The Historical Cost Mistake

Constant ITEM Purchasing Power Accounting, the financial capital maintenance in units of constant purchasing power model is, unfortunately, not chosen by a single SA accountant in SA to measure financial capital maintenance in real value maintaining units of constant purchasing power despite the fact that it is authorized in the IASB´s Framework, Par 104 (a) since 1989 as an alternative to the very destructive traditional HC model at all levels of low inflation and deflation. SA accountants value balance sheet constant real value non-monetary items using the traditional HC model in terms of which they implement the stable measuring unit assumption. SA accountants unknowingly destroy the real values of constant items never maintained at a rate equal to the rate of inflation because they, unfortunately, choose to measure financial capital maintenance in nominal monetary units when they apply the very destructive stable measuring unit assumption for an unlimited period of time during indefinite inflation. They unknowingly make the wrong choice. Since they all do it, since it is the traditional choice and since it is also authorized in the Framework, Par 104 (a) which is applicable in the absence of specific IFRS, they unknowingly make the Historical Cost Mistake.

In the same breath, SA accountants do exactly the opposite: they acknowledge that inflation is destroying the real value of the depreciating Rand used as a depreciating monetary medium of exchange and they index or inflation-adjust by means of the CPI constant real value non-monetary income statement items like salaries, wages, rentals, etc by increasing their nominal values at a rate at least equal to the rate of inflation thus keeping their non-monetary real values constant over the time period in question.

On the one hand they acknowledge that the nominal values of income statement items like salaries and wages have to be indexed or inflation-adjusted by means of the CPI because inflation is destroying the real value of the Rand and on the other hand they assume - at exactly the same time and during exactly the same period - that the constantly depreciating Rand is perfectly stable, but, only for the valuation of balance sheet constant real value non-monetary items like Retained Earnings, Issued Share capital, capital reserves, provisions, other shareholder equity items, etc as well as for the other income statement items not inflation adjusted. SA accountants thus, unknowingly, destroy their real values at a rate equal to the rate of inflation to the amount of about R200 billion (Date 2010), year in year out, decade after decade when they maintain the stable measuring unit assumption for an unlimited period of time during indefinite inflation.

Kindest regards

Nicolaas Smith

Copyright © 2010 Nicolaas J Smith

The Historical Cost Mistake

Updated on 31 May 2014

The Historical Cost Mistake is the implementation of the stable measuring unit assumption under Historical Cost Accounting during inflation and deflation. Stopping the stable measuring unit assumption, i.e., implementing Capital Maintenance in Units of Constant Purchasing Power in terms of the Daily Index fixes the Historical Cost Mistake.

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• Constant Item Purchasing Power Accounting per IFRS

Historical Cost accountants are unknowingly and unintentionally responsible for the destruction of the real value of constant real value non-monetary items never or not fully updated daily /maintained constant in real value daily over time when they choose to measure financial capital maintenance in nominal monetary units in terms of the IASB´s Conceptual Framework (2010), Par. 4.59 (a) as it forms part of IFRSs. Almost all accountants choose the Historical Cost Accounting model which includes the stable measuring unit assumption.

Inflation can be any value, for example 2000 % per annum in the case of Brazil during phases in their 30 years of hyperinflation. When accountants choose to measure financial capital maintenance in terms of units of constant purchasing power in terms of the Daily CPI instead of in terms of nominal monetary units as per Par. 4.59 (a) - all constant real value non-monetary items are maintained constant at their constant real values – at any level of inflation/lhyperinflation as happened in Brazil - or deflation. It is thus clearly not inflation but accountants choosing the HCA model - under which they implement the stable measuring unit assumption who are unknowingly and unintentionally responsible for the destruction of the real value of constant real value non-monetary items never or not fully updated daily/maintained constant in real value daily over time.

Brazil in effect implemented Capital Maintenance in Units of Constant Purchasing Power (CMUCPP)  in terms of a Daily Index (their Unidade Real de Valor in 1994) when various different governments implemented various different Daily indexes to Daily index all non-monetary items as well as many monetary items (money loans/deposits) in the Brazilian economy for 30 years from 1964 to 1994 as stated to me by the Brazilian Central Bank.

Inflation also does not destroy the real values of fixed nominal payments of constant real value non-monetary items like salaries, wages, rents, pensions, etc. Inflation can only erode the real value of money and other  monetary items over time, nothing else. Accountants choosing the HCA model, under which they implement the stable measuring unit assumption, are unintentionally and unknowingly responsible for the destruction of the real values of fixed nominal payments of constant real value non-monetary items. When CMUCPP in terms of a Daily CPI is implemented the real value of payments of constant real value non-monetary items are maintained constant at any level of inflation or deflation. See Brazil from 1964 to 1994.

It is thus accountants choosing the HCA model that do the destroying with the stable measuring unit assumption (in the case of constant real value non-monetary items never or not fully maintained) and not inflation. Inflation only erodes the real value of monetary items, nothing else. Accountants freely choose to implement the HCA model instead of the CMUCPP model. No-one forces them to implement HCA during low and high inflation or deflation.

The level of inflation simply indicates the level of daily constant purchasing power adjustments in terms of the Daily CPI necessary to maintain the real value of constant real value non-monetary items over time. It is accountants choosing the HCA model – in fact, their choice to implement the stable measuring unit assumption - that is destroying the real value of constant real value non-monetary items never or not fully updated over time and not inflation. Inflation only erodes the real value of money and other monetary items over time.

IFRS / US GAAP authorized solution to the Historical Cost Mistake: Daily Indexing

Financial capital maintenance in units of constant purchasing power is authorized in both IFRS and US GAAP as the alternative to Historical Cost Accounting, i.e., financial capital maintenance in nominal monetary units (or the Historical Cost Mistake).

The Historical Cost Mistake is, obviously, fixed with Daily Indexing: Capital Maintenance in Units of  Constant Purchasing Power in terms of the Daily CPI during low inflation and high inflation and deflation and in terms of the US Dollar parallel rate during hyperinflation.

Daily Indexing

1. Accounting Daily Indexing
2. Comprehensive Daily Indexing

1. Accounting Daily Indexing is implementing CMUCPP in terms of the Daily CPI instead of HCA. That only eliminates the destruction of the real value of constant real value non-monetary items never or not fully maintained constant in real value by HCA. Accounting Daily Indexing keeps the constant real value non-monetary economy perfectly stable my stopping the stable measuring unit assumption in accounting, i.e. stopping HCA.

2. Under Comprehensive Daily Indexing, Accounting Daily Indexing is combined with daily indexing of the entire money supply in terms of the Daily CPI. This only eliminates the effect of inflation and deflation from only monetary items. Nothing else. It does not stop inflation or deflation. It stops the destruction of the real value of monetary items over time by inflation and it stops the increase in the real value of monetary items over time during deflation. It only eliminates the effect of inflation and deflation on only monetary items. It would be as if there is no inflation or deflation - while actual inflation or deflation continues.

For example, Daily Inflation Indexing the $3 trillion in global government inflation-indexed bonds maintains the real value of this USD 3 trillion perfectly stable over time on a daily basis, but it does not stop the inflation or deflation in the countries concerned. The inflation or deflation continues, but it is as if there is not inflation or deflation for the holders of the $3 trillion sovereign capital inflation-adjusted bonds inflation-indexed daily.

Daily indexing only removes the effect of inflation and deflation. It does not stop the inflation or deflation. It is as if there is no inflation or deflation.

This is free, authorized under IFRs and US GAAP and available to all countries and economies.

Daily Indexing is free. It kills the need for very costly Dollarization or a currency board at no cost while the countries'  central banks maintain their full monetary creation and monetary policy powers (what they lose under Dollarization and a currency board).

Copyright © 2008 Nicolaas Smith

The Historical Cost Mistake

There are three distinct economic items in the economy:

1. Variable real value non-monetary items
2. Monetary items
3. Constant real value non-monetary items


Variable real value items

The first economic items were variable real value items. Their real values were determined by supply and demand. Their values were not yet expressed in terms of money because money has not yet been invented at that time.

The first economies functioned without money. They were barter economies. People bartered economic items they possessed or produced in excess of their own personal needs for other products they desired from other people who had an excess of the products they in turn possessed or produced.

There was no money and no double entry accounting model at that time. There was no stable measuring unit assumption. There were no historical cost items. There was no inflation because there was no money. There was no medium of exchange. There was no monetary unit of account. There were no financial reports: no profit and loss accounts and no balance sheets. There was no Consumer Price Index. There were no nominal monetary units since there was no money and there were no units of constant purchasing power because there was no CPI.

There were no monetary items and no constant items. There were only variable items.


Money


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

a. Medium of exchange
b. Store of value
c. Unit of account

At that stage there were two distinct economic items in the economy: variable items and monetary items.

Variable items were defined in monetary terms after the invention of money, since money came to be used as the basic unit of account in the economy. The economy was divided in the monetary economy and the non-monetary or real economy. There were monetary items and non-monetary items.

Monetary items

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

Non-monetary items

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

Non-monetary items were made up of only variable items at that time. There were no constant items because double entry accounting was still not invented yet.

There were still no units of constant purchasing power because there was still no CPI. There was still no HCA model, no stable measuring unit assumption and no HC items. There were still no double entry financial reports: still no profit and loss accounts and still no balance sheets.

Inflation

When inflation reared its ugly head soon after the invention of money it destroyed the real value of money and other monetary items as it does today. Inflation caused the only systemic economy-wide real value destruction in monetary items at that time and as it continues today in inflationary economies.

There was no second systemic economy wide real value destruction in constant real value non-monetary items as a result of accountants unknowingly destroying the real value of constant items never or not fully updated because they choose to measure financial capital maintenance in nominal monetary units when they implement the stable measuring unit assumption as part of the HC model.


Constant items


Finally the double entry accounting model was invented. It was first comprehensively codified by Luca Pacioli in his book Summa de arithmetica, geometria, proportioni et proportionalita, published in Venice in 1494.

The invention of the double entry accounting model established the accounting framework for maintaining the real values of constant real value non-monetary items – the third distinct category of economic items. The double entry accounting model’s fundamental function of maintaining the real value of constant items is only possible with a Constant Purchasing Power Accounting model as provided for in International Financial Reporting Standards by the International Accounting Standards Board in the Framework for the Preparation and Presentation of Financial Statements, Paragraph 104 (a) in an inflationary or deflationary economy. South African accountants unknowingly destroy the real value of constant items never or not fully updated in the SA real economy on a massive scale when they implement the stable measuring unit assumption as part of the traditional Historical Cost Accounting model. This mistake costs South Africa about R200 billion per annum compounded into the future if SA accountants keep on selecting the traditional Historical Cost model as they all do today instead of the CIPPA model as provided for by IFRSs.

Examples of constant items in today’s economy are salaries, wages, rents, pensions, taxes, duties, fixed interest payments, all other Profit and Loss Account items, retained earnings, issued share capital, capital reserves, share issue premiums, share issue discounts, all other shareholder’s equity items, provisions, trade debtors, trade creditors, other non-monetary debtors and creditors, taxes payable and receivable, deferred tax assets and liabilities, dividends payable and receivable, royalties payable and receivable, etc.

Copyright © 2008 Nicolaas Smith