Accountants value economic activity

The debate of how to account for value has been around for decades.

Robert Kemp, CPA Professor, University of Virginia – CC http://www.glgroup.com/News/Fair-Value-Accounting---The-Good-And-Bad-Of-It-In-The-Real-World-27848.html


The three distinct economic items in the economy

1. variable items
2. monetary items and
3. constant items

are economic values. Each economic item is an economic value expressed in terms of money. SA accountants account economic transactions involving these three economic items in an organized manner when they implement a double entry accounting model: journal entries, general ledger accounts, trial balances, cash flow statements, items in the Profit and Loss Account, assets and liabilities in the Balance Sheet plus other financial, management and costing reports.

SA accountants value economic items when they account economic activity in the accounting records and prepare financial reports of SA economic entities based on the double entry accounting model. Accounting entries are valuations of the economic items (the debit items and the credit items) being accounted.

SA accountants do not simply record economic activity. Accounting is not just a scorekeeping or recordkeeping of economic events. Accountants value economic items when they account them. Subsequent accounting entries are part of continuous generally accepted accounting practice of valuation of the economic items originally valued and accounted over time as required by SA Generally Accepted Accounting Practice and IFRS implemented in conjunction with the IASB´s Framework.

The measurement basis SA accountants choose to value constant real value non-monetary items determines whether they maintain or destroy their real values. Inflation being a monetary phenomenon cannot destroy the real value of constant real value non-monetary items. When accountants value constant items at their HC nominal monetary values they unknowingly destroy their constant real non-monetary values at a rate equal to the rate of inflation because the depreciating monetary unit of account is the same as the depreciating monetary medium of exchange and inflation destroys the real value of the depreciating monetary medium of exchange. Only when they choose to measure financial capital maintenance in real value maintaining units of constant purchasing power – as they can freely do in terms of the IASB´s Framework, Par. 104 (a) - do they maintain their real values over time.

Variable Items

SA accountants value variable real value non-monetary items in terms of IFRS or SA GAAP. “Listed companies use IFRS and the unlisted companies could use either IFRS or Statements of GAAP.”

Monetary items

SA accountants value monetary items at their original nominal monetary values; that is, at their original HC values since monetary items can not be updated or indexed during the current financial period for the purpose of

1. accounting their values during the reporting period,
2. determining the profit or loss for the reporting period, and
3. measuring financial capital maintenance in either nominal monetary units or constant purchasing power units

during inflation or deflation.

Inflation – not SA accountants - destroys the real value of SA monetary items over time. The internal real value of the Rand is automatically adjusted downwards as it is being destroyed by the economic process of inflation in SA´s inflationary economy as indicated by the rate of change in the CPI. Inflation destroys the real value of monetary items under any accounting model and also when no accounting model is implemented; that is, when a business does not account its economic activities; for example, street vendors. The accounting model has no affect on the real value of monetary items during the reporting period.

Double entry accounting cannot maintain the real value of monetary items during the reporting period. It is not an attribute of double entry accounting to maintain the real value of monetary items during the reporting period. Inflation destroys the real value of monetary items no matter which accounting model is used. That is why low inflation is so critical for long term sustainable economic growth.

Low inflation is what long term sustainable economic growth is built on. Alan Greenspan.

Constant items

SA accountants can choose to measure financial capital maintenance in either nominal monetary units or in real value maintaining units of constant purchasing power as authorized by the IASB in the Framework, Par. 104 (a).

It is very obvious that how SA accountants choose to measure financial capital maintenance does make a big difference to the real value of constant items. There is no substance in the statement that economic resources´ values – per se - are independent of the way in which we value them – no matter how well respected and how important that person is in the SA accounting and academic circles. The accounting model SA accountants choose in terms of the Framework, Par. 104 (a) is of critical importance. When they choose to measure financial capital maintenance in real value maintaining units of constant purchasing power they will maintain the real values of, for example, all SA banks´ and companies´ retained income values constant over time, all else being equal, instead of unknowingly destroying them as the currently do. The only way they can maintain the real value of constant real value non-monetary items during inflation and deflation is by choosing a Constant Purchasing Power Accounting model as per the IASB´s Framework, Par. 104 (a).

Not a single SA accountant in SA chooses to measure financial capital maintenance in real value maintaining units of constant purchasing power as authorized by the IASB in the Framework, Par. 104 (a). SA accountants, unfortunately, choose to measure financial capital maintenance in nominal monetary units and thereby, unknowingly, destroy the real values of constant items at a rate equal to the rate of inflation when they are never or not fully updated over time when they implement the very destructive stable measuring unit assumption as part of the HCA model. SA accountants are unknowingly killing the real economy at the rate of about R200 billion per annum – each and every year - as long as they carry on implementing the very destructive stable measuring unit assumption.

© 2005-2010 by Nicolaas J Smith. All rights reserved

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Three fundamentally different basic economic items

The economy is divided in the monetary and non-monetary or real economy. Economic items consist of monetary and non-monetary items. Non-monetary items are sub-divided in variable real value non-monetary items and constant real value non-monetary items. There are thus three fundamentally different basic economic items in the economy: monetary items, variable items and constant items.


Variable real value non-monetary 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 was not yet invented at that time.

The first economies 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 inflation because there was no money. There was no monetary medium of exchange. There was no monetary unit of account. There was no monetary store of wealth. There was no money illusion.

There was no double entry accounting model at that time.

There were thus no Historical Cost Accounting model, no stable measuring unit assumption, no historical cost items and no nominal monetary units.

There was also no Consumer Price Index at that time and consequently there were no units of constant purchasing power and no real value maintaining Constant Purchasing Power Accounting model.

There were no financial reports: e.g. no profit and loss accounts and no balance sheets.

There were no monetary items and no constant items. There were only variable real value items not yet expressed in monetary terms.

Examples of variable real value non-monetary items in today’s economy are property, plant, equipment, inventory, shares, raw materials, merchandise, patents, trademarks, etc.


Monetary items


Money was then invented over a long period of time as a response to the limitations imposed by the barter economy. Eventually money came to fulfil the following three functions:

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

Non-monetary items were only defined in monetary terms after the invention of money when it came to be used as the basic monetary unit of account in the economy. The economy came to be 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.

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

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 was still no Historical Cost Accounting model and still no stable measuring unit assumption. There was still no Constant Purchasing Power Accounting model. There were still no double entry financial reports: still no profit and loss accounts and still no balance sheets.

Inflation

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

Inflation destroys the real value of money. Deflation creates real value in money.

Inflation reared its ugly head soon after the invention of money. It only destroyed the real value of money and other monetary items at that time as it does today. Inflation did not and can not destroy the real value of variable and constant items. Inflation has no effect on the real value of non-monetary items.

There was only one systemic economy-wide process of real value destruction at that time. The economic process of inflation destroyed the real value of money and other monetary items equally throughout the monetary economy at that time as it does today in economies subject to inflation.

There was no second systemic economy-wide accounting practice destroying the real value of constant real value non-monetary items never or not fully updated as we experience today because the real value destroying Historical Cost Accounting model, which includes the very destructive stable measuring unit assumption, was not yet invented at that time. Today South African accountants unknowingly destroy the real values of constant real value non-monetary items never or not fully updated because they choose to measure financial capital maintenance in SA banks and companies in nominal monetary units when they implement the very destructive stable measuring unit assumption as part of the real value destroying traditional Historical Cost Accounting model.


Constant items


Finally the double entry accounting model was invented. It was first comprehensively codified by the Italian Franciscan monk, 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 enables accountants to maintain the real values of both income statement as well as balance sheet constant real value non-monetary items – the third distinct category of economic items. Maintaining the real value of constant items in the SA economy where accountants use the double entry accounting model to account all economic activity is, however, only possible with the real value maintaining Constant Purchasing Power Accounting model during inflation. It is not possible, at present, while SA accountants implement the real value destroying traditional Historical Cost Accounting model because of their application of the very destructive stable measuring unit assumption during inflation. SA accountants unknowingly destroy real value on a massive scale in the real economy when they implement the traditional Historical Cost model.
The specific choice of measuring financial capital maintenance in units of constant purchasing power (the CPPA model) at all levels of inflation and deflation as contained in the Framework for the Preparation and Presentation of Financial Statements, was approved by the International Accounting Standards Board’s predecessor body, the International Accounting Standards Committee Board, in April 1989 for publication in July 1989 and adopted by the IASB in April 2001.
“In the absence of a Standard or an Interpretation that specifically applies to a transaction, management must use its judgement in developing and applying an accounting policy that results in information that is relevant and reliable. In making that judgement, IAS 8.11 requires management to consider the definitions, recognition criteria, and measurement concepts for assets, liabilities, income, and expenses in the Framework. This elevation of the importance of the Framework was added in the 2003 revisions to IAS 8." IAS Plus, Deloitte.


IAS8, 11: “In making the judgement, management shall refer to, and consider the applicability of, the following sources in descending order:
(a) the requirements and guidance in Standards and Interpretations dealing with similar and related issues; and
(b) the definitions, recognition criteria and measurement concepts for assets, liabilities, income and expenses in the Framework.”
There is no applicable International Financial Reporting Standard or Interpretation regarding the valuation of constant real value non-monetary items, e.g. issued share capital, retained earnings, capital reserves, all other items in Shareholders Equity, trade debtors, trade creditors, deferred tax assets and liabilities, taxes payable and receivable, all other non-monetary receivables and payables, Profit and Loss account items such as salaries, wages, rents, etc. The Framework is thus applicable.
The scope of the Framework includes dealing with defining, recognizing and measuring the items in financial statements and dealing with the concepts of capital and capital maintenance.
Framework, Par. 104 (a)

Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power.

The Framework, Par. 110 states that the choice of the measurement bases and the concept of capital maintenance will decide the accounting model applied in the preparation of the financial reports. The Framework applies to different accounting models and is a guide to the preparation and presentation of the financial reports under the chosen accounting model.

The Framework is the IASB approved basis for accountants to choose, in terms of Par. 104 (a), to measure financial capital maintenance in units of constant purchasing power – the CPPA model - instead of in nominal monetary units – the traditional HCA model. They can, in terms of Par. 110, choose the Constant Purchasing Power Accounting model implementing the constant purchasing power financial capital concept, capital maintenance concept and the determination of profit/loss in terms of units of constant purchasing power instead of the Historical Cost capital concept, capital maintenance concept and the determination of profit/loss in terms of nominal monetary units.

The Framework, Par. 102 states that most companies choose a financial concept of capital. Capital is the same as the shareholders´ equity of a company or its net assets when a financial concept of capital is adopted, for example, invested purchasing power or invested money.

The maintenance of capital is as important as its recognition and definition. Capital maintenance is an accounting practice implementing a concept of capital.

The Framework states that the needs of the users of financial reports should be the basis for choosing the correct concept of capital by a company. When the users of financial reports are mainly concerned with the preservation of the purchasing power of the invested capital or its nominal value, then a financial concept of capital should be used.

According to the Framework, the choice of the measurement bases and the concept of capital maintenance will decide the accounting model applied in the preparation of the financial reports. A profit is made under the financial capital maintenance concept only when the period-end financial (or money) net asset value is greater than at the start of the period, after subtracting distributions and contributions to and from shareholders during the accounting period. Financial capital maintenance can be calculated in either units of constant purchasing power or in nominal monetary units.

The real value maintaining Constant Purchasing Power Accounting model is thus an IASB approved alternative to the real value destroying traditional Historical Cost Accounting model.

The Framework states that the capital maintenance concept deals with how companies define the capital they want to preserve. It is the connection between the concepts of capital and the concepts of profit/loss since it gives the point of reference for calculating profit/loss.

Examples of constant real value non-monetary items in today’s economy are Profit and Loss Account items like salaries, wages, rentals, pensions, taxes, duties, fixed interest payments, etc as well as balance sheet items like retained earnings, issued share capital, capital reserves, share issue premiums, share issue discounts, provisions, capital reserves, all other shareholder’s equity items, 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.

CIPPA is an IASB approved alternative to Historical Cost Accounting

The International Accounting Standards Board´s Framework introduced the real value maintaining Constant ITEM Purchasing Power Accounting model as an alternative to the real value destroying traditional Historical Cost Accounting model in 1989 in Par. 104 (a) where it states that financial capital maintenace - not variable real value non-monetary items, e.g. property, plant, equipment, inventory, intangible assets, etc, - can be meansured in either nominal monetary units - the very destructive traditional HCA model - or in units of constant purchasing power: the CIPPA model. [10] The Framework is part of International Financial Reporting Standards.

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The CIPPA model is chosen by hardly any accountant in non-hyperinflationary economies even though it would maintain the real values of constant real value non-monetary items - e.g. issued share capital, retained income, other shareholder equity items, trade debtors, trade creditors, etc for an unlimited period of time. This is because the CIPPA model is generally viewed by accoutants as a 1970´s failed inflation-accounting model that requires all non-monetary items - variable real value non-monetary items and constant real value non-monetary items - to be inflation-adjusted by means of the Consumer Price Index.

The IASB did not approve CIPPA in 1989 as an inflation accounting model. CIPPA by measuring financial capital maintenance in units of constant purchasing power incorporates an alternative capital concept, financial capital maintenance concept and profit determination concept to the Historical Cost capital concept, financial capital maintenance concept and profit determination concept. CIPPA only requires all constant real value non-monetary items, e.g. issued share capital, retained income, all other items in Shareholders Equity, trade debtors, trade creditors, deferred tax assets and liabilities, taxes payable and receivable, all items in the profit and loss account, etc to be valued in units of constant purchasing power. Variable real value non-monetary items, e.g. property, plant, equipment, listed and unlisted shares, inventory, etc are valued in terms of IFRS and are not required in terms of the Framework, Par. 104 (a) to be valued in units of constant purchasing power.

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The IASB requires entities to implement IAS 29 which is a CPP inflation accounting model during hyperinflation.

Accountants can choose Constant Item Purchasing Power Accounting

The IASB´s Framework, Par. 104 (a) states: "Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power."

The word can means it is a choice open to all accountants since 1989 to measure financial capital maintenance (not variable real value non-monetary items) in units of constant purchasing power.

Several IFRS statements correctly prevent the use of price-level accounting methods of measurement for the valuation of variable real value non-monetary items, e.g. IAS16 Property, Plant and Equipment, intangible assets( IAS38) and inventories (IAS2) during the accounting period including at the financial report date - in non-hyperinflationary economies. IAS29 requires restatement of all non-monetary items in units of constant purchasing power during hyperinflation.

I agree that IAS16, IAS38 and IAS2 take precedence over the Framework - since these Standards relate to variable real value non-monetary items.

The Scope of the Framework includes:

Par. 5. The Framework deals with:

.........

(c) the definition, recognition and measurement of the elements from which financial statements are constructed; and

(d) concepts of capital and capital maintenance.

Capital is not a variable real value non-monetary item. Capital is a constant real value non-monetary item - like e.g. all the items in Shareholders Equity, etc.

The Framework, Par. 110 states: "The selection of the measurement bases and concept of capital maintenance will determine the accounting model used in the preparation of the financial statements."

When accountants choose to measure financial capital maintenance in units of constant purchasing power, they choose to implement the real value maintaining Constant Item Purhasing Power Accounting model instead of the real value destroying traditional Historical Cost Accounting model. This choice is open to all accountants since April 1989 as stated in the Framework, Par. 104 (a).

There is no applicable IFRS statement regarding the valuation of constant real value non-monetary items, e.g. all elements in Shareholders Equity, etc. Par. 104 (a) of the Framework is thus valid as an IFRS basis for accountants to choose to measure financial capital maintenance in units of constant purchasing power thus implementing the constant purchasing power financial capital concept and capital maintenance concept instead of the Historical Cost capital concept and capital maintenance concept.

The IASB approved option of measuring financial capital maintenance in units of constant purchasing power has nothing to do with the valuation of variable real value non-monetary items. It is all about "concepts of capital and capital maintenance" [par. 5 (d)] which " will determine the accounting model used in the preparation of the financial statements" [par. 110]. Nothing at all about the valuation of variable real value non-monetary items like PPE, intangible assets and inventory. It is stated under the section: Concepts of Capital and Capital Maintenance in the Framework.

As a result of the Framework, Par. 104 (a) all accountants in the world (who implement IFRS) choose - knowingly or unknowingly - either the Historical Cost or the Constant Item Purchasing Power accounting model. They all choose the very destructive HCA model because

(1) it is the traditional accounting model,

(2) they and accounting authorities do not undestand the real value destroying effect of the stable measuring unit assumption during low inflation and

(3) they and accounting authorities do not understand the real value maintaining effect of choosing financial capital maintenance in constant purchasing power units in terms of the IASB´s Framework, Par. 104 (a) which states that "Financial capital maintenance can be measured in nominal monetay units or in units of constant purchasing power."

The IASB requires them to implement IAS 29 which is based on the inflation accounting CPPA model - during hyperinflation.

The Framework, Par. 104 (a) empowers accountants to implement the real value maintaining Constant Item Purchasing Power Accounting model during non-hyperinflationary periods which requires only constant items to be inflation-adjusted by means of the CPI during non-hyperinflationary periods.

Difference between deflation and disinflation

Updated on 23 July 2013

Deflation is a sustained decrease in the general price level resulting in a sustained increase in the real value of money and other monetary items not deflation-adjusted daily as well as constant real value non-monetary items treated as monetary items (e.g. trade debtors, trade creditors, all other non-monetary receivables, all other non-monetary payables, etc.), i.e., not measured in units of constant purchasing power in terms of a daily index, under Historical Cost Accounting. These items are worth more in real value all the time during deflation as opposed to being worth less in real value all the time during inflation. Deflation is negative inflation. The above only applies to monetary items not deflation-adjusted daily under Capital Maintenance in Units of Constant Purchasing Power. Constant items are always and everywhere measured in units of constant purchasing power in terms of a daily index under CMUCPP.

Disinflation is lower inflation. Prices are still rising during disinflation, but at a lower rate. The general price level still rises, but, at a slower rate resulting in a continued, but, lower rate of real value destruction in money and other monetary items as well as constant real value non-monetary items treated as monetary items. A lowering of inflation is not deflation but disinflation.

Under Accounting Capital Maintenance in Units of Constant Purchasing Power under which all constant real value non-monetary items are always measured in units of constant purchasing power in terms of a daily index only money and monetary items not inflation-adjusted daily lose real value all the time during inflation and disinflation and gain in real value all the time during deflation.

Under Economic Capital Maintenance in Units of Constant Purchasing Power under which

(1) all constant real value non-monetary items are always and everywhere measured in units of constant purchasing power in terms of a daily index and

(2) all monetary items (except local currency bank notes and coins outside the banking system) are inflation-adjusted or deflation-adjusted daily

only local currency bank notes and coins outside the banking system lose real value all the time during inflation and disinflation and gain in real value all the time during deflation.

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Deflation means the general price level is not increasing at all, but, actually decreasing continuously and the internal functional currency – money - and other monetary items as well as constant items treated as monetary items under HCA not deflation-adjusted daily in terms of a daily index are worth more all the time. Deflation causes an increase in the real value of money and other monetary items as well as constant items treated as monetary items under HCA not deflation-adjusted daily in terms of a daily index.

Inflation destroys real value in money and monetary items not inflation-adjusted daily as well as constant items treated as monetary items under HCA, i.e., not measured in units of constant purchasing power in terms of daily index. Disinflation destroys real value in money, etc. more slowly. Deflation creates real value in money, etc.

Inflation is a sustained increase in the general price level. Disinflation is a slower sustained increase in the general price level. Deflation is a sustained decrease in the general price level.

Disinflation happens after a period of higher inflation in what are normally considered low inflation economies and is sometimes initially popularly confused with deflation. During disinflation many prominent prices, for example, oil, fuel, commodity, property and food prices are falling, but, the general price level is still actually rising, albeit at a much slower rate than during normal low inflation. When the slowing annual inflation rate moves lower and lower it eventually gets to a zero percent annual rate for maybe a month or two. When the general price level then continues to decline even further - below zero percent per annum - the economy flips over (a very big change) from inflation to deflation: not just a slower increase in the general increasing price level as during disinflation but actually a sustained decrease in the general price level below zero percent per annum which causes an increase in the real value of money, etc.: the opposite of inflation or negative inflation.

Countries (excluding Japan) have little recent experience of deflation. Deflation is generally regarded as a very serious economic problem that everyone is trying to avoid at all costs especially after what happened during the Great Depression.


Copyright © 2008 Nicolaas Smith

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

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

Accountants unknowingly destroy banks´ and companies´ capital

No double entry accounting model creates value.

Not all double entry accounting models maintain value.

Not all double entry accounting models destroy value.

No double entry accounting model can create real economic value out of nothing. Deflation creates real value in monetary items as a result of a decrease in the general price level below 0% inflation with all models of double entry accounting.

The fundamental double entry accounting model, per se, does not destroy real value. Accountants are unknowingly responsible for the destruction of real value in constant items never or not fully updated when they choose the HC model and implement the stable measuring unit assumption.

An attribute of the double entry accounting model is that it maintains the real value of constant items during inflation and deflation only when a CPP model is used as authorized by the IASB in the Framework, Par. 104 (a).

Monetary items

The double entry accounting model is incapable of maintaining the real value of monetary items in an inflationary or deflationary economy. Nothing can be done about the fact that above zero percent inflation destroys the real value of monetary items in any accounting model or even without an accounting model. The accounting model has nothing to do with the valuation of monetary items. Real value is always destroyed in monetary items in an inflationary economy with the implementation of whatever accounting model.

Since the double entry accounting model always requires all debit balances to equal all credit balances, a net monetary asset balance will require a one-sided net monetary loss entry while a net monetary liability balance will require a one-sided net monetary gain entry.

The double entry accounting model is also incapable of preventing the creation of value in monetary items in a deflationary economy.

The Historical Cost and Current Cost Accounting models do not account the net monetary loss or gain of inflation or deflation; that is, there are no one-sided net monetary loss or one-sided net monetary gain entries.

Only CPPA models including the RVA model account one-sided net monetary gain and one-sided net monetary loss entries.

Variable items

SA accountants value variable items in terms of IFRSs or SA GAAPs under all accounting models with appropriate entries to the P+L and shareholders equity accounts to maintain the double entry balance. Inflation does not affect the real values of variable real value non-monetary items.

Constant items

The Historical Cost and Current Cost models are specific double entry accounting models but they do not maintain the real value of constant items. When accountants choose these models they destroy the real value of constant items under inflation and create real value in constant items under deflation like inflation in monetary items. The CPP and Real Value Accounting models are constant purchasing power models that maintain the real value of constant items under both inflation and deflation.

The reason that it appears that inflation has a non-monetary effect is the fact that there is no value destruction at 0% inflation in constant items. The reason for that is that at 0% inflation the HC, CC, CPP and RVA models all maintain the real values of constant items. When inflation keeps on declining and gets to 0% and further general price level declines result in an increase in the real value of money when the economy enters into deflation, then the HCA model creates value in constant items while the CPP and RVA models maintain constant items´ real values by reducing constant items´ nominal values at the rate of deflation. Deflation creates real value in money while accountants would unknowingly create value in constant items during deflation when they implement either the HC or CC accounting models instead of CPP or RV accounting.

It does not make any difference which accounting model is used. No accounting model can reduce or stop inflation’s monetary effect. Only a reduction in inflation can reduce and only 0% can stop inflation’s monetary effect.

Inflation does not erode - which is exactly the same as destroy- the real value of historical cost non-monetary items. Accountants choosing HCA unknowingly do that.

Inflation does not destroy the real value of non-monetary items that do not hold their purchasing power. Accountants choosing HCA do that unknowingly.

Inflation does not destroy the real value of fixed nominal payments.

Inflation does not destroy the real value of constant real value non-monetary items never or not fully updated over time.

When accountants choose to measure financial capital maintenance in units of constant purchasing power instead of in nominal monetary units in terms of the IASB´s Framework Par. 104 (a) as it forms part of IFRSs - all constant real value non-monetary items are maintained at their constant real values – at any level of inflation or deflation.

Copyright © 2008 Nicolaas Smith

Inflation does not affect the real value of non-monetary items

Inflation affects the fundamental value of all monetary items. Inflation destroys the real value of all monetary items directly and equally.

“Inflation is always and everywhere a monetary phenomenon.” Milton Friedman

Inflation does not affect the real values of non-monetary items. The accounting model accountants choose affects the real values of constant real value non-monetary items.

The following three paragraphs are not true and correct - they are simply generally accepted, but still completely wrong:

*Inflation erodes the real value of nominally fixed payments. The real value of fixed nominal payments (like rents, pensions, wages, interest, and taxes) are eroded by inflation.

*Inflation erodes the real value of historical cost accounting items. Inflation erodes the real values of non-monetary assets and liabilities stated at historical cost; e.g., retained earnings, issued share capital, capital reserves, provisions, taxes, dividends, trade payables and receivables, etc. Two percent inflation - the European Central Bank's definition of price stability – will erode by 51 percent the real value of historical cost non-monetary items over 35 years.

*Inflation destroys the real value of non-monetary items which do not hold their value in terms of purchasing power.

Erode is exactly the same as destroy in the above cases.

It is not inflation, but, accountants implementing the stable measuring unit assumption (the traditional HC model) who unknowingly destroy the real values of nominally fixed payments and constant items stated at historical cost. The rate of inflation simply indicates the rate of real value destruction over the time period involved.

There are no fixed nominal payments and there are no constant real value non-monetary income, expenses, assets and liabilities stated at historical cost when accountants choose a CPP model. In this case the rate of inflation simply indicates the rate of adjustment required to maintain the real value of constant items expressed in the functional currency in the internal economy.

No real value is destroyed in constant items over any period of time when accountants choose to implement a CPP model at any level of inflation. It is thus accountants choosing the HC model who unintentionally destroy the real value of constant items and not inflation.

Inflation does not affect the fundamental value of constant real value non-monetary items, e.g. salaries and retained earnings.

It is accountants choosing the HC model - instead of the IASB-suggested CPP model - and implementing the stable measuring unit assumption who unwittingly destroy the real value of nominally fixed payments and the real values of constant items stated at historical cost when they choose to measure financial capital maintenance in nominal monetary units.

Copyright © 2008 Nicolaas Smith

Only Constant Item Purchasing Power Accounting maintains constant items´ real values

There are no constant real value non-monetary items without double entry accounting.

A fundamental attribute of the Constant Item Purchasing Power Accounting model is that it maintains the real values of constant items during inflation (increasing nominal values) and deflation (decreasing nominal values) as a result of the measurement of financial capital maintenance in units of constant purchasing power. A fundamental attribute of the traditional Historical Cost Accounting model is that it destroys the real values of constant items never or not fully updated (increased) during inflation and creates real value in constant items never or not fully updated (decreased) during deflation as a result of the stable measuring unit assumption.

CPPA maintains constant items´ real values while HCA destroys constant items´ real values. SA accountants unknowingly are responsible for maintaining or destroying constant items´ real values in the SA real economy depending on the choice they make in terms of the IASB´s Framework, Par. 104 (a) which forms part of IFRSs.

The fact that SA accountants value economic activity does not mean that they can create value out of nothing simply by accounting economic items using the double entry accounting model. They cannot and do not use the basic accounting model to create wealth out of thin air. It is not part of the wealth creating process. No accounting model can create real value out of nothing.

SA accountants can maintain the real value of constant items in the real economy, but, only when they choose to measure financial capital maintenance in units of constant purchasing power as provided for in the Framework, Par. 104 (a). They can not do that when they choose to measure financial capital maintenance in nominal monetary units; that is, when they choose the traditional HCA model, unfortunately also provided for in Par. 104 (a). In fact, accountants do exactly the opposite when they choose to measure financial capital maintenance in nominal monetary units: they unknowingly destroy the real values of constant items never or not fully updated under the HC model at the rate of inflation.

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”

Not a single SA Chartered Accountant chooses to measure financial capital maintenance in units of constant purchasing power in terms of the IASB´s Framework Par. 104 (a) for any SA company listed on the Johannesburg Stock Exchange. Not one CA chooses the Constant Purchasing Power Accounting model under which she or he would maintain the real values of all constant items in a JSE listed company.

All CAs in JSE listed companies choose to measure financial capital maintenance in nominal monetary units. All Financial Directors and Chief Financial Officers of JSE listed companies state in their notes to the balance sheet that their companies´ accounts have been prepared based on the Historical Cost model; that is, that they implement the stable measuring unit assumption. In so doing, they, as well as all other accountants in all unlisted SA companies, are unknowingly responsible for the destruction of the real value of all constant items never or not fully updated in their companies in the SA real economy at the current 13% rate of inflation. This amount to about R200 billion per annum in current values compounded into the future for as long as SA accountants choose to implement the stable measuring unit assumption as it forms part of the HCA model; that is, for as long as they make the Historical Cost Mistake.

The accountants in these companies are unknowingly and unintentionally responsible – because they choose to measure financial capital maintenance in nominal monetary units in terms of Par. 104 (a) - for the destruction of the real values of 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 never or not fully updated at the rate of inflation in SA.

Only Constant Purchasing Power Accounting models can maintain the real value of constant items over time in inflationary and deflationary economies. Real Value Accounting is a CPPA model presenting all items at today’s real value. The valuation of economic items, the measurement of financial capital maintenance in constant purchasing power units and the determination of profit are the same under CPPA models and the RVA model. Generally CPPA models present results calculated in units of constant purchasing power at the CPI rate prevailing at the period end date. Those results or real values are not updated every month in the future when the CPI changes. Historical CPP values are thus presented as HC values in the future when the CPI changes. They are thus calculated in units of CPP and then presented in the future at their HC values at the period end date. The RVA model measures financial capital maintenance in units of constant purchasing power – it is a CPPA model - and always presents all CPP calculated items updated at the latest CPI value in the future.

Copyright © 2008 Nicolaas Smith

Accountants value economic activity

The three distinct economic items in the economy:

1. variable items
2. monetary items and
3. constant items
are all three economic values. Each economic item has an economic value expressed in terms of money. The accounting model deals with these three economic items in an organized manner: journal entries, trial balances, general ledger accounts, cash flow statements, items in the Profit and Loss Account, assets and liabilities in the balance sheet plus other financial, management and costing reports.

South African accountants value economic items when they account economic activity in the accounting records and prepare financial reports of SA economic entities based on the double entry accounting model. Every accounting entry is a valuation of the economic items (the debit item and the credit item) being accounted.

SA accountants do not simply record economic activity. Accounting is not just a scorekeeping of economic events. Accountants value economic items when they account them. Subsequent accounting entries are part of continuous generally accepted accounting practices of valuation of the economic items originally valued and accounted over time as required by SA Generally Accepted Accounting Practices, International Accounting Standards and IFRSs applied in conjunction with the IASB´s Framework.

Variable Items

SA accountants value variable items in terms of IASs and IFRSs or SA GAAPs. No real value is unknowingly destroyed in the value of variable items by accountants choosing the traditional HCA model as long as the International Standards or GAAPs are implemented. “Listed companies use IFRS and the unlisted companies could use either IFRS or Statements of GAAP.”

Monetary items

SA accountants value monetary items at their original nominal monetary values; that is, at their original HC values since monetary items cannot be updated in current period accounts and financial reports published during the current period. Inflation – not accountants - destroys the real value of monetary items over time – currently at the high rate of 13% per annum. The real value of a monetary item is determined by the rate of inflation as indicated by the change in the CPI. Inflation destroys the value of monetary items under any accounting model and also when no accounting model is implemented; that is, when a business does not account its economic activities; for example, street vendors.

Constant items

SA accountants choose to value constant items in either nominal monetary units or in units of constant purchasing power in terms of the Framework, Par. 104 (a):

“Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power.”

How they value constant items does make a difference to the fundamental values of constant items. The accounting model accountants choose in terms of Par. 104 (a) is of critical importance. When SA accountants choose to measure financial capital maintenance in units of constant purchasing power they choose to value constant items in units of constant purchasing power, as provided for by IFRSs in the Framework, Par. 104 (a) and they maintain their real values over time. The only way SA accountants can maintain the real value of constant items during inflation or deflation is by choosing the Constant Purchasing Power Accounting model. Not a single SA accountant in SA chooses to measure financial capital maintenance in units of constant purchasing power as per Par. 104 (a). All SA accountants, unfortunately, choose to value constant items in nominal monetary units and thus, unknowingly, destroy their real values at the rate of inflation. In so doing, SA accountants are, for example, unknowingly destroying the real value of all retained earnings balances in all SA companies at the rate of inflation and unknowingly destroying the real value of issued share capital balances of companies with no Fixed Assets to revalue at least equal to the original real value of their issued share capital. SA accountants are unintentionally killing the real economy.

© 2005-2010 by Nicolaas J Smith. All rights reserved

No reproduction without permission.

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

DOUBLE ENTRY ACCOUNTING - per se – neither creates nor destroys value

DOUBLE ENTRY ACCOUNTING - per se – neither creates nor destroys value.

Double entry accounting - per se - maintains value.

Historical Cost Accounting destroys real value during low inflation when entities do not own sufficient revaluable fixed assets.

Only Constant ITEM Purchasing Power Accounting which rejects the stable measuring unit assumption maintains the real value of constant real value non-monetary items over time in low inflationary economies.

The IASB´s Framework:

Par 104 (a):

"Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power."

INFLATION destroys value in monetary items with and without an accounting model.

Inflation or hyperinflation can not destroy the real value of constant real value non-monetary items never or not fully updated over time. Put in another way: inflation and hyperinflation do not destroy the real value of non-monetary items which do not hold their value in terms of purchasing power.

Real value is only destroyed in constant items never or not fully updated over time when accountants freely choose to implement the stable measuring unit assumption instead of units of constant purchasing power as they can do in terms of IFRSs.

SA Chartered Accountants unknowingly destroy real value on a massive scale in the SA real economy when they choose – without anyone forcing them to make that choice - to measure financial capital maintenance in nominal monetary units in terms of Paragraph 104 (a) of the IASB´s Framework.

CAs freely choose the Historical Cost Accounting model under which they implement the stable measuring unit assumption. In so doing, they unintentionally destroy about R200 billion in the real value of constant items never or not fully updated in the real economy each and every year.

Only when accountants choose to implement the stable measuring unit assumption is value destroyed in constant items never or not fully updated. Both the Historical and the Current Cost Accounting models destroy value in an inflationary economy because accountants choose to implemnt the stable measuring unit assumption in the valuation and accounting of constant real value non-monetary items.

When CA´s choose to measure financial capital maintenance in units of constant purchasing power they will stop destroying about R200 billion in real value annually in the real economy.

Inflation-adjusting accounts in a low inflation environment is part of International Financial Reporting See the Framework (1989), par 104 (a). Salaries, wages, rents, interest, pensions, utilities, etc are inflation-adjusted in most economies.
When CAs choose to measure financial capital maintenance in units of constant purchasing power they will reject the stable measuring unit assumption in terms of IFRSs.
Simply choosing to measure financial capital maintenance in units of constant purchasing power, as per Par 104 (a), SA accountants will stop unknowingly destroying about R200 billion in real value in the SA real economy each and every year, they will follow IFRSs, they will reject the stable measuring unit assumption and they will inflation-adjust all constant items in the SA economy.

© 2005-2010 by Nicolaas J Smith. All rights reserved
No reproduction without permission.

It does make a big difference

Nicolaas Smith

Fin24

Oct 15 2008 23:23

Some clarification about the R200 billion unknowingly being destroyed in SA retained earnigns balances by Chartered Accountants implementing the stable measuring unit assumption in combination with inflation:

+/- R200 billion PER ANNUM will be maintained for an unlimited period of time PER ANNUM - all else being equal: a new +/- R200 billion PER ANNUM each and every year FOREVER - all else (including 13% inflation) being equal.

Inflation is hopelessly too high in SA. The higher inflation the higher the value and vice versa. It is PER ANNUM for an unlimited period of time. It does make a big difference. And that is only with respect to real value destroyed or maintained in retained earnings balances.

It is also very interesting that IFRSs are already prepared for rejecting the stable measuring unit assumption via Par 104 (a) in the IASB´s Framework: ""Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power."

I think the reason the majority of accountants world wide choose nominal monetary units instead of units of constant pruchasing power is because of relatively low inflation world wide - or the absence of very high inflation.

Brazil chose units of constant purchasinc power during 30 years of hyperinflation: from 1964 to 1994 BECAUSE they were in hyperinflation. They implemented units of constant purchasing power via their indexing of all non-monetary items during those 30 years.

In that way they maintained their real economy while they had hyperinflation in their monetary economy.

Impressive advantages to just brush away.

Nicolaas Smith

Fin24

Oct 15 2008 21:46

What about the +/- R200 billion real value destroyed in retained earnings annually in the SA real economy by Chartered Accountants implementing the stable measuring unit assumption? That value will be maintained for an unlimited period of time when CA´s stop the stable measuring unit assumption. Also remember that 90% of private sector investment is funded from retained earnings. Rejecting the stable measuring unit assumption is already part of IFRS´s since it is part of The Framework (Par. 104 a )Rejecting the stable measuring unit assumption will make the hyperinflationary or high inflationary destruction of the SA real economy impossible. Impressive advantages to just brush away. I´m sure the SA government will be quite interested to hear the full story. I plan to tell them and everyone in SA the full story. http://realvalueaccounting.blogspot.com/

True though it may be ...

Jack

Fin24

Oct 15 2008 21:06

You've been banging on about this for a long time. However, true though it may be, businessmen dont like it! It helps them to have equity and assets stated at artificially lower values, because it inflates ROE, ROA etc! Of course, its good in another way too. They can point to higher, more recent COS and use this as an excuse to increase prices! These are the real reasons businesses don't want RVA. I dont believe they can be persuaded otherwise. It would have to be a statutory rule

One small step for accountants; one giant leap for mankind.

Collateralised Debt Obligations (CDOs) are variable real value non-monetary items valued at fair value. They are neither constant real value non-monetary items nor monetary items.

Real Value Accounting deals with the inflation-adjustment of historical cost non-monetary items or constant items; for example, issued share capital, retained earnings, all other items in shareholder´s equity, trade debtors, trade creditors, deferred tax assets, deferred tax liabities, etc.

Under Real Value Accounting banks´ issued share capital, retained earnings, capital reserves (excluding the revaluation reserve under current Historical Cost accounting - non-existent under Real Value Accounting) and all items in shareholder´s equity would be updated from the date each item was contributed at the rate of inflation over the time period to today´s date.

Banks would thus maintain the real value of their equity instead of having the real value of their capital destroyed at the rate of inflation under the current Historical Cost paradigm which is an important part of the current problem: see governments recapitalizing banks.

Also see the blatantly small values for historical cost share capital in older multinationals´ balance sheets compared to the large more recently contributed retained earnings balances.

The real values of the banks´ issued share capital values as well as their retained earnings balances were always in the past destroyed during inflationary periods because accountants applied the stable measuring unit assumption as they do today and will in the future be destroyed at the rate of inflation as long as accountants carry on applying the stable measuring unit assumption.

This destruction will stop under Real Value Accounting: that is, when accountants choose to maintain capital in units of constant purchasing power in terms of the IASB´s Framework Par. 104 (a):

"Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power."

One small step for accountants; one giant leap for mankind.

It´s the stable measuring unit assumption, stupid!

I do not remember that I have ever stated that I “accuse” Chartered Accountants of destroying value. I state that CAs unknowingly, unintentionally and unwittingly destroy the real value of all constant real value non-monetary items never updated (e.g. Retained Earnings) or not fully updated in the South African real economy at the annual rate of inflation to a conservatively estimated amount of about R200 billion plus per annum when they choose to implement the stable measuring unit assumption – a Generally Accepted Accounting Practice – as part of the Historical Cost Accounting model.


It is the stable measuring unit assumption that destroys the real value of all “non-monetary items which do not hold their value in terms of purchasing power”.

Chartered Accountants choose to implement the stable measuring unit assumption. They are not forced to do that by the SA government - as you are now falsely implying. I have stated this to you before on this thread but you fail to specify where in the SA Companies Act, or SA GAAPs or IASB IFRSs CAs are forced to implement the stable measuring unit assumption. Since they are not – as you well know, you now falsely imply that they are forced by the SA government to do that. That is not true. The SA Government will not fall for your false statement.

I will give you a very clear example:

At the end of year one the company CA in a hypothetical company reported that there was, inter alia, R 1 million cash in a zero interest bank account and that the Retained Earnings balance was R 1 million. The CA decided that the company will do its accounting based on the Historical Cost Accounting model. The company was completely dormant during the second financial year. At the end of the second year the board of directors decided to pay the single owner a dividend of R1 million. Inflation was 13.4% at the end of the second year.

It is very clear that inflation destroy 13.4% of the real value of the R1 million in the zero interest bank account .

Since Retained Earnings is a non-monetary item which do not hold its value it is also very clear that the stable measuring unit assumption (whereby the CA assumed that the Rand was stable as far as the accounting of Retained Earnings was concerned) destroyed 13.4% of the real value of the R1 million Retained Earnings balance during the second year.

CAs choose to implement the stable measuring unit assumption. They are not forced by the SA government or by anyone or anything to do that. They can stop any time they want.

This happens in all SA companies with Retained Earnings balances in the companies.


SA accountants are killing the real economy to the tune of about R200 billion each and every year.

CAs implement the HCA model because choosing it as the basic accounting model is generally accepted. The destruction of real value in the real economy is thus an integral part of the HCA model. CAs unknowingly choose that when they choose the generally accepted HCA model.
The abandoning of the stable measuring unit assumption would obviously lead to zero inflation in the real economy – or zero destruction of real value in the real economy.
All constant items would maintain their real values.

It does nothing to inflation in the monetary economy.

But, it maintains the real value of all constant items in the real economy. That is: 0% inflation in the real economy or maintaining about R200 billion (or maybe even double that) plus in real value in the real economy forever. I can assure you that that would warm the SA government´s heart quite a lot – and everyone´s in South Africa.

It would also make a Zimbabwe situation in the SA economy impossible.

What I propose is not “Remeasuring reported results” of all accounts on a primary valuation basis but inflation-adjusting on a primary valuation basis only all constant real value non-monetary items as they are accounted on a day to day basis during the month and at every date the CPI value changes.
It is all about inflation-adjusted accounts, but, only all constant real value non-monetary items. Not variable items and monetary items on a primary valuation basis. Only constant items.
All salaries and wages and many other values are already inflation-adjusted in SA.

© 2005-2010 by Nicolaas J Smith. All rights reserved
No reproduction without permission.

Inflation destroys an extra R212.54 billion in real value and Mboweni gets a 27% salary increase.

When our Chartered Accountants stop the stable measuring unit assumption as they are allowed to do by International Financial Reporting Standards as issued by the International Accounting Standards Board then workers´ salaries will automatically be inflation-adjusted on a monthly basis and their standard of living will be maintained year after year.

That will also stop our CAs destroying about R200 billion in real value in our real economy each and every year.

In the IASB´s

Framework for the Preparation and Presentation of Financial Statements

Par 104 (a) it is stated:

“Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power.”

Measuring financial capital maintenance in units of constant purchasing power means rejecting the stable measuring unit assumption.

IFRSs thus allow the Historical Cost Accounting model and at the same time they also allow our Chartered Accountants the option of rejecting the stable measuring unit assumption when they allow them to measure financial capital maintenance in units of constant purchasing power.

A year ago inflation stood at 7%. It is now 6.4 percentage points higher at 13.4%. A 1% increase in inflation destroys an extra R18.29 billion in the real value of the Rand and about an extra R14.92 billion in the real or non-monetary economy because our CAs assume there is no inflation when they apply the stable measuring unit assumption. That means that the 6.4% increase in inflation destroyed an extra 6.4 X (18.29 + 14.92) = R 212.54 billion during the last year.

So under Mboweni´s watch an extra R212.54 billion have been destroyed in the SA economy during the last year and he gets a 27% increase in salary.

When our CAs stop the stable measuring unit assumption the destruction of real value in the non-monetary or real economy will be zero. That will help Mboweni a lot.

That will take care of about half of the real value destroyed by inflation and in the case of the non-monetary economy, the destruction by the combination of inflation and our CAs stable measuring unit assumption that they can stop in terms of IFRSs any time they want to.