Constant Item Purchasing Power Accounting - Abstract - Part 1 of 5

Constant Item Purchasing Power Accounting – CIPPA

The IFRS-authorized alternative to HCA which automatically stops the erosion of capital by the stable measuring unit assumption forever.

Abstract

Constant Item Purchasing Power Accounting (CIPPA) completes the process which was prematurely stopped when disclosure of constant purchasing power information in terms of FAS 89 Financial Reporting and Changing Prices, which completely superseded FAS 33, was made voluntary in 1986. IFRS authorized the principle of financial capital maintenance in units of constant purchasing power during low inflation and deflation in the Framework (1989), Par 104 (a) which states “Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power.” That authorized the completion of the process, namely, Constant Item Purchasing Power Accounting.

The process of financial capital maintenance in units of constant purchasing power during low inflation and deflation can only be completed with the split of non-monetary items in variable and constant items. Otherwise it is not possible during low inflation and deflation. Just like in the high-inflation 1970´s and 80's, no-one will (or has to) accept measuring all non-monetary items on a primary valuation basis in units of constant purchasing power during low inflation and deflation. Only constant items are measured in units of constant purchasing power on a primary valuation basis during low inflation and deflation. Variable items are measured in terms of US GAAP or IFRS. Plus the net monetary loss or gain has to be accounted during low inflation and deflation under CIPPA. IAS 29 defines financial capital maintenance in unit of constant purchasing power only during hyperinflation, namely, all non-monetary items (the fact that there is a split between variable and constant items is not required to be known/identified: it is not relevant) are valued in units of constant purchasing power only during hyperinflation which the IASB describes as an exceptional circumstance. Without knowing which items are constant items you cannot have financial capital maintenance in units of constant purchasing power during low inflation and deflation. The split allows the process to be completed.

It is not inflation but the implementation of the stable measuring unit assumption which unknowingly, unnecessarily and unintentionally erodes the existing constant real non-monetary value of banks´ and companies´ shareholders´ equity never maintained constant as a result of insufficient revaluable fixed assets (revalued or not) under the HCA model during low inflation with the free choice of implementing financial capital maintenance in nominal monetary units (which is a fallacy during inflation and deflation) in terms of US GAAP and IFRS. This amounts to hundreds of billions of US Dollars of real value erosion in the world´s non-monetary or real economy each and every year as amply demonstrated during the current financial crisis. CIPPA automatically stops this erosion forever in all entities that at least break even during inflation and deflation whether they own revaluable fixed assets or not.

The IASB, FASB and accountants mistakenly blame this erosion on inflation and act as if they are powerless to do anything about it. That is not correct. Inflation has no effect on the real value on non-monetary items.

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

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

Prof. Dr. Ümit GUCENME, Dr. Aylin P. ARSOY, Changes in financial reporting in Turkey, Historical Development of Inflation Accounting 1960 – 2005 (Bursa: Uludag University, 2005), p 9.

The authors were invited to present their paper at the Ohio State University in 2005.

http://www.mufad.org/index2.php?option=com_docman&task=doc_view&gid=9&Itemid=100


CIPPA would automatically maintain the real value of all constant real value non-monetary items – e.g. banks´ and companies´ shareholders´ equity – constant forever in all entities that at least break even – ceteris paribus – whether they own revaluable fixed assets or not and without the requirement of more capital from capital providers in the form of more money or additional retained profits to simply maintain the existing constant real value of existing shareholders´ equity constant thus boosting the world economy with hundreds of billions of US Dollars each and every year during inflation when the stable measuring unit assumption is freely rejected, that is, when financial capital maintenance in units of constant purchasing power during low inflation and deflation (CIPPA) is chosen.

The critical difference in this change of IFRS-authorized accounting model compared to previous attempts to replace the HCA model is that it is clearly and undeniably proven that the stable measuring unit assumption – not inflation – unnecessarily erodes a significant amount of real value in the world´s constant item economy with traditional HCA during low inflation each and every year.

It is known and admitted that real value is being eroded in companies’ capital and profits. This is mistakenly blamed on inflation. “The basic proposition underlying Statement 33—that inflation causes historical cost financial statements to show illusory profits and mask erosion of capital—is virtually undisputed.” FAS 89, p5. Fortunately, the perpetual automatic remedy during inflation and deflation was authorized in IFRS in the Framework (1989), Par 104 (a).

Nicolaas Smith

Copyright (c) 2005-2011 Nicolaas Smith. All rights reserved. No reproduction without permission.

Perpetual automatic capital maintenance versus perpetual automatic capital erosion

Constant Item Purchasing Power Accounting versus Historical Cost Accounting

CIPPA equals perpetual automatic capital maintenance while HCA equals  perpetual automatic capital erosion.

CIPPA: The IFRS-authorized alternative to HCA which automatically stops the erosion of capital by the stable measuring unit assumption forever.

Accounting cannot and does not create constant real non-monetary value out of nothing. On the one hand, the basic proposition that historical cost financial statements show illusory profits and mask erosion of capital is virtually undisputed. On the other hand, CIPPA automatically maintains existing constant real non-monetary value (capital) constant forever in all entities that at least break even - ceteris paribus - whether they own revaluable fixed assets or not.

Nicolaas Smith

Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Net monetary gains and losses authorized in IFRS during low inflation and deflation

Entities with net monetary item assets (weighted average of monetary item assets greater than weighted average of monetary item liabilities) over a period of time, e.g. a year, will suffer a net monetary loss (less real monetary item value owned/more real monetary item value – real monetary item assets – eroded) during inflation – all else being equal. Companies with net monetary item liabilities (weighted average of monetary item liabilities greater than the weighted average of monetary item assets) will experience a net monetary gain (less real monetary item value owed/more real monetary item liabilities eroded) during inflation – ceteris paribus.
Net monetary gains and losses are calculated and accounted during hyperinflation as required by IAS 29 Financial Reporting in Hyperinflationary Economies. The calculation and accounting of net monetary gains and losses have also been authorized in IFRS with the measurement of financial capital maintenance in units of constant purchasing power in terms of the IASB´s Framework (1989), Par 104 (a) during low inflation and deflation, i.e. under the Constant Item Purchasing Power Accounting model. Net monetary gains and losses are not required to be computed under the traditional Historical Cost Accounting model although it can be done.

“Computing the gains or losses from holding monetary items can be done and the information disclosed when the books are maintained on a historical-cost basis.”

Harvey Kapnick, Chairman of Arthur Anderson & Company, Value based accounting: Evolution or revolution, Saxe Lecture, 1976, Page 6.

http://newman.baruch.cuny.edu/DIGITAL/saxe/saxe_1975/kapnick_76.htm

Net monetary gains and losses are constant real value non-monetary items once they are accounted in the income statement. All items accounted in the income statement are constant real value non-monetary items.

This omission under the Historical Cost paradigm to compute the gains and losses from holding monetary items is one of the consequences of the stable measuring unit assumption as implemented as part of the traditional Historical Cost Accounting model.

The Measuring Unit principle: The unit of measure in accounting shall be the base money unit of the most relevant currency. This principle also assumes the unit of measure is stable; that is, changes in its general purchasing power are not considered sufficiently important to require adjustments to the basic financial statements.

Paul H. Walgenbach, Norman E. Dittrich and Ernest I. Hanson, (1973), Financial Accounting, New York: Harcourt Brace Javonovich, Inc. Page 429.

The practice of calculating and accounting net monetary gains and losses under hyperinflation and under low inflation and deflation only with the implementation of IFRS-authorized financial capital maintenance in units of constant purchasing power (CIPPA), but, not during the implementation of the traditional Historical Cost Accounting model during low inflation and deflation is one of the various confounding generally accepted perplexities in the accounting profession.

Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Inflation is always and everywhere a monetary phenomenon

Inflation is always and everywhere a monetary phenomenon.

Milton Friedman, A monetary history of the United States 1867 - 1960 (1963)

http://books.google.com/books?id=Q7J_EUM3RfoC&pg=PR3&dq=Milton+Friedman,+A+monetary+history+of+the+United+States+1867+-+1960+(1963)&ei=L5A6SYXMBIy4yATAw9ChBw#PPP1,M1

Inflation is a sustained annual increase in the general price level of goods and services in an economy. Prices are generally quoted in terms of money. When the general price level rises more than the annual increase in real value in the economy, each unit of the monetary unit buys fewer goods and services; consequently, annual inflation only erodes the real value of each monetary medium of exchange unit evenly over time. Inflation has no effect on the real value of non-monetary items.

Annual inflation erodes real value evenly in money and other monetary items over time. There are, consequently, hidden monetary costs to some and monetary benefits to others from this erosion in purchasing power in monetary items that are assets to some while - a the same time - liabilities to others; e.g. the capital amount of loans. The debtor (in the case of a monetary loan) gains during inflation since he or she has to pay back the nominal value of the loan, the real value of which is being eroded by annual inflation. The debtor (of a monetary loan) pays back less real value during inflation. The creditor (in the case of a monetary loan) loses out because he or she receives the nominal value of the loan back, but, the real value paid back is lower as a result of inflation. Efficient lenders recover this loss in real value by charging interest at a rate higher they hope will be higher than the actual inflation rate during the period of the loan.

An increase in the general price level (inflation) erodes the real value of money and other monetary items with an underlying monetary nature, e.g. the capital values of bonds and loans. However, inflation has no effect on the real value of variable real value non-monetary items (e.g. property, plant, equipment, cars, gold, inventories, finished goods, foreign exchange, etc.) and constant real value non-monetary items (e.g. issued share capital, retained profits, capital reserves, other shareholder equity items, salaries, wages, rentals, pensions, trade debtors, trade creditors, taxes payable, taxes receivable, deferred tax assets, deferred tax liabilities, dividends payable, dividends receivable, etc.).


Fixed constant real value non-monetary items never updated are effectively treated like monetary items by accountants implementing the stable measuring unit assumption as part of the HCA model during low inflation. Implementing the HCA model unknowingly, unintentionally and unnecessarily erodes their real values at a rate equal to the annual rate of inflation because they are measured in nominal monetary units during low inflation. Inflation only erodes the real value of money which is the nominal monetary unit of account in the economy. This unknowing, unintentional and unnecessary erosion in fixed constant real value non-monetary items never maintained constant during low inflation stops when accountants choose to measure financial capital maintenance in units of constant purchasing power. It is thus the implementation of financial capital maintenance in nominal monetary units in terms of the Historical Cost Accounting model and not inflation that is doing the eroding.

The extremely rapid erosion of the real value of money during hyperinflation is compensated for by the rejection of the stable measuring unit assumption in International Accounting Standard IAS 29 Financial Reporting in Hyperinflationary Economies. IAS 29, which has to be implemented during hyperinflation, requires all non-monetary items (variable real value non-monetary items and constant real value non-monetary items) to be measured in units of constant purchasing power by inflation-adjusting them in terms of the period-end CPI. The stable measuring unit assumption is thus rejected in the presentation of restated Historical Cost or Current Cost financial statements but not in operation during the accounting period since the IASB still accepts HC or CC financial statements to be restated with the implementation of IAS 29 during hyperinflation.

PricewaterhouseCoopers state the following regarding the use of the HCA model during hyperinflation:

"Inflation-adjusted financial statements are an extension to, not a departure from, historic cost accounting."

Financial Reporting in Hyperinflationary Economies – Understanding IAS 29, PricewaterhouseCoopers, May 2006, p 5.

The main measure of inflation in low inflation economies is the annual inflation rate, calculated from the annualized percentage change in a general price index - normally the Consumer Price Index - published on a monthly basis. The correct measure of inflation in hyperinflationary economies is the parallel rate - where a parallel rate is in use, officially or unofficially. The CPI published a month and a half to two months after the hyperinflationary changes in the real value of the monetary unit actually happened, is completely impractical and totally ineffective as a measure of inflation when the aim is to stabilize the real economy during hyperinflation as Brazil so effectively did with daily indexation during 30 years of high and hyperinflation. This is only possible with daily indexing of all non-monetary items as was done in Brazil from 1964 to 1994 or with measuring financial capital maintenance in units of constant purchasing power in terms of IAS 29 during hyperinflation, i.e. inflation-adjusting all non-monetary items (variable real value non-monetary items and constant real value non-monetary items) on a daily basis applying the daily change in the parallel rate and not the period-end CPI as currently required by IAS 29.

Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Money makes the world go round

Money makes the world go round


Money is the greatest economic invention of all time. Money did not exist and was not discovered. Money was invented over a long period of time.

Money is not perfectly stable in real value even though all historical cost accountants assume that when they implement the stable measuring unit assumption during low inflation and deflation. They assume, in principle, that money is perfectly stable all the time when they measure all balance sheet constant real value non-monetary items, e.g. issued share capital, retained earnings, capital reserves, all other items in shareholders´ equity, provisions, trade debtors , trade creditors, all non-monetary payables, all non-monetary receivables, all income statement items (excluding constant real value non-monetary items like salaries, wages, rentals, transport fees, etc. which they correctly inflation-adjust annually) at their historical costs when they implement financial capital maintenance in nominal monetary units (the Historical Cost Accounting model) during low inflation and deflation as authorized in IFRs in the Framework (1989), Par 104 (a).

Money is not the same as constant real value during inflation and deflation. Money only has a constant real value over time during sustainable zero annual inflation which has never been achieved in the past and is not likely soon to be achieved in the future.

Bank notes and coins are physical token instances of money. Money is a monetary item which is used as a monetary medium of exchange and serves at the same time as a monetary store of value and as the monetary unit of account for the accounting of economic activity in a country or a monetary union. All three basic economic items - monetary items, variable real value non-monetary items and constant real value non-monetary items - are valued in terms of money. The European Monetary Union uses the Euro as its monetary unit. The US Dollar is the monetary unit most widely traded internationally. The Rand Common Monetary Area which includes South Africa, Namibia, Swaziland and Lesotho employs the Rand as the common monetary unit or monetary unit.

An earlier form of money was commodity money; e.g. gold, silver and copper coins. Today money is generally fiat money created by government fiat or decree.

Money is a medium of exchange which is its main function. Without that function it can never be money. The historical development of money led it also to be used as a store of value and as the unit of measure to account the values of economic items.

Money is the only unit of measure that is not a stable value under all circumstances. Money is only perfectly stable in real value at zero per cent annual inflation. This has never been achieved over a sustainable period of time. All other units of measure are fundamentally stable units of measure, e.g. inch, centimetre, ounce, gram, kilogram, pound, etc.

Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Deduction of cost of inflation during low inflation and deflation authorized in IFRS since 1989

Accountants have to calculate the net monetary loss or gain from holding net monetary item assets or net monetary item liabilities, respectively, when they choose financial capital maintenance in units of constant purchasing power during low inflation and deflation (the Constant Item Purchasing Power Accounting model) in the same way as the IASB currently requires its calculation and accounting during hyperinflation in IAS 29 Financial Reporting in Hyperinflationary Economies. There are significant net monetary losses and net monetary gains during low inflation and deflation too, but they are not required to be calculated when accountants choose the traditional Historical Cost Accounting model.


It is an inexplicable contradiction that net monetary gains and losses are required in IFRS (IAS 29) to be calculated and accounted during hyperinflation but not during non-hyperinflationary periods, especially when the IASB-approved alternative to HCA, namely CIPPA does require their calculation and accounting during low inflation and deflation.

“Statement 33 was not a completed product. First, it required adjustment of only two of the items known to be affected by price changes, cost of sales and depreciation. Second, two adjusted amounts for cost of sales and depreciation were required to be reported, one on a constant purchasing power basis and one on a specific price basis. Third, the adjusted amounts together with two new items required to be disclosed, gain or loss on monetary items and certain holding gains, were not required to be reported in an articulating set of adjusted statements of financial position and performance.” FAS 89, p 6

“Computing the gains or losses from holding monetary items can be done and the information disclosed when the books are maintained on a historical-cost basis.”

Harvey Kapnick, Chairman of Arthur Anderson & Company, Value based accounting: Evolution or revolution, Saxe Lecture, 1976, Page 6.

http://newman.baruch.cuny.edu/DIGITAL/saxe/saxe_1975/kapnick_76.htm

Deducting the cost of inflation as an expense in the income statement has thus been authorized in IFRS since 1989. Harvey Kapnick´s viewpoint thus prevailed, but, not under the Historical Cost Accounting model as he advocated. It prevailed under financial capital maintenance in units of constant purchasing power, that is, under the Constant Item Purchasing Power Accounting model.

Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

CIPPA increases a company’s net asset value

CIPPA increases a company’s net asset value


A company’s capital is synonymous with its Net Assets or Shareholders Equity under a financial concept of capital such as invested money or invested purchasing power. The Net Asset Value is equal to Assets minus Liabilities.


The intrinsic value of a company is its actual value based on an underlying perception of its true value including all aspects of the business, in terms of both tangible and intangible factors.

Most often intrinsic worth is estimated by analyzing a company's fundamentals.

Intrinsic value is the actual value of company, as opposed to its market price or book value. The intrinsic value includes other variables such as brand name, trademarks, and copyrights that are often difficult to calculate and sometimes not accurately reflected in the market price. One way to look at it is that the market capitalization is the price (i.e. what investors are willing to pay for the company) and intrinsic value is the value (i.e. what the company is really worth). Different investors use different techniques to calculate intrinsic value.

There is no single, universally accepted way to obtain this figure.

The intrinsic value of most companies will not simply increase at the moment of changeover to CIPPA with a change in accounting policy from the traditional Historical Cost Accounting model to measuring financial capital maintenance in units of constant purchasing power during low inflation and deflation because CIPPA only increases the net asset value of most companies over time in the future as compared to continuing with the traditional HCA model.


This is the case for those companies which do not have 100% of the inflation-adjusted original real values of all contributions to Shareholders´ Equity invested during low inflation in revaluable fixed assets with an equivalent maintained fair value (revalued or with unrecorded holding gains) in order not to erode Shareholders Equity’s original real value under the traditional Historical Cost Accounting model implemented by most companies.

Example

Historical Cost Accounting

Opening balances

Capital ................1000

Retained Earnings 1000

Equity .................2000

Liabilities ..................0

Total Liabilities ...2000



Fixed Assets .....1000

Trade Debtors ..1000

Total Assets .....2000


Net Asset Value = Assets – Liabilities = Equity

= [Fixed Assets + Trade Debtors] – Liabilities = [Capital + Retained Earnings]

= [1000 + 1000] – 0 = [1000 + 1000]

= 2000



Assumptions: 10% inflation during the next financial year.

Fixed Assets revalued at a rate equal to the inflation rate (only to simplify the example)

No other changes


At the end of the financial year:


Capital ..................1000

Revaluation Reserve 100

Retained Earnings  .1000

Equity ...................2100

Liabilities ....................0

Total Liabilities......2100



Fixed Assets ...1100

Trade Debtors 1000

Assets ............2100



Net Asset Value = Assets – Liabilities = Equity


= [Fixed Assets + Trade Debtors] – Liabilities = [Capital + Retained Earnings]

= [1100 + 1000] – 0 = [1100 + 1000]

= 2100



Constant Item Purchasing Power Accounting

Opening balances are the same.

Assumptions are the same.

At the end of the financial year:



Capital .................1100

Retained Earnings 1100

Equity .................2200

Liabilities ..................0

Total Liabilities ...2200



Fixed Assets ...1100

Trade Debtors 1100

Total Assets ...2200



Net Asset Value = Assets – Liabilities = Equity


= [Fixed Assets + Trade Debtors] – Liabilities = [Capital + Retained Earnings]

= [1100 + 1100] – 0 = [1100 + 1100]

= 2200



CIPPA increases the future net asset value of most companies compared to simply continuing with the current HCA model.

This will increase the net asset value of most companies listed on stock exchanges and most unlisted companies in the world economy.

When accountants change the way they value constant real value non-monetary items they generally increase the net asset values of companies too. This increases the intrinsic and market values of companies too.

Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Historical Cost Accounting is not an appropriate accounting policy

HCA is not an appropriate accounting policy


Auditors state in the audit report that the directors´ responsibility for the financial statements includes selecting and applying appropriate accounting policies. The audit report also normally states under the Auditors´ Responsibility that an audit includes evaluating the appropriateness of accounting policies used in a company. So, both the directors and the auditors have a responsibility with regards to appropriate accounting policies for a company.

The implementation of the stable measuring unit assumption which is based on a fallacy and financial capital maintenance in nominal monetary units per se which is a fallacy during inflation and deflation means that the use of the HCA model is not an appropriate accounting policy for companies during inflation and deflation. The IASB already agrees that the stable measuring unit assumption and financial capital maintenance in nominal monetary units per se are not appropriate accounting policies in hyperinflationary economies.

IAS 29 Financial Reporting in Hyperinflationary Economies states that:

“In a hyperinflationary economy, reporting of operating results and financial position in the local currency without restatement is not useful. Money loses purchasing power at such a rate that comparison of amounts from transactions and other events that have occurred at different times, even within the same accounting period, is misleading.” IAS 29 Par 2

When it can be clearly demonstrated that a company’s HC accounting policy selected by the board of directors eroded a significant percentage of the real value of the company´ Shareholders´ Equity as a result of the company’s implementation of the stable measuring unit assumption when the company assumes that it would be for an unlimited period of time during indefinite inflation when they know that financial capital maintenance in units of constant purchasing power as approved by the IASB in the Framework (1989), Par 104 (a), is an IFRS-compliant alternative freely available to the company and that it would stop the unknowing, unintentional and unnecessary erosion of existing constant non-monetary real value in existing constant real value non-monetary items never maintained constant by the implementation by the company´s board and accountants of financial capital maintenance in nominal monetary units during low inflation and deflation, then the traditional HCA model, in principle, is not an appropriate accounting policy.

The principle of financial capital maintenance in units of constant purchasing power during low inflation and deflation has been subjected to a “thourough, open, participatory and transparent, due process” at the IASB before it was approved in the Framework (1989), Par 104 (a) twenty two years ago. The principle is thus generally accepted in the accounting and auditing professions. However, the practice of financial capital maintenance in unit of constant purchasing power during low inflation and deflation (CIPPA) is not yet generally accepted. Neither have accounting software packages been adapted for the implementation of CIPPA, nor have accountants and accounting personnel been trained to implement financial capital maintenance in units of constant purchasing power during low inflation and deflation, nor have audit procedures been adapted by auditors to audit companies implementing the Constant Item Purchasing Accounting model.

Currently financial capital maintenance in units of constant purchasing power during low inflation and deflation (CIPPA) is thus an appropriate accounting policy and HCA not an appropriate accounting policy, in principle, but, not in practice. The current implementation of the HCA model is thus still an appropriate accounting policy, in practice, although not in principle. However, as soon as the practical implementation of financial capital maintenance in units of constant purchasing power accounting during low inflation and deflation (CIPPA) has passed proper due process; accounting software packages have been adapted to CIPPA; accountants and accounting personnel have been trained to implement CIPPA and audit procedures have been adapted by audit firms to audit companies implementing CIPPA, then the HCA model will certainly not be an appropriate accounting policy - in principle and in practice.

This will not happen overnight. As was stated in US FAS 89 in 1986: “Mr. Mosso dissented to the issuance of Statement 33 and he dissents to its rescission, both for the same reason. He believes that accounting for the interrelated effects of general and specific price changes is the most critical set of issues that the Board will face in this century.”

and

“Relative to most changes in financial reporting, the changes required by Statement 33 were monumental. Because most accountants and users of financial statements have been inculcated with a model of financial reporting that assumes stability of the monetary unit, accepting a change of this consequence would take a lengthy period of time under the best of circumstances.”

Nicolaas Smith

Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Audited HC Financial Reports do not fairly present the financial position of companies

Nine requirements


Audited annual financial statements provided by companies which prepare them using the traditional Historical Cost Accounting model, i.e., when the board of directors choose to measure financial capital maintenance in nominal monetary units during low inflation and deflation instead of in units of constant purchasing power in terms of the IASB´s Framework (1989), Par 104 (a), are compliant with IFRS, but, do not fairly present the financial position of the companies as required by legislation in most countries.

The SA Companies Act, No 71 of 2008, Article 29.1 (b), for example, states:

“If a company provides any financial statements, including any annual financial statements, to any person for any reason, those statements must -


(b) present fairly the state of affairs and business of the company, and explain the transactions and financial position of the business of the company;”

Audited financial statements prepared in terms of the HCA model do not fairly present the financial position of companies when the directors do not:

(1) state in the annual financial statements that their choice of the traditional Historical Cost Accounting model which includes the very erosive stable measuring unit assumption, erodes the real value of constant real value non-monetary items never maintained, at a rate equal to the annual rate of inflation;

(2) state that this includes the erosion of the real value of Shareholders´ Equity when the company does not have sufficient revaluable fixed assets that are or can be revalued via the Revaluation Reserve equal to the updated original real value of all contributions to Shareholders’ Equity under the HCA model during low inflation;

(3) state the percentage and amount of Shareholders´ Equity that are not being maintained constant; i.e., the percentage and amount of Shareholders´ Equity that are subject to real value erosion at a rate equal to the annual inflation rate because of the directors´ choice, in terms of the Framework (1989), Par 104 (a), to maintain financial capital maintenance in nominal monetary units instead of in units of constant purchasing power – both methods being compliant with IFRS;

(4) state the amount of real value eroded during the last and previous financial years in Shareholders´ Equity and all other constant real value non-monetary items never maintained constant because of the directors´ choice to implement the Historical Cost Accounting model;

(5) state the updated total amount of real value eroded from the company’s inception to date in this manner in at least Shareholders´ Equity never maintained constant as described above;

(6) state the change in the updated real value of Shareholders´ Equity if the directors should decide – as they are freely allowed to do at any time - to measure financial capital maintenance in units of constant purchasing power instead of in nominal monetary units (which is a very popular accounting fallacy approved by the IASB) as authorized by the IASB in the Framework (1989), Par 104 (a);

(7) state the directors´ estimate of the amount of real value to be eroded by their implementation of the stable measuring unit assumption (which is based on another popular accounting fallacy approved by the IASB) during the following accounting year under the HC basis;

(8) state that the constant non-monetary real value calculated in (7) represents the amount of constant non-monetary real value the company would gain during the following accounting year and every year thereafter for an unlimited period of time – ceteris paribus - when the directors´ choose to measure financial capital maintenance in units of constant purchasing power – which is compliant with IFRS – as provided in the Framework (1989), Par 104 (a) which they are free to choose any time they decide;

(9) state the directors´ reason(s) for choosing financial capital maintenance in real value eroding nominal monetary units instead of in real value maintaining units of constant purchasing power during low inflation in terms of the IASB´s Framework (1989), Par 104 (a).

Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Three concepts of capital maintenance under IFRS

IFRS authorized financial capital maintenance in units of constant purchasing power in the original Framework (1989), Par. 104 (a) which means that there are three concepts of capital maintenance under IFRS.

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Nicolaas Smith
 
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

The statement that inflation erodes the real value of non-monetary items has no substance.

Presently, inflation accounting describes a complete price-level inflation accounting model, namely the Constant Purchasing Power inflation accounting model defined in IAS 29 required by the IASB to be implemented during hyperinflation. It serves to maintain the real values of all non-monetary items – variable and constant real value non-monetary items - by inflation-adjusting them by means of the CPI during hyperinflation which is an exceptional circumstance.
“In a hyperinflationary economy, reporting of operating results and financial position in the local currency without restatement is not useful. Money loses value at such a rate that comparison of amounts from transactions and other events that have occurred at different times, even within the same accounting period, is misleading.” IAS 29.2

Some people believe that there is no doubt that inflation erodes the real value of monetary as well as non-monetary items that do not maintain their real value in terms of purchasing power.

At the time (2008), I agreed. Subsequently it became very clear to me that inflation has no effect on the real value of non-monetary items over time. The understanding of the real value eroding effect of the stable measuring unit assumption is a work in progress. Not inflation, per se, but the implementation of the stable measuring unit assumption during low inflation as it forms part of the HCA model, erodes the real value of constant real value non-monetary items never or not fully updated over time.

There is no substance in the statement that inflation erodes the real value of non-monetary items which do not hold their real value over time. Inflation has no effect on the real value on non-monetary items over time.

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

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

http://www.mufad.org/index2.php?option=com_docman&task=doc_view&gid=9&Itemid=100


HC accounting unknowingly erodes or maintains (please note: not create) the real value of constant real value non-monetary items (please note: not variable real value non-monetary items) depending on whether the  IASB-approved real value eroding traditional HCA model under the very erosive stable measuring unit assumption is implemented during non-hyperinflationary periods for an unlimited period of time during indefinite inflation or the IASB approved real value maintaining Constant Item Purchasing Power Accounting model under which the stable measuring unit assumption is rejected at all levels of inflation and deflation for an unlimited period of time.

Nicolaas Smith

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

Accountants freely choose HCA

By doing listed companies´ accounts in terms of IFRS as required by the rules of most stock exchanges, boards of directors – advised by the accountants on the boards - have to choose between a physical and a financial capital concept in terms of the IASB´s Framework (1989), Par 102. According to the Framework (1989), Par103 the choice of the appropriate concept of capital by a company should be based on the needs of the users of its financial reports.
A company’s capital is synonymous with its Shareholders´ Equity or Net Assets when a financial concept of capital, such as invested purchasing power or invested money, is chosen. Most boards of directors decide that they will adopt, in terms of the Framework (1989), Par 102, a financial (instead of a physical) concept of capital, namely invested money (instead of invested purchasing power), in preparing their companies’ financial statements. As a result of choosing a financial concept of capital, namely invested money, in terms of Par 102, the boards of directors next choose a financial concept of capital maintenance in terms of Par 104.


Under the financial capital maintenance concept a company, in terms of the Framework (1989), Par 104, only earns a profit when the financial (or money) value of the net assets at the end of the accounting period exceeds the financial (or money) value of net assets at the beginning of the period, after excluding any contributions from and distributions to shareholders during the accounting period. This is obviously not true and correct in real or constant purchasing power terms. This is only true and correct when 100% of the updated original real value of all contributions to shareholders´ equity is invested in revaluable fixed assets (revalued or not) during low inflation or per se during sustainable zero percent annual inflation – something that has never been achieved in the past and is not likely to be achieved any time soon.

Listed companies´ boards of directors generally choose financial capital maintenance in nominal monetary units in terms of the Framework (1989), Par 104 (a) because, in their opinion - in terms of Par 103 - the users of the company’s financial statements are primarily concerned with the maintenance of nominal invested capital instead of the maintenance of the purchasing power of invested capital when a financial capital maintenance in units of constant purchasing power concept – as per Par 104 (a) – should be used. The boards of directors thus choose to do their companies´ accounts based on the traditional Historical Cost Accounting model. They believe and support the IASB statement in Par 104 (a) that “financial capital maintenance can be measured in nominal monetary units” which is actually a fallacy during inflation and deflation. It is impossible to maintain the constant real value of Shareholders´ Equity constant with financial capital maintenance in nominal monetary units per se during inflation and deflation.

In my opinion, a survey would find that the users of companies´ financial statements are generally primarily concerned with the maintenance of the constant purchasing power (real value) instead of the nominal value of their invested capital.

It is only possible to maintain the real value of Shareholders´ Equity constant in nominal monetary units when 100% of the inflation-adjusted original real values of all contributions to Shareholders´ Equity are invested in revaluable fixed assets with an equivalent fair value - either revalued or with unrecorded holding gains - under the traditional Historical Cost Accounting model implemented by most companies during low inflation. It is not normally the case in the economy that companies invest 100% of the original real values of all contributions to Shareholders´ Equity in revaluable fixed assets.

In terms of the Framework (1989), Par 105, the capital maintenance concept deals with how companies define the capital they want to preserve. It is the link between the concept of capital and the concept of profit or loss since it is the point of reference for calculating profit or loss. A company first has to choose a capital maintenance concept before its return of capital and return on capital can be calculated. Only acquired net asset values greater than the capital maintenance requirement can be taken as profit; i.e. a return on capital.

Nicolaas Smith
 
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

No revaluable fixed assets required per se

A company’s capital is synonymous with its Net Assets or Shareholders Equity under a financial concept of capital such as invested money or invested purchasing power.
100% of the inflation-adjusted original real value of all contributions to Shareholders´ Equity have to be invested in revaluable fixed assets with an equivalent maintained fair value (revalued or with unrecorded hidden holding gains) in order not to erode any Shareholders Equity’s existing constant real non-monetary value during low inflation under the traditional Historical Cost Accounting model – i.e. measuring financial capital maintenance in nominal monetary units as implemented by most entities.

The existing constant real non-monetary value of that portion of existing shareholders´ equity not invested in revaluable fixed assets (revalued or not) is currently unknowingly, unintentionally and unnecessarily being eroded at a rate equal to the annual rate of inflation when the constant real value non-monetary item Shareholders Equity is measured in nominal monetary units, i.e. implementing the very erosive stable measuring unit assumption as done by most entities when they implement the HCA model for an unlimited period of time during indefinite low inflation.

Most entities do not meet the requirement to investment 100% of the updated original real value of all contributions to Shareholders´ Equity in revaluable fixed assets. Entities that possibly meet the 100% of the updated original real value of all contributions to shareholder´s equity requirement are hotel, hospital, property and similar companies. In practice this means that the real value of Retained Profits never maintained of most companies and banks are unknowingly, unintentionally and unnecessarily being eroded at a rate equal to the annual rate of inflation by entities implementing the IASB-approved traditional HCA model during low inflation.

Implementing the IASB-approved alternative, namely, financial capital maintenance in units of constant purchasing power during low inflation and deflation (CIPPA) as authorized in 1989 in the exact same Framework (1989), Par 104 (a), stops this unknowing, unintentional and unnecessary erosion by the implement of the stable measuring unit assumption forever at all levels of inflation in all entities that at least break even - whether they own revaluable fixed assets or not and without the requirement of more money or more Retained Earnings just to maintain the existing constant real non-monetary value of existing Shareholders´ Equity constant.

No-one will disagree that inflation and not the stable measuring unit assumption erodes the real value of money and other monetary items in the monetary economy despite the fact that central banks and monetary authorities regard the erosion of from 2 to 6% per annum of the real value of the monetary unit as the achievement and maintenance of “price stability” in the economic system. Obviously it is not price stability at all. It is 2 to 6% per annum away from price stability. It is the central bank´s choice of “price stability”: their definition of “price stability”. Absolute price stability is a year-on-year increase of zero percent in the Consumer Price Index. Positive annual inflation of up to 2% is a high degree of price stability. It is not absolute price stability.

The IASB only requires the implementation of IAS 29 Financial Reporting in Hyperinflationary Economies during hyperinflation. The IASB defines hyperinflation as cumulative inflation over three years approaching or equal to 100%, i.e. annual inflation of 26% for three years in a row. This means that central banks could define “price stability” as annual inflation at any rate from 0.001 to 25.99% per annum.

Nicolaas Smith
 
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

The difference between deflation and disinflation

Deflation is a sustained absolute decrease in the general price level resulting in a sustained increase in the real value of the monetary unit (money) and other monetary items. Disinflation is a decrease in the inflation rate.

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Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

The Framework (1989) applies

There are no specific IFRS relating to the concepts of capital and capital maintenance. The Framework thus applies.

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Salaries and wages inflation-adjusted during low inflation

The annual indexation or inflation-adjustment of salaries and wages in a low inflationary environment is a blessing to users since it enables them to maintain the real values of salaries and wages constant during inflation. This involves labour union negotiations with employer bodies. They usually agree on an annual increase in the depreciating monetary unit payment values for constant real value non-monetary salaries and wages to maintain their purchasing power constant in a low inflationary economy where the real value of the monetary unit of account is continuously being eroded by inflation. The nominal values of constant real value non-monetary salaries and wages are thus increased or indexed or inflation-adjusted by means of the CPI to cover or compensate for at least the expected rate of erosion in the real value of the depreciating monetary which is the depreciating unstable monetary unit of account for accounting purposes as well as the depreciating unstable monetary medium of exchange for payment purposes in the economy. The period is normally for the year ahead. They normally agree on an additional percentage increase for increases in productivity or for social reasons.
Both parties to the salary and wage negotiations agree that constant real value non-monetary salaries and wages cannot be accounted or valued at traditional nominal Historical Cost implementing the very erosive stable measuring unit assumption whereby accountants simply assume that the depreciating monetary unit is perfectly stable in a low inflationary economy. Workers would not receive the constant purchasing power values of their salaries and wages when fixed HC salaries and wages are paid in depreciated monetary units whose real values are continuously being eroded by inflation. They would not receive their full constant real non-monetary values of their salaries and wages.

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

Inflation can only erode the real value of the depreciating unstable monetary medium of exchange (depreciating unstable money, i.e. the depreciating unstable functional currency inside an inflationary economy) - the depreciating unstable monetary unit - and other depreciating unstable monetary items.

Inflation has no effect on the real values of salaries and wages which are constant real value non-monetary items. Inflation can only erode the real value of money (the functional currency inside an economy) and other monetary items. Accountants implementing the very erosive stable measuring unit assumption as part of the traditional HCA model when they keep salaries and wages fixed over time, unknowingly, unintentionally and unnecessarily erode the real value of salaries and wages when they do not inflation-adjust them by means of the CPI when they maintain the stable measuring unit assumption for an unlimited period of time during indefinite inflation.

Inflation cannot erode the real value of non-monetary items. Inflation can only erode the real value of the unstable monetary medium of exchange (the unstable functional currency - unstable money) used to transfer the constant real non-monetary values of salaries and wages from the employer to the employee.

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

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

http://www.mufad.org/index2.php?option=com_docman&task=doc_view&gid=9&Itemid=100

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

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

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

“Income Statement


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

All items in the income statement are constant real value non-monetary items to be continuously inflation-adjusted by applying the monthly change in the annual CPI during low inflation and deflation. The real values of salaries and wages would thus not be eroded by inflation if they were valued in nominal monetary units (fixed salaries and wages), but by the choice of the measurement basis, namely, Historical Cost, i.e. in nominal monetary units, which means the implementation of the very erosive stable measuring unit assumption whereby accountants consider that the continuous erosion of the purchasing power of the monetary unit is not sufficiently important during low inflation in order to require the indexation or inflation-adjustment or measurement in units of constant purchasing power of the existing constant real values of constant real value non-monetary salaries and wages by means of the CPI in order to maintain their existing constant real non-monetary values constant. What accountants do, in essence, is they assume the constantly depreciating monetary unit of account – the depreciating monetary unit – is perfectly stable when they implement the stable measuring unit assumption. Accountants assume the depreciating monetary unit is perfectly stable, but, only for this particular purpose.

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

Accountants, on the other hand, do exactly the opposite: they acknowledge that inflation is eroding the real value of the depreciating monetary unit used as a depreciating monetary medium of exchange and they index or inflation-adjust or measure in units of constant purchasing power by means of the CPI some, not all, constant real value non-monetary income statement items like salaries, wages, rentals, etc by increasing their nominal values at a rate at least equal to the annual rate of inflation thus keeping their non-monetary real values constant over the time period in question.

On the one hand accountants currently acknowledge that the nominal values of some (not all) income statement items like salaries and wages have to be indexed or inflation-adjusted by means of the CPI because inflation is eroding the real value of the monetary unit and, on the other hand, they assume - at exactly the same time and during exactly the same period - that the constantly depreciating monetary unit is perfectly stable, but, only for the valuation of balance sheet constant real value non-monetary items like Retained Earnings, Issued Share capital, capital reserves, provisions, other shareholder equity items, etc as well as for the other income statement items not inflation adjusted. Accountants thus, unknowingly, unintentionally and unnecessarily erode their real values at a rate equal to the annual rate of inflation to the amount of hundreds of billions of US Dollars world-wide, year in year out, decade after decade when they maintain the stable measuring unit assumption for an unlimited period of time during indefinite inflation.

Accountants at companies listed on stock exchanges comply with IFRS. If a country should enter into hyperinflation they would implement IAS 29. They would then apply the CPP inflation accounting model and index or inflation-adjust all income statement items plus balance sheet constant real value non-monetary items by means of the CPI. They would update, for example, Issued Share Capital and Retained Earnings for all listed companies and banks from the dates these items were contributed or came about and maintain their existing constant real non-monetary values constant, but, only for as long as the economy is in hyperinflation.

When the economy is not in hyperinflation any more they would stop the IAS 29 required real value maintaining CPP inflation accounting model and go back to the real value eroding HC model (as as Brazil did in 1994 and Turkey did in 2005) and again erode all these constant real value non-monetary items´ existing constant real non-monetary values at a rate equal to the annual rate of inflation when they maintain the stable measuring unit assumption for an unlimited period of time during indefinite inflation. They could also choose to implement the real value maintaining Constant real value non-monetary item Purchasing Power Accounting model during low inflation and maintain the real values of only constant real value non-monetary items in units of constant purchasing power in terms of the IASB´s Framework (1989), Par 104 (a) while they would valuevariable real value non-monetary items in terms of IFRS.

Accountants can freely choose to change right now to the real value maintaining financial capital maintenance in units of constant purchasing power model (CIPPA) during low inflation and deflation in terms of the IASB´s Framework (1989), Par 104 (a). The choice is theirs since financial capital maintenance in units of constant purchasing power was authorized in the IASB´s Framework (1989), Par 104 (a) in1989 and is applicable in the absence of specific IFRS (see IAS8.11). No-one stops them from making that choice.

Auditors would certify that companies´ financial statements fairly present their businesses and comply with IFRS when boards of directors choose to continuously measure financial capital maintenance in units of constant purchasing power during low inflation and deflation in terms of the Framework (1989), Par 104 (a).

Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

This project is not about inflation accounting

This project, contrary to Prof Geoffrey Whittington’s book "Inflation Accounting", is not about inflation accounting during high and hyperinflationary periods.

This project is not about accountants implementing 1970-style inflation accounting in low inflationary economies by inflation-adjusting all non-monetary items equally by means of the CPI.

The following peer reviewed article Financial Statements, Inflation & The Audit Report I wrote was published in SAICA´s journal- Accountancy SA - in September 2007.

“In most countries, primary financial statements are prepared on the historical cost basis of accounting without regard either to changes in the general level of prices or to increases in specific prices of assets held, except to the extent that property, plant and equipment and investments may be revalued.” ¹

The International Accounting Standards Board (IASB) only recognizes two economic items:

1.) Monetary items defined as “money held and items to be received or paid in money;” and
2.) Non-monetary items: All items that are not monetary items.

Non-monetary items include variable real value non-monetary items valued, for example, at fair value, market value, present value, net realizable value or recoverable value.

They also include Historical Cost items based on the stable measuring unit assumption.

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

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

This makes these Historical Cost items equal to monetary items in the case of companies´ Retained Income balances and the issued share capital values of companies with no well located and well maintained land and/or buildings or other variable real value non-monetary items able to be revalued at least equal to the original real value of each contribution of issued share capital.

Retained Income is a constant real value non-monetary item valued at Historical Cost which makes it subject to the destruction of its real value by inflation – exactly the same as in cash.

It is an undeniable fact that South Africa’s functional currency’s internal real value is constantly being destroyed by inflation in the case of our low inflationary economy, but this is not considered important enough to adjust the real values of constant real value non-monetary items in the financial statements - the universal stable measuring unit assumption.

The combination of the Historical Cost Accounting model and low inflation is thus indirectly responsible for the destruction of the real value of Retained Income equal to the annual average value of Retained Income times the average annual rate of inflation. This value is easy to calculate in the case of each and every company in South Africa with Retained Income. It is also possible to calculate this value for all companies in the world economy with Retained Income.

It is broadly known that the destruction of the internal real value of the monetary unit of account is a very important matter and that inflation thus destroys the real value of all variable real value non-monetary items when they are not valued at fair value, market value, present value, net realizable value or recoverable value.

But, everybody suddenly agrees, in the same breath, that for the purpose of valuing Retained Income - a constant real value non-monetary item - the change in the real value of money is not regarded as important to update the value of Retained Income in the financial statements. Everybody suddenly then agrees to destroy hundreds of billions of Dollars in real value in all companies´ Retained Income balances all around the world.

Yes, inflation is very important!

All central banks and thousands of economists and commentators spend huge amounts of time on the matter. Thousands of books are available on the matter. Financial newspapers and economics journals dedicate thousands of columns to the fight against inflation.

But, when it comes to constant real value non-monetary items, it doesn’t seem as if inflation is important. We happily destroy hundreds of billions of Dollars in Retained Income real value year in year out.

However, when you are operating in an economy with hyperinflation (perhaps only Zimbabwe at the moment with 3 713% inflation), then we all agree that you have to update everything in terms of International Accounting Standard IAS 29 Financial Reporting in Hyperinflationary Economies. You have to update variable AND constant real value non-monetary items.

But, ONLY as long as your annual inflation rate has been 26% for three years in a row adding up to 100% - the rate required for the implementation of IAS 29.

Once you are not in hyperinflation anymore, for example, 15% annual inflation for as many years as you want, then you are not allowed to update constant real value non-monetary items any more. Then you must destroy their real value again – at 15% per annum. Or 7.0% per annum in the case of South Africa (April 2007).

For example:

Shareholder value permanently destroyed by the implementation of the Historical Cost Accounting model in Exxon Mobil's Retained Income during 2005 exceeded $4.7bn for the first time. This compares to the $4.5bn shareholder real value permanently destroyed in 2004 in this manner. (Dec 2005 values).

The application by BP, the global energy and petrochemical company, of the stable measuring unit assumption in the accounting of their Retained Income resulted in the destruction of at least $1.3bn of shareholder value during 2005. (Dec 2005 values).

Royal Dutch Shell Plc, a global group of energy and petrochemical companies, permanently destroyed $2.974 billion of shareholder value during 2005 as a result of the application of the stable measuring unit assumption in the accounting of their Retained Income. (Dec 2005 values).

Should this value be reflected in the financial statements?

Maybe it should.

Nicolaas Smith”

Footnotes

¹ International Accounting Standards Committee, (1995), International Accounting Standard 1995, London, IASC, Page 502

² Paul H. Walgenbach, Norman E. Dittrich and Ernest I. Hanson, (1973), Financial Accounting, New York: Harcourt Brace Javonovich, Inc. Page 429.

http://www.accountancysa.org.za/resources/ShowItemArticle.asp?ArticleId=1235&issue=857

This article was first published in Accountancy SA (September 2007, pg 38). Accountancy SA is published by the South African Institute of Chartered Accountants. www.accountancysa.org.za

The understanding of the global, economy-wide erosion of banks´ and companies´ capital and profits (equity) during low inflation caused by the implementation of the stable measuring unit assumption is an ongoing process. In 2007 I, like almost everyone else, still believed that inflation eroded the real value of non-monetary items. Since then I have realized that I made a mistake by believing what everyone else believes and state with regard to the erosive effect of inflation on the real value of non-monetary items. I realized since then that inflation is in fact always and everywhere only a monetary phenomenon, as the late Milton Friedman so eloquently stated. I realized since then that inflation can only erode the real value of money and other monetary items – nothing else. I realized since then that inflation has, in fact, no effect on the real value of non-monetary items as so correctly stated by Prof Dr. Ümit GUCENME and Dr. Aylin Poroy ARSOY from Uludag University, Bursa, Turkey:

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

This project  is thus not about inflation-accounting. Inflation accounting is a model of accounting to be applied only during very high and hyperinflation. Inflation accounting is specifically defined in IAS 29 Financial Reporting in Hyperinflationary Economies and required by IFRS only during hyperinflation.

The theme of this project is financial capital maintenance in units of constant purchasing power accounting during low inflation and deflation (as implemented via the Constant Item Purchasing Power Accounting model) as authorized in IFRS in the Framework (1989), Par 104 (a). Stated differently: the theme of this book is the rejection of the stable measuring unit assumption, i.e. the rejection of the generally accepted, globally implemented, traditional Historical Cost Accounting model, during low inflation and deflation as authorized in IFRS in the Framework (1989), Par 104 (a). The rejection of the stable measuring unit assumption is authorized in IFRS since financial capital maintenance in units of constant purchasing power during low inflation and deflation (CIPPA) is authorized in IFRS in the Framework (1989), Par 104 (a) as an alternative to financial capital maintenance in nominal monetary units, i.e. the Historical Cost Accounting model under which the stable measuring unit assumption is implemented.

Non-monetary items are subdivided in variable real value non-monetary items and constant real value non-monetary items. Only constant real value non-monetary items are inflation-adjusted under financial capital maintenance in units of constant purchasing power (CIPPA) in terms of the Framework, Par 104 (a) to maintain their existing constant real non-monetary values constant during low inflation and deflation in order to measure financial capital maintenance in units of constant purchasing power instead of in nominal monetary units. That is what this project is about. Variable items are valued in terms of IFRS or GAAP in a manner that takes into account all elements - including inflation - which determine the variable item’s real value at the date of valuation during low inflation and deflation. Monetary items are always valued at their original nominal monetary values under all accounting models and under all economic environments. Constant real value non-monetary items are also valued in terms of IFRS in units of constant purchasing power when financial capital maintenance is measured in units of constant purchasing power during low inflation and deflation by implementing the CIPPA model.

This project is about accountants knowingly maintaining the existing real values of constant real value non-monetary items - e.g., banks´ and companies´ Shareholders´ Equity – constant during low inflation and deflation for an unlimited period of time in all entities that at least break even – ceteris paribus – by continuously implementing the real value maintaining financial capital maintenance in units of constant purchasing power model (CIPPA) as approved in the IASB´s Framework, Par 104 (a) in 1989.

This project is about accountants knowingly indexing or inflation-adjusting or updating or measuring in units of constant purchasing power only constant real value non-monetary items by implementing the CIPPA model during low inflation and deflation as approved in IFRS in the IASB´s Framework (1989) Par, 104 (a), instead of unknowingly, unintentionally and unnecessarily eroding their real values on a massive scale with their implementation of the very erosive stable measuring unit assumption as it forms part of the traditional HCA model when they measure financial capital maintenance in nominal monetary units for an unlimited period of time during indefinite inflation.

This project is about accountants knowingly choosing to measure financial capital maintenance in banks and companies in real value maintaining units of constant purchasing power during low inflation and deflation as approved in the IASB´s Framework, Par 104 (a) instead of in real value eroding nominal monetary units as a result of their choice to implement the very erosive stable measuring unit assumption during low inflation also authorized by the IASB in the Framework, Par 104 (a) twenty two years ago.

This project is about accountants rejecting the stable measuring unit assumption and instead adopting IASB-approved real value maintaining constant purchasing power units as the measurement basis for only constant items including banks´ and companies´ Shareholders´ Equity and not only for income statement constant items, e.g. salaries, wages, rentals, etc during non-hyperinflationary conditions.

This project is about stopping the implementation of the Historical Cost Accounting model which unknowingly, unintentionally and unnecessarily erodes hundreds of billions of US Dollars per annum of existing constant real value in existing constant real value non-monetary items (bank´s and companies´ capital) in the real economy because they choose to implement the traditional HCA model when they implement the very erosive stable measuring unit assumption for an unlimited period of time during indefinite inflation instead of the IASB-approved real value maintaining CIPPA model.

Accountants make the Historical Cost Mistake by implementing the very erosive stable measuring unit assumption during inflation as part of the traditional HCA model for an unlimited period of time during indefinite inflation.

This project is about accountants being able to knowingly maintain hundreds of billions of US Dollars per annum of existing constant real non-monetary value in the real economy for an unlimited period of time in all entities that at least break even complying with IFRS instead of unknowingly, unintentionally and unnecessarily eroding that value year in year out as they unknowingly do at the moment when they maintain the stable measuring unit assumption for an unlimited period of time during indefinite inflation.

This project is about accountants abandoning the very erosive traditional HCA model and adopting the real value maintaining CIPPA model in low inflationary and deflationary economies as authorized in 1989 in the IASB´s Framework, Par 104 (a).

Monetary items

Current monetary item accounts cannot be indexed or inflation-adjusted or valued in units of constant purchasing power under any accounting model because the real value of money cannot be maintained constant during inflation or deflation.

Variable items

It is not proposed in this project that variable real value non-monetary items are to be value in units of constant purchasing power or to be consistently indexed or inflation-adjusted or updated by accountants in terms of the change in the monthly CPI as a measurement basis for the purpose of primary valuation during the current accounting period, for financial capital maintenance in units of constant purchasing power and for calculating the period-end profit or loss during low inflation and deflation. Variable items are valued by accountants in terms of IFRS during low inflation and deflation. The IASB specifically requires the implementation of IAS 29 Financial Reporting in Hyperinflationary Economies during hyperinflation. Variable items are required to be valued in units of constant purchasing power, i.e. inflation-adjusted or updated in terms of the period-end CPI, during hyperinflation in terms of IAS 29 since the IASB regards hyperinflation as an exceptional circumstance.

It is very clear from the IASB´s Framework (1989), Par 104 (a) that measuring financial capital maintenance in real value maintaining units of constant purchasing power is authorized in IFRS by the IASB as the basis for a CIPPA 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 HCA model) only during low inflation and deflation, and that financial capital maintenance in units of constant purchasing power can be measured in units of constant purchasing power only during high and hyperinflation. In typical international accounting standard fashion it simply states that either the one (financial capital maintenance in nominal monetary units) or the other (financial capital maintenance in units of constant purchasing power) can be used. That means at all levels of inflation and deflation - which includes low inflation.

The IASB does, however, specifically require the implementation of IAS 29 during hyperinflation. IAS 29 is based on the Constant Purchasing Power Accounting (CPPA) inflation accounting model requiring all non-monetary items (variable real value non-monetary items and constant real value non-monetary items) to be measured in units of constant purchasing power, i.e. to be inflation-adjusted or updated by means of the period-end CPI during hyperinflation. CPPA is a generally accepted inflation accounting model required in IFRS to be implemented only during hyperinflation. Both the IFRS-authorized principle of financial capital maintenance in units of constant purchasing power (inflation-adjusting non-monetary items) and the CPPA model during hyperinflation are generally accepted. CPPA is a price-level accounting model as Prof Whittington state: “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.” While the principle of financial capital maintenance in units of constant purchasing power is generally accepted, the implementation of the Constant Item Purchasing Power Accounting model under which this principle is implemented during low inflation and deflation, is not yet generally accepted. Although CIPPA is also a price-level accounting model, this results in most accountants automatically assuming that price-level accounting always refers only to inflation accounting.

In the Framework, Par 101 the IASB states that companies most commonly use the traditional HC model 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 and, secondly, to implement the Current Cost Accounting model when entities choose a physical capital concept.

The IASB - as far as measurement bases are concerned - specifically deals with historical cost, current cost, realizable (settlement) value, present value, market value, recoverable value, fair value, ect, which accountants, in fact, use to value variable items in terms of IFRS during low inflation and deflation.

In the Framework (1989), Par 104 (a) the IASB authorizes accountants to measure financial capital maintenance in real value maintaining units of constant purchasing power at all levels of inflation and deflation – including low inflation. When they choose to do that, it indicates that they choose the CIPPA model instead of their current choice, the very erosive traditional Historical Cost Accounting model. 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 companies state in their opening notes to their balance sheet that their financial reports have been prepared based on the traditional Historical Cost model. We normally find that they use different measurement bases to different degrees and in different combinations including constant real value non-monetary items in the income statement that are indexed or inflation-adjusted or valued in units of constant purchasing power by applying the CPI in low inflationary economies: e.g. salaries, wages, rentals, utility fees, transport fees, etc. Indexation or inflation-adjustment or valuing in units of constant purchasing power is thus already a generally accepted accounting practice in low inflationary economies, but, only for some, not all, income statement constant real value non-monetary items (all income statement items are constant real value non-monetary items the moment they are accounted in the income statement) and not at all for balance sheet constant real value non-monetary items.

Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Reasons why accountants do not yet select CIPPA

Accountants do not yet select financial capital maintenance in units of constant purchasing power and accounting professors and lecturers do not teach accounting students to select the real value maintaining IFRS-approved alternative to the 3000 year old very erosive generally accepted traditional Historical Cost Accounting model because

(1) they still automatically assume that any price-level accounting model always refers to the CPP inflation accounting model to be used only during high and hyperinflation,

(2) they do not yet realize that the implementation of the traditional Historical Cost Accounting model unknowingly, unintentionally and unnecessarily erodes real value on a significant scale (hundreds of billions of US Dollars per annum) in the world´s real economy when financial capital maintenance in nominal monetary units is implemented, and

(3) they do not yet realize that they can automatically stop this massive annual erosion of existing constant real value in existing constant real value non-monetary items never maintained constant by simply selecting the alternative approved by the IASB predecessor body, the IASC Board, 22 years ago, namely, the measurement of financial capital maintenance in units of constant purchasing power during low inflation and deflation as approved in the Framework, Par 104 (a) which is compliant with IFRS and was adopted by the IASB in 2001.

(4) they still believe and implement the IASB-authorized fallacy that "financial capital maintenance can be measured in nominal monetary units."

(5) they still believe and implement the stable measuring unit assumption that is based on the fallacy that changes in the real value of the monetary unit of account is not sufficiently important to require financial capital maintenance in units of constant purchasing power during low inflation and deflation,

(6) they still believe the fallacy that "the erosion of business profits and invested capital is caused by inflation" as stated by the FASB in FAS 89

(7) they still believe that since the central bank and monetary authorities control the rate of inflation, there is thus nothing they can do about this generally acknowledged erosion of companies´ and banks´ equity (especially evident during the sub-prime financial crisis).

If they had realized the enormous amount of real value eroded each and every year by the implementation of financial capital maintenance in nominal monetary units (the traditional Historical Cost Accounting model) during low inflation, they would have stopped the stable measuring unit by.

Prof Geoffrey Whittington is one of the world’s leading experts on inflation accounting and International Financial Reporting now Standards. It is clear from his benchmark book, Inflation Accounting (1983), that CPP inflation accounting, as implemented in the period leading up to 1983, was used by accountants during high and hyperinflation to index or inflation-adjust all non-monetary accounts by means of a general index - normally the CPI which reflected changes in the purchasing power of the functional currency.

Whittington’s book was published in 1983. The IASB´s Framework which authorized measuring financial capital maintenance in units of constant purchasing power during low inflation and deflation was approved in 1989.

Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

CIPPA is authorized during low inflation

The statement that financial capital maintenance can be measured in either constant purchasing power units or in nominal monetary units in the IASB´s Framework, Par 104 (a) means that CIPPA has been authorized by the IASB since 1989 as an alternative to the traditional HCA model during periods of low inflation and deflation. This means that the international accounting profession has been in agreement regarding the use of financial capital maintenance in units of constant purchasing power during low inflation and deflation for the last 22 years.
Measurement in constant monetary units (e.g. constant Dollars), i.e. in units of constant purchasing power by inflation-adjusting constant real value non-monetary items during low inflation and deflation as an alternative paradigm is authorized not only in IFRS, but, also in particular country´s accounting regulations. An alternative measurement in constant monetary units paradigm has been authorized in Portuguese accounting in the Plano Offical de Contas (POC) also since 1989.

“Os registos contabilísticos devem basear-se em custos de aquisição ou de produção, quer a escudos nomonais, quer a escudos constantes.”

Carlos Baptista da Costa and Gabriel Correia Alves, Contabilidade Financeira, Rei dos Livros, 1996, P 79

Income statement constant real value non-monetary items like salaries, wages, rentals, utilities, transport fees, etc are normally valued by accountants in units of constant purchasing power during low inflation in most economies. Payments in money for these items are normally inflation-adjusted by means of the CPI to compensate for the erosion of the real value of the unstable monetary medium of exchange by inflation. Inflation is always and everywhere a monetary phenomenon and can only erode the real value of money (the functional currency inside an economy) and other monetary items. Inflation cannot and does not erode the real value of non-monetary items. See GUCENME and ARSOY above.

Constant real value non-monetary items´ real values can knowingly be maintained by accountants choosing the CIPPA model as per the IASB´s Framework during low inflation as authorized in 1989 instead of currently unknowingly being eroded by the implementation of the traditional HCA model when they apply the very erosive stable measuring unit assumption for an unlimited period of time during indefinite inflation. It is thus the choice of accounting model and not inflation that maintains or erodes the real value of constant real value non-monetary items like Retained Earnings, Issued Share capital, capital reserves, other shareholder equity items never maintained, etc. when accountants choose to implement the very erosive stable measuring unit assumption for an unlimited period of time during indefinite inflation.

Implementing the low inflation CIPPA model as approved in the Framework, Par 104 (a) means accountants choose to reject the stable measuring unit assumption which they implement when they choose to measure financial capital maintenance in nominal monetary units – also in terms of the Framework, Par 104 (a).

Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Benefits of financial capital maintenance in units of constant purchasing power not generally realized

The benefits of financial capital maintenance in units of constant purchasing power are not generally understood as a result of the fact that most entities still think that it only relates to inflation accounting during hyperinflation. CIPPA is not inflation accounting. It is implemented at all levels of inflation and deflation.

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Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Inflation-adjusted accounts during low inflation is a blessing to users - Part 2

Inflation-adjusted income statement constant real value non-monetary items, for example, salaries, wages, rentals, etc. are – right this very moment – a blessing to users all around the world because they maintain the constant real value or purchasing power of salaries, wages, rentals, etc. constant during low inflation as long as the inflation-adjustment is at least equal to inflation over the period in question. Millions of workers, their trade unions, governments, accountants, economists and people in general would agree that the practice of inflation-adjusting accounts in a low inflation environment is a blessing to users. In fact, it is one of the basic pillars of a stable economy as has been amply proven by Brazilian accountants, economists and the Brazilian Central Bank during the 30 years of very high and hyperinflation from 1964 to 1994 when they maintained their internal demand in the country relatively stable by inflation-adjusting salaries, wages, rentals and many other non-monetary items in their real economy.


Inflation-adjusted balance sheet constant real value non-monetary items, e.g. Issued Share capital, Retained Earnings, Share premiums, Capital Reserves, General Reserves, all other items in Shareholders´ Equity, trade debtors, trade creditors, taxes payable, taxes receivable, salaries payable, salaries receivable, all other non-monetary payables, all other non-monetary receivables, etc in a low inflation economy would be a blessing to everyone in that economy when accountants simply decide to change from their current implementation of the very erosive stable measuring unit assumption – which is based on a fallacy – and financial capital maintenance in nominal monetary units (the traditional Historical Cost Accounting model) which is impossible during inflation and another fallacy, and freely choose to implement the real value maintaining financial capital maintenance in units of constant purchasing power model during low inflation and deflation ( as applied in the Constant Item Purchasing Power Accounting model) as approved by the IASB in the Framework, Par 104 (a) in 1989. Accountants implementing financial capital maintenance in units of constant purchasing power during low inflation would knowingly maintain - instead of the generally accepted HCA model currently unknowingly, unnecessarily and unintentionally eroding real value in constant real value non-monetary items never maintained as it also did last year and all the years before and will do next year if the very erosive stable measuring unit assumption is not stopped – all else being equal.

Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Inflation-adjusted accounts are a blessing during low inflation - Part 1

Inflation-adjusted income statement constant real value non-monetary items, for example, salaries, wages, rentals, etc. are – right this very moment – a blessing to users all around the world because they maintain the constant real non-monetary value or constant real non-monetary purchasing power of salaries, wages, rentals, etc during low inflation as long as the inflation-adjustment is at least equal to inflation over the period in question. Millions of workers, their trade unions, governments, accountants and people in general would agree that the practice of inflation-adjusting accounts in a low inflation environment is a blessing to users in the world economy. It is one of the basic pillars of a stable economy as has been amply proven by Brazilian accountants during the 30 years of very high and hyperinflation from 1964 to 1994 when they maintained their internal demand in the country relatively stable by daily inflation-adjusting salaries, wages, rentals and other non-monetary items in their real economy. This was not done during Zimbabwe´s period of hyperinflation and was a major factor in the eventual hyperinflationary monetary meltdown which led to the death of the Zimbabwe Dollar on 20 th November, 2008.

Inflation-adjusted balance sheet constant real value non-monetary items, e.g. Issued Share capital, Retained Earnings, Share premiums, Capital Reserves, General Reserves, all other items in Shareholders´ Equity, trade debtors, trade creditors, taxes payable, taxes receivable, salaries payable, salaries receivable, all other non-monetary payables, all other non-monetary receivables, etc. in the world´s low inflationary economies would be a blessing to everyone when accountants simply decide to change from their current implementation of their very erosive stable measuring unit assumption – which is based on a fallacy – and financial capital maintenance in nominal monetary units per se which is impossible during inflation and deflation and another fallacy and freely choose to implement the real value maintaining financial capital maintenance in units of constant purchasing power accounting model (Constant Item Purchasing Power Accounting) as approved by the IASB in IFRS in the Framework( 1989), Par 104 (a) twenty two years ago. Accountants measuring financial capital maintenance in units of constant purchasing power (implementing CIPPA) would knowingly maintain for an unlimited period of time – all else being equal - instead of currently unknowingly, unnecessarily and unintentionally erode as they also did last year and all the years before and will do next year if they do not stop with their very erosive stable measuring unit assumption hundreds of billions of US Dollars in constant item real value annually in the world´s real economy.

Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.