly referred to as the Sandi-lands Committee, submitted its report in June 1975. The committee indicated a preference for “value to the business” as the measure of assets for balance-sheet purposes. Value to the business of an asset may be replacement cost, net realizable value or “economic value,” depending on the circumstances. As a practical matter, however, replacement cost ordinarily would represent value to the business. The accounting proposed was entitled current cost accounting. The Committee concluded that the most useful representation of enterprise income would exclude all holding gains and losses in order to come to a figure characterized as operating profit. A leaning toward physical capital was thus set in motion for standard setters.

In March 1980 the Accounting Standards Committee of the United Kingdom and Ireland issued Statement of Standard Accounting Practice No. 16 on current cost accounting. The Statement required certain companies to present current cost financial statements either as a supplement to the historical cost statements or a replacement for those statements. Income would be shown in two tiers:

Current cost profit (of the enterprise), and Current cost profit attributable to shareholders.

Physical capital underlies the determination of enterprise in-come. Recognition is given to net monetary working capital as a necessary element of operating capability. As prices of goods and services change, additional (or lesser) net monetary work-ing capital is required. Accordingly, current cost profit is ad-justed for those required capital changes.

Provision is made for a gearing adjustment in determining current profit attributable to shareholders. The gearing ad-justment reflects the effect of leveraging on what is distributa-ble to common shareholders. It recognizes that operating capability (which requires working capital) will have been financed in part by borrowing and to that extent holding gains and losses (less interest paid on the borrowings) accrue to shareholders. Lemke states that the “rationale for the gearing adjustment is quite straightforward. It assumes that a firm’s debt-equity ratio will remain fairly stable and that a portion of current cost increases can therefore be financed by debt (without changing the risk characteristics of the firm)” [Sterling et al, 1980].

Australia

In October 1976 the Australian Society of Accountants and the Institute of Chartered Accountants in Australia issued a provisional statement on current cost accounting, which was amended in 1978 and superseded in November 1983 by State-ment of Accounting Practice, Current Cost Accounting. The Statement is unequivocal on the capital maintenance issue, where it states: “Profit under CCA is measured by increments in capital, defined as operating capability. This avoids the inadvertent erosion of operating capability which may occur as the result of conventional measurement of profit” [p.x].

The Statement strongly recommends presentation of supplementary current cost financial statements in addition to conventional statements. The portion of holding gains and losses attributable to monetary liabilities and monetary assets would be taken to a current cost reserve — a proprietary view.
The Statement offers an interesting comment on the proprietary/entity view of an enterprise by illustrating how a proprietary result would be calculated, together with the fol-lowing comment:

As gains on loan capital do not increase operating capability, and hence are not an element of the CCA net profit of the entity, any distributions to shareholders from the gain on loan capital reserve constitute a reduction in the operating capability of the entity unless replaced by additional equity funds or loan capital [p.x].

Canada

In December 1982 the Accounting Research Committee of the Canadian Institute of Chartered Accountants recommended that large publicly held companies present as a supplement to their historical cost financial statements (a) certain information about the current cost of inventory and property, plant and equipment and (b) certain information measured in constant dollars. The recommendations were characterized as intended to assist in assessing maintenance of enterprise operating capability, as well as maintenance of operating capability financed by common shareholders, thus opting for maintenance of physical capital in determining income (loss).

The recommendations accommodate varying views of the nature of capital by recommending disclosure of a financing adjustment that might be useful in assessing maintenance of the common shareholders’ proportionate interest in operating capability. Also recommended for disclosure is a constant dollar financing adjustment intended to assist in assessing maintenance of financial capital. The financing adjustment concerns the portion of holding gains and losses presumed to have been financed by borrowings and, accordingly, to that extent are not borne by (or a benefit to) common shareholders.

International
The International Accounting Standards Committee, in is-suing IAS 15, Information Reflecting the Effects of Changing Prices [1981], referred to two approaches to the determination of income:
(a) income after the general purchasing power of shareholders’ equity has been maintained, and
(b) income after the operating capacity of the enterprise has been maintained, which may or may not include a general price level adjustment [p.x].

Except for those indirect references, capital maintenance is not mentioned in the Statement.
Neglect of Capital Maintenance — Consequences

Two factors contributing to the dormancy of attention to capital maintenance in the United States until the 1970s were (a) an inflation rate modest enough not to upset the usual assumption that the effects of inflation could be ignored for purposes of financial accounting and (b) a focus on the match-ing of costs with revenues as a driving mechanism for periodic income determination. Capital maintenance was assumed to be a fall out of a “good” match.
Neglect of capital maintenance as the conceptual twin of income led to some developments in financial reporting that might be characterized as instinctive reactions to symptoms, rather than reasoned analysis with an anchor.

The first of those reactions grew out of the perception that if prices have risen, the conventional historical cost system would produce an “unreal profit” element in income unless replacement or current costs were matched with revenues. Thus was born a family of patches on the conventional accrual system, including Lifo costing of cost of sales and accelerated depreciation charges. Holding gains and losses under those practices were not accounted for (or, at least, the accounting was delayed) and, accordingly were excluded from income, thus tending to a physical capital effect in a system ostensibly based on maintenance of financial capital. Thus the capital maintenance and income notions inherent in the system were mixed. The resulting capital maintenance notion was uninter-pretable except to say that capital was partly financial in nature based on some historical measures of changes in wealth and partly physical.

The second instinctive reaction concerned the nature of periodic income, as compared with lifetime income. Many observers long have been uneasy with the idea that a measure of periodic income, for a year or any part of enterprise lifetime, should be similar in nature to income for a lifetime. Although there is agreement that lifetime income runs from the point of cash (or cash equivalence) invested by owners in forming a business to final cash distribution to owners upon liquidation, there has been concern that periodic income would be distorted if a cash grounding were the basis for determining periodic income. Cash grounding in an accrual system means that revenues manifest likely cash prospects and expenses represent actual or probable cash outlays. The uneasiness led to putting more patches on the system. A notable example was the deferred method of allocating income taxes under which events with probable cash consequences, like a change in tax rates, are ignored currently. Another example was the earlier practice of providing for no insurance (commonly called self insurance) even though the timing and amount of cash outlays for risks not insured were not predictable with reasonable accuracy. Patches like that fly in the face of the idea that income is a capital increment. Whatever the nature of capital, so is the nature of income.

The third reaction is more subtle. Standard setters for financial reporting have visited and revisited on a number of occasions the question of financial statement geography or display of the effects of extraordinary, unusual, or nonrecurring happenings. Treatment of those effects have been modified many times. Eventual erosion of the results has not been unusual. In the 1940s the tugging forces were characterized as the operating performance view of an income statement versus the all-inclusive view. In the 1980s the same forces are tugging at each other. Continuing debate about treatment of nonrecurring items is a manifestation of an unresolved issue that is much more fundamental than issues of display.

The argument that the capital sought to be maintained should be that which produces a sustainable source of income implies that the effects of windfalls, or of unforeseen happenings should be excluded from income. Presumably, the effects of windfalls, gains in some instances and losses in others, tend to be offsetting over time and accordingly, so the argument goes, should be ignored in determining the capital necessary to sustain a level of income. Attention to conceptual issues concerning capital maintenance would have, at least, provided a reasoned basis for resolving issues about extraordinary items. The ad hoc approach has not withstood the forces of erosion.

Unfortunately, attention to capital maintenance spurts and flags, depending on the rate of change in inflation. Continuing attention through periods of modest inflation, as well as periods of high inflation, would heighten chances for improved financial reporting and, most certainly, would provide a better rationale for any patches put on the financial accounting model.

REFERENCES

Anthony, R. N., Tell It Like It Was, Homewood, Ill.: Richard D. Irwin, 1983. Burgert, R., “Reservations about Replacement Value Accounting in the
Netherlands,” Abacus (December 1972), pp. xx. Financial Accounting Standards Board, Conceptual Framework for Financial
Accounting and Reporting: Elements of Financial Statements and Their
Measurement (Discussion Memorandum), Stamford, CN: 1976. Sterling, R. R. and K. W. Lemke, Maintenance of Capital, (papers from the
Clarkson Gordon Symposium, University of Alberta), Houston: Scholars
Book Co. 1982. Van Sloten, P. J., “Dutch Contribution to Replacement Value Accounting
Theory and Practice,” University of Manchester, U.K., Occasional Paper
No. 21, International Centre for Research in Accounting, 1981.