Basis for Historical Cost Accounting

“In most countries, primary financial statements are prepared on the historical cost basis of accounting without regard either to changes in the general level of prices or to increases in specific prices of assets held, except to the extent that property, plant and equipment and investments may be revalued.” IAS 29 Par 6. HCA is the generally accepted traditional basic accounting model used by most entities during low inflation and deflation.

IFRS only define two economic items: monetary items (IAS 29 Par 12 and IAS 21 Par 8) and non-monetary items (IAS 29 Par 14). There are, however, three fundamentally distinct basic economic items in the economy as defined above. Constant real value non-monetary items and variable real value non-monetary items are defined indirectly in IFRS. According to the Framework, Par 104 (a) financial capital maintenance can be measured in units of constant purchasing power during low inflation and deflation. Although IAS 29 is only to be applied during hyperinflation, it defines monetary and non-monetary items. According to IAS 29 Par 12: “Monetary items are not restated because they are already expressed in terms of the monetary unit current at the balance sheet date.”

IAS 29 Par 14 defines non-monetary items as all items that are not monetary items. Since monetary items are not restated only non-monetary items can thus be measured in units of constant purchasing power or inflation-adjusted or restated or updated during inflation and deflation. As such, non-monetary items measured in units of constant purchasing power during low inflation and deflation are thus constant real value non-monetary items; e.g. all income statement items, all items in shareholders´ equity, trade debtors, trade creditors, taxes payable and receivable, etc. Non-monetary items that are not measured in units of constant purchasing power during low inflation and deflation are thus variable real value non-monetary items since they have variable real values over time and are valued in terms of specific IFRS.

Non-monetary items also include Historical Cost items based on the stable measuring unit assumption under the HCA model.

One of the basic principles in accounting is “The Measuring Unit principle: The unit of measure in accounting shall be the base money unit of the most relevant currency.

This principle also assumes the unit of measure is stable; that is, changes in its general purchasing power are not considered sufficiently important to require adjustments to the basic financial statements.” ²

Inflation is always and everywhere a monetary phenomenon. Milton Friedman. Money (the functional currency) is not perfectly stable during inflation and deflation. Inflation destroys the real value of money and other monetary items at the rate of inflation as indicated by the change in the Consumer Price Index. Sustainable zero annual inflation has never been achieved in the past and is not likely to be achieved any time soon in the future.

HC accountants, on the other hand, simply assume that the functional currency (money) is perfectly stable in low inflationary and deflationary economies only for the purpose of valuing balance sheet constant items which they account as HC items; they measure them in nominal monetary units implementing financial capital maintenance in nominal monetary units. In conformity with world practice they do not apply this assumption to the valuing of certain Income Statement constant items, namely salaries, wages, rentals, etc which they inflation-adjust annually. HC accountants value other income statement items in nominal monetary units, i.e. at HC. HC accountants do not regard changes in the general purchasing power or real value of money to be sufficiently important during low inflation and deflation to continuously measure financial capital maintenance in units of constant purchasing power as they have been authorized in IFRS in the Framework, Par 104 (a) in 1989. They generally choose to implement financial capital maintenance in nominal monetary units, also authorized in IFRS in the Framework, Par 104 (a). However, it is impossible to maintain the real value of financial capital constant by measuring financial capital maintenance in nominal monetary units per se during inflation and deflation. Financial capital maintenance in nominal monetary units per se during inflation and deflation is a popular accounting fallacy.

This led accountants to choose to implement the traditional Historical Cost Accounting model during non-hyperinflationary periods where under they select to maintain the stable measuring unit assumption (also IFRS-approved and also based on a fallacy) for an unlimited period of time during indefinite low inflation. They value both variable items stated at HC in terms of IFRS, as well as constant items also stated at HC in terms of the HCA model, in nominal monetary units during non-hyperinflationary periods. Both HC variable and HC constant items are thus considered by accountants to be simply HC non-monetary items.

SA accountants thus treat the portion of Shareholders´ Equity in SA companies not maintained constant by investment in sufficient revaluable fixed assets as a monetary item. They thus unknowingly destroy its real value at a rate equal to the annual rate of inflation amounting in total to about R200 billion per annum in the SA real economy.

Kindest regards

Nicolaas Smith
realvalueaccounting@yahoo.com

Copyright © 2010 Nicolaas J Smith