Inflation has no effect on the real value of non-monetary items

Inflation cannot erode or destroy the real value of non-monetary items. Erode is in the case of the functional currency, in fact, the same as destroy – there is absolutely no difference. Inflation can only destroy the real value of the unstable monetary medium of exchange (the unstable functional currency - the unstable Rand) used to transfer the constant real non-monetary values of salaries and wages from the employer to the employee.

“Purchasing power of non monetary items does not change in spite of variation in national currency value.”

Prof Dr. Ümit GUCENME, Dr. Aylin Poroy ARSOY, Changes in financial reporting in Turkey, Historical Development of Inflation Accounting 1960 - 2005, Page 9.

The destruction at a rate equal to the rate of inflation of all constant real value non-monetary items never maintained during inflation stops the very moment the Boards of Directors of SA companies and SA accountants choose to implement the IASB-approved financial capital maintenance in units of constant purchasing power model no matter what the level of inflation in the SA economy. The choice is theirs. The power to stop killing the real economy is in their hands - as authorized since 1989 in the IASB´s Framework, Par 104 (a) which is applicable in the absence of specific IFRS. It is SA accountants´ choice of accounting model and not inflation that maintains or destroys the real value of constant real value non-monetary items in SA´s low inflationary economy.

The constant real non-monetary values of salaries and wages expressed in terms of the depreciating unstable Rand as the depreciating unstable monetary unit of account are presently being maintained at the actual levels currently being achieved in SA when their nominal monetary values are indexed or inflation-adjusted by means of the CPI in SA´s low inflationary environment. This happens not because of a lowering of inflation, but because of SA accountants and SA trade unions valuing salaries and wages in units of constant purchasing power - inflation-adjusting them - instead of the Historical Cost measurement basis for this particular purpose.

If the parties to the salary and wage determination process were to agree to value salaries and wages at fixed Historical Cost – like Iceland recently decided to freeze salaries because of their financial crisis - then their constant real non-monetary values would be destroyed at a rate equal to the rate of inflation since constant real value non-monetary salaries and wages are expressed in term of the depreciating monetary unit of account in SA, namely, in depreciating Rands and are normally paid in depreciating Rands. Salaries and wages are not depreciating monetary items. They are constant real value non-monetary items. They are, however, normally paid in depreciating Rands which are depreciating monetary items during inflation.

“Income Statement

This standard requires that all items in the income statement are expressed in terms of the measuring unit current at the balance sheet date.” IAS 29, Par 26.

All items in the income statement are constant real value non-monetary items to be expressed or maintained or inflation-adjusted in terms of the measuring unit current (normally the CPI) at the balance sheet date in the case of IAS 29 and CIPPA models. Salaries and wages, being income statement items, are constant real value non-monetary items.

The real values of salaries and wages would thus not be destroyed by inflation if they were valued in nominal monetary units, but by the choice of the measurement basis, namely, Historical Cost which means the implementation of the very destructive stable measuring unit assumption whereby SA accountants consider that the continuous destruction of the purchasing power of the Rand – currently at 6.2% p.a. - is not sufficiently important to index or inflation-adjust the nominal values of constant real value non-monetary salaries and wages by means of the CPI in order to maintain their real values constant. What SA accountants do, in essence, is they assume the constantly depreciating monetary unit of account – the depreciating Rand – is perfectly stable when they implement the stable measuring unit assumption. SA accountants assume the depreciating Rand is perfectly stable, but, only for this particular purpose.

Constant purchasing power indexation or inflation-adjustment or measurement in units of constant purchasing power as authorized in the Framework, Par 104 (a) is thus applicable for financial capital maintenance in units of constant purchasing power since there is no particular IFRS which deals with it. It is a SA Generally Accepted Accounting Practice and well understood in SA´s low inflationary economy, but, currently, only for some - not all - constant real value non-monetary items in the income statement, e.g. salaries, wages, rentals, etc.
Copyright © 2010 Nicolaas J Smith

Inflation has no effect on the real value of non-monetary items

Monetary items

Money was invented over a long period of time. Eventually money came to fulfil the following three functions during inflation and deflation:

1) Unstable medium of exchange
2) Unstable store of value
3) Unstable unit of account

Non-monetary items were only defined in unstable monetary terms after the invention of unstable money. The economy came to be divided in the unstable monetary economy and the non-monetary or real economy. There were only unstable monetary items and variable real value non-monetary items. There were no constant real value non-monetary items yet. The non-monetary or real economy consisted of only variable items.

Monetary items are money held and items with an underlying monetary nature.

Examples of monetary items in today’s economy are bank notes and coins, bank loans, bank savings, other monetary savings, bank account balances, treasury bills, commercial bonds, government bonds, mortgage bonds, student loans, car loans, consumer loans, credit card loans, notes payable, notes receivable, all monetary loans, etc.

Unstable money and other monetary items´ real values are continuously being destroyed by inflation. Inflation only destroys the real value of unstable money and other monetary items. Inflation has no effect on the real value of non-monetary items.

Non-monetary items are all items that are not monetary items.

Non-monetary items in today’s economy are divided into two sub-groups:

a) Variable real value non-monetary items
b) Constant real value non-monetary items

There were still no units of constant purchasing power because there was still no CPI at that time. There were still no real value destroying Historical Cost Accounting model and very destructive stable measuring unit assumption accounting fallacy. There were still no price-level accounting, no Constant Purchasing Power inflation accounting model for hyperinflationary economies and no Constant ITEM Purchasing Power Accounting model for low inflationary and deflationary economies. There were still no financial reports. There were still no very popular accounting fallacies authorized by the IASB.

Inflation

Inflation is always and everywhere a monetary phenomenon: Milton Friedman.

Inflation is a sustained rise in the general price level of goods and services in an economy over a period of time. Prices are normally set in terms of the unstable money or unstable functional currency in an economy or economic region. Inflation always and everywhere destroys the real value of depreciating money and other depreciating monetary items over time. Inflation has no effect on the real value of non-monetary items. Disinflation is a decrease in the rate of increase of the general price level. Inflation still destroys the real value of depreciating money and other depreciating monetary items during disinflation; just at a slower rate than before.

Deflation is a sustained decrease in the general price level. Deflation creates real value in appreciating money and other appreciating monetary items over time, recently mainly seen in the Japanese economy.

Inflation reared its ugly head soon after the invention of money. It only destroyed the real value of depreciating money and other depreciating monetary items at that time as it does today. Inflation did not and can not destroy or erode (which is the same as destroy) the real value of non-monetary items – either variable or constant real value non-monetary items.

Inflation has no effect on the real value of non-monetary items.


“Purchasing power of non monetary items does not change in spite of variation in national currency value.”

Prof Dr. Ümit GUCENME, Dr. Aylin Poroy ARSOY, Changes in financial reporting in Turkey, Historical Development of Inflation Accounting 1960 - 2005, Page 9.

Kindest regards,

Nicolaas Smith

Inflation has no effect on the real value on non-monetary items

A house is a variable real value non-monetary item. Let us assume a house in Port Elizabeth is fairly valued in the PE market at say R 2 million on 1st January in year one. With no change in the market a year later but with inflation at 6% in SA, the seller would increase his or her price to R2.12 million - all else being equal. The house’s real value remained the same. The depreciating monetary price for the house expressed in the depreciating Rand medium of exchange – all else being equal - was inflation-adjusted to compensate for the destruction of the real value of the depreciating Rand in the internal SA market by 6% annual inflation. It is clear that inflation does not affect the house’s variable non-monetary real value – all else being equal.

However much inflation rises, it can only make the Rand more worthless at a higher rate and over a shorter period of time. Heaven forbid that what happened in Zimbabwe recently would ever happen in SA. As inflation rises the price of the house would rise to keep pace with inflation or value destruction in the real value of the Rand – all else being equal. The real value of the property will be updated as long as the house is valued as a variable real value non-monetary item at its market price, a measurement base dictated by IFRS and also practiced in all open markets.

When a property was valued at Historical Cost in the not so distant past in a company’s balance sheet it may have stayed at its original HC of, for example, R 100 000 for 28 years since January, 1981 in the company’s balance sheet. When it is eventually sold today for R 1.4 million we can see that inflation did not destroy the property’s variable real non-monetary value – all else being equal. Inflation only destroyed the real value of the depreciating Rand, the depreciating monetary medium of exchange, over the 28 year period - all else being equal. This was taken into account by the buyer and seller at the time of the sale. The selling price in Rand was increased to compensate for the destruction of the real value of the Rand by inflation. R1.4 million today (2009) is the same as R100 000 in January, 1981 – all else being equal.

As the two lady academics from Turkey state: Purchasing power of non monetary items does not change in spite of variation in national currency value.

Kindest regards,

Nicolaas Smith

Inflation has no effect on the real value of non-monetary items

Inflation, being a uniquely monetary phenomenon, can not, by definition, destroy the real value of non-monetary items. Inflation has no effect on the real value of non-monetary items.

It is SA accountants’ choice of accounting model that determines whether they carry on currently unintentionally destroying real value in constant real value non-monetary items never or not fully updated (the real value destroying traditional HCA model) when they maintain the stable measuring unit assumption for an unlimited period of time during indefinite inflation or maintain those values in future for an unlimited period of time (the IASB approved real value maintaining CIPPA model) – all else being equal.

It is not inflation that is doing the destroying in the real value of constant items. It is our accountants unknowingly doing the destroying when they implement the very destructive stable measuring unit assumption for an unlimited period of time during indefinite inflation.

This is the case with all constant items never or not fully inflation-adjusted including the unintentional destruction by SA accountants of the real value of Shareholders´ Equity in SA banks and companies which do not have sufficient variable items that can be or are revalued via the Revaluation Reserve or with insufficient holding gains to compensate for the real value shortfall in Shareholders´ Equity under HCA.

Inflation has no effect on the real value of non-monetary items

Geoffrey Whittington, one of the world’s leading experts in inflation accounting and International Financial Reporting Standards stated:

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“Constant Purchasing Power Accounting (CPP) is a consistent method of indexing accounts by means of a general index which reflects changes in the purchasing power of money.” Inflation Accounting, Geoffrey Whittington. P. 73.

It is clear from Whittington’s benchmark book that CPPA can be applied in periods of high and hyperinflation to index or inflation-adjust non-monetary accounts by means of a general index, normally the CPI, which reflects changes in the purchasing power of the functional currency. Accountants in this manner determine the values of non-monetary items when

(1) they account them during the reporting period
(2) calculate the period-end profit or loss and
(3) measure financial capital maintenance in units of constant purchasing power

during high and hyperinflation.

Whittington signed off the preface to his book in 1983. The IASB´s Framework was authorized in 1989.

This book, contrary to Whittington’s book, is not about SA accountants implementing 1970-style inflation accounting in the SA economy during low inflation.

This book is about SA accountants maintaining the real values of constant real value non-monetary items during low inflation in the SA economy by implementing the Constant Purchasing Power Accounting model as authorized in the IASB´s Framework, Par. 104 (a) which forms part of International Financial Reporting Standards.

This book is about SA accountants indexing or inflation-adjusting constant items never or not fully updated in the low inflationary SA economy by means of the CPI which reflects changes in the purchasing power of the Rand, as authorized in the IASB´s Framework which forms part of IFRS.

This book is about SA accountants choosing to measure financial capital maintenance in SA companies in units of constant purchasing power during low inflation as authorized in the IASB´s Framework which forms part of IFRS.

This book is about SA accountants rejecting the stable measuring unit assumption during low inflation as authorized in the IASB´s Framework which forms part of IFRS.

This book is about stopping SA accountants unknowingly destroying about R200 billion of real value in the SA real economy each and every year when they choose to implement the traditional Historical Cost Accounting model instead of the CPPA model as authorized in the IASB´s Framework which forms part of IFRS: because they unknowingly make the Historical Cost Mistake.

This book is about SA accountants being able to maintain about R200 billion of real value in the SA real economy for an unlimited period of time instead of unknowingly destroying it year in year out as they do at the moment.

This book is about SA accountants abandoning the Historical Cost Accounting model and adopting the Constant Purchasing Power Accounting model in SA´s low inflationary economy – as authorized in the IASB´s Framework which forms part of IFRS.

Current reporting period monetary item accounts cannot be indexed or inflation-adjusted under any circumstance because the real value of money cannot be maintained during inflation or deflation under any circumstance.

This book does not propose that the historical costs of variable real value non-monetary items, e.g. property, plant, equipment, shares, stock, raw materials, patents, trademarks, etc, are to be consistently indexed or inflation-adjusted by SA accountants by means of the CPI for the purpose of valuation during the current accounting period, for calculating the period-end profit or loss and for financial capital maintenance during low inflation. Variable items are valued by SA accountants in terms of IFRS or SA Generally Accepted Accounting Practice excluding during hyperinflation when the implementation of International Accounting Standard IAS 29 Financial Reporting in Hyperinflationary Economies is specifically required by the IASB. SA has never experienced hyperinflation which may explain a possible lack of profound analysis of value accounting in SA.

This book is about SA accountants rejecting the stable measuring unit assumption in the SA economy at all levels of inflation and deflation as authorized in the IASB´s Framework which forms part of IFRS.

It is very clear from the IASB´s Framework, Par. 104 (a) that measuring financial capital maintenance in units of constant purchasing power is authorized by the IASB as the basis for a CPPA model at any level of inflation and deflation. The IASB does not state that financial capital maintenance can be measured in nominal monetary units (the traditional HC model) only during low inflation and that it can be measured in units of constant purchasing power (the CPP model) only during high and hyperinflation. It states simply that either the one or the other can be used. That means at all levels of inflation and deflation. It does, however, specifically require IAS 29 during hyperinflation.

In the Framework, Par. 101 the IASB states that companies most commonly use the traditional HC measurement basis to prepare their financial reports and that other measurement bases are used in combination with HC. The IASB does, however, specifically require entities only in hyperinflationary economies – being exceptional circumstances - to implement IAS 29. IAS 29 is based on CPPA. No-where is it stated by the IASB that the basic CPPA model can only be used during high inflation and hyperinflation or that it can not be used during low inflation.

The IASB - as far as measurement bases are concerned - specifically mentions historical cost, current cost, realizable (settlement) value, present value, market value, recoverable value and fair value which SA accountants, in fact, use to value variable items like property, plant, equipment, stock, shares, raw materials, patents, trademarks, etc in terms of IFRS or SA GAAP.

In Par. 104 (a) the IASB authorizes SA accountants to measure financial capital maintenance in units of constant purchasing power which would determine that they use the CPPA model instead of the traditional HC that they use at the moment. Although SA accountants choose to measure financial capital maintenance in nominal monetary units, that is, they choose the HC model, they do, however, use units of constant purchasing power to index or inflation-adjust constant items like salaries, wages, rentals, etc. SA accountants can also use units of constant purchasing power, in terms of Par. 104 (a), to value constant items like retained earnings, issued share capital, other shareholder equity items, trade debtors and creditors, etc to implement a CPP concept of capital maintenance. The IASB notes that entities use various different measurement bases in varying combinations and to different degrees in their financial reports.

We commonly find that SA companies state in their opening notes to their balance sheet that their financial reports have been prepared based on the traditional HC model. We normally find that they use different measurement bases to different degrees and in different combinations including items that are indexed or inflation-adjusted by means of the CPI in SA´s low inflationary economy; e.g. salaries, wages, rentals, utility prices, transport fees, etc. CPP indexing or inflation-adjustment is thus currently a generally accepted accounting practice in SA´s low inflationary economy only for the above-mentioned items.

In the case of salaries and wages the annual CPP indexation or inflation-adjustment normally involves labour union negotiations with employer bodies. To maintain the constant purchasing power of salaries and wages – which are expressed in nominal Rand monetary terms - they normally agree on an annual increase in the nominal Rand payment values of salaries and wages that covers – or compensates for or inflation-adjusts for - at least the expected rate of destruction in the real value of the Rand – which is the monetary medium of exchange in SA for the payment of constant purchasing power salaries and wages - for the period in question – normally the year ahead - plus an additional percentage increase for increases in productivity or for political or social reasons by government employment-contract negotiators.

CPP indexation or inflation-adjustment is thus part of IFRS and it is also a SA generally accepted accounting practice and well understood in SA´s low inflationary economy for constant real value non-monetary items like salaries, wages, rents, etc.

Despite the fact that CPPA is authorized in the IASB´s Framework, Par. 104 (a) as it forms part of IFRS since April 1989 as an alternative choice to the traditional HC model at any level of inflation and deflation, it is, unfortunately, not chosen by a single SA accountant in SA to measure financial capital maintenance in units of constant purchasing power and to value constant items in the balance sheet like retained earnings, issued share capital, other shareholder equity items, taxes payable and receivable, trade debtors and trade creditors, etc. SA accountants value these items at HC. Where CPPA is not applied and these constant items are never or not fully updated SA accountants unknowingly destroy their real values at the rate of inflation because they choose to measure financial capital maintenance in nominal monetary units; that is, they choose the traditional HC model which includes the stable measuring unit assumption.

The real values of these constant real value non-monetary items are not being destroyed by inflation since inflation is a monetary phenomenon and can only destroy the real value of money and other monetary items; namely, in SA, the real value of the monetary medium of exchange, the Rand; that is, the SA functional currency. Milton Friedman, the American economist and Noble Laureate, correctly stated that: Inflation is always and everywhere a monetary phenomenon. Inflation has no effect on the real value of non-monetary items. Inflation cannot erode or destroy the real value of non-monetary items. Erode is, in fact, the same as destroy – there is no difference. SA accountants´ choice of implementing the stable measuring unit assumption as part of the HC model – instead of the CPP option - means that they unknowingly destroy the real values of constant items never or not fully updated in the SA real economy on a massive scale. The erosion or destruction stops the moment they choose to implement the CPPA model no matter what the level of inflation or deflation. The choice is theirs as authorized in the IASB´s Framework which is part of IFRS. It is thus SA accountants´ choice of accounting model and not inflation that is doing the destroying. The real values of these constant items are unknowingly being destroyed by SA accountants because they, unfortunately, implement the stable measuring unit assumption only for the purpose of valuing the above specified constant items. When they value and account constant items like retained earnings, issued share capital, capital reserves, provisions, other shareholder equity items, trade debtors and creditors, taxes payable and receivable, deferred tax assets and liabilities, etc, they assume that changes in the Rand´s general purchasing power are not sufficiently important to require adjustments to the nominal values of these constant items in order to maintain their real values constant over time. They value and account them at their historical costs and unknowingly destroy their real values at the rate of inflation each and every year – as long as they carry on implementing the HC model and the stable measuring unit assumption.

In the same breath, they do exactly the opposite: they now suddenly acknowledge that inflation is destroying the real value of the Rand as a monetary medium of exchange and they index or inflation adjust by means of the CPI constant real value non-monetary items like salaries, wages, rents, pensions, etc by increasing their nominal values at the rate of inflation thus keeping their real values constant over the time period in question.

SA accountants of listed JSE companies comply with IFRS. If SA should enter into hyperinflation they would implement IAS 29. They would then apply the CPPA model and index or inflation-adjust items like retained earnings, issued share capital, capital reserves, provisions, other shareholder equity items, trade debtors and creditors, taxes payable and receivable, deferred tax assets and liabilities, etc by means of the CPI. They would update issued share capital for all JSE listed companies from the date it was contributed, etc and maintain their real values constant under hyperinflation.

When SA is not in a hyperinflationary economy any more they would stop the CPPA model and go back to the real-value-destroying HC model and again destroy all these items´ real values at the rate of inflation or they can choose to carry on with the CPPA model and maintain their real values constant or they can choose to change now to the CPPA model in terms of Par. 104 (a). The choice is theirs since CPPA has already been authorized in the IASB´s Framework since 1989.

Inflation accounting is generally only used in periods of very high inflation, for example in the 1970´s and during hyperinflation, e.g. in the current hyperinflationary economy in Zimbabwe. The IASB´s IAS 29 is only required during hyperinflation. Hyperinflation is defined by the IASB as a cumulative inflation rate of 100% over three years; that is, 26% per annum inflation for three years in a row.

The principal objective of this book is to demonstrate with actual values that SA accountants unknowingly destroy the real value of constant items never or not fully updated in the SA real economy on a massive scale because they choose to measure financial capital maintenance in nominal monetary units in terms of Par. 104 (a); that is, they choose to implement the stable measuring unit assumption as it forms part of the traditional Historical Cost Accounting model only for this purpose.

It is an objective of this book to show that measuring financial capital maintenance in units of constant purchasing power - as authorized in the IASB´s Framework, Par. 104 (a) - is the only way to maintain the real values of constant real value non-monetary items at all levels of inflation and deflation in the SA economy; namely, with a Constant Purchasing Power Accounting model. It is the only way to stop SA accountants unknowingly destroying the real value of constant items on a massive scale in the SA real economy during inflation.

Another objective is to show that there are three distinct economic items in the economy, namely, variable real value non-monetary items, monetary items and constant real value non-monetary items and that they are valued in distinctly different ways during the reporting period when SA accountants choose to measure financial capital maintenance in units of constant purchasing power in terms of Par. 104 (a).

It is an objective of this book to start a process to stop SA accountants unknowingly destroying the real values of constant items at the rate of inflation where they are never or not fully updated in the real economy because they choose to measure financial capital maintenance in nominal monetary units. The objective is thus to get SA accountant to choose the other official option in Par. 104 (a); namely, to measure financial capital maintenance in units of constant purchasing power during low inflation as authorized in IFRS.

Measuring financial capital maintenance in units of constant purchasing power means rejecting the stable measuring unit assumption and with it the traditional Historical Cost Accounting model; that is, it means indexing all constant real value non-monetary items by means of the CPI at all levels of inflation and deflation in the SA economy, except during hyperinflation when indexing of not only constant items but all non-monetary items are to be done, not at the CPI, but, at the parallel rate. See Hyperinflation. Indexing by means of the CPI during hyperinflation as required in IAS 29 is one of the main reasons for its failure as an accounting standard.

The IASB does not state anything in Par 104 (a) about measuring financial capital maintenance in units of constant purchasing power being an option only or specifically for the purpose of inflation accounting in high inflationary and hyperinflationary economies. It is an IASB authorized alternative to the traditional HC model at any level of inflation or deflation as clearly evident from the wording of Par. 104 (a). This book is mainly about that. Obviously, CPPA is also applicable in high inflationary and hyperinflationary periods when inflation accounting per se is normally used. This book is, however, mainly about measuring financial capital maintenance in units of constant purchasing power as an alternative to HCA during low inflation in the SA economy in order to stop SA accountants unknowingly destroying massive amounts of real value in the real economy.

Any accounting practice that adjusts monetary values to compensate for or to correct the effect of the destruction of the monetary medium of exchange’s real value can be seen as inflation accounting since inflation destroys the real value of the monetary unit of account which is used as the monetary medium of exchange in the internal economy. All updating of salaries, minimum wages, rentals, utility prices, etc is currently maintaining the real values of those items in units of constant purchasing power – where it is exactly the same as the inflation rate during the relevant period - even when the main accounting model is stated to be the traditional HCA model.

Framework, Par. 110:

The selection of the measurement bases and concept of capital maintenance will determine the accounting model used in the preparation of the financial statements.

The IASB authorizes two concepts of capital maintenance in Par. 104 (a): in nominal monetary units; i.e. the HCA model - and in units of constant purchasing power; i.e. the CPPA model. The IASB does not exclude the CPPA model during low inflation. It authorizes it as an alternative to the traditional HCA model at all levels of inflation and deflation. It only mandates that it specifically requires IAS 29, which is based on CPPA, during hyperinflation.

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Copyright © 2008 Nicolaas Smith