Objectives of general purpose financial reporting / accounting

            The objectives of general purpose financial reporting / accounting are:

1)  Automatic maintenance of the constant purchasing power of capital in all entities that at least break even - ceteris paribus.¹ ² ³

          2) Provision of continuously updated decision-useful financial information about the reporting entity to capital providers and other users.

            An entity has continuously maintained the constant real non-monetary value of equity (equal to net assets) if it has as much equity - expressed in units of constant purchasing power - at the end of the reporting period as it had at the beginning of the period, after excluding any distributions to, and contributions from, owners during the period. Consequently: a profit is earned only if the constant purchasing power of equity at the end of the period exceeds the constant purchasing power of equity at the beginning of the period, after excluding any distributions to, and contributions from, owners during the period.

The German economist Werner Sombart (1863-1941) wrote in "Medieval and Modern Commercial Enterprise" that "The very concept of capital is derived from this way of looking at things; one can say that capital, as a category, did not exist before double-entry bookkeeping. Capital can be defined as that amount of wealth which is used in making profits and which enters into the accounts." ^

^ Lane, Frederic C; Riemersma, Jelle, eds (1953). Enterprise and Secular Change: Readings in Economic History. R. D. Irwin. p. 38.  (quoted in "Accounting and rationality)."

The objectives of general purpose financial reporting are supposed to answer the question: what is financial reporting, i.e. accounting, supposed to do? The only accounting model possible to be used by entities implementing a capital concept is double-entry accounting: without double-entry accounting the concept of capital as an legal economic item separate from its owner or owners is not possible: for every debit/asset (e.g. cash) there is an equivalent credit/liability (e.g. capital) in double-entry accounting. The existing constant real non-monetary value of this existing capital has to be automatically maintained constant in all entities that at least break even during inflation and deflation for an indefinite period of time. This is only possible with financial capital maintenance in units of constant purchasing power.

Every concept of capital logically gives rise to its respective capital maintenance concept.

The IASB´s Conceptual Framework for Financial Reporting (2010)

The following paragraphs remain the same as originally stated in the Framework (1989).

Concepts of Capital Maintenance and the Determination of Profit

Par. 4.59. The concepts of capital in paragraph 4.57 give rise to the following concepts of capital maintenance:

(a) Financial capital maintenance. Under this concept a profit is earned only if the financial (or money) amount of the net assets at the end of the period exceeds the financial (or money) amount of net assets at the beginning of the period, after excluding any distributions to, and contributions from, owners during the period. Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power.

(b) Physical capital maintenance. Under this concept a profit is earned only if the physical productive capacity (or operating capability) of the entity (or the resources or funds needed to achieve that capacity) at the end of the period exceeds the physical productive capacity at the beginning of the period, after excluding any distributions to, and contributions from, owners during the period. *

*The Conceptual Framework (2010), Par 4.59.

The concepts of capital in the Conceptual Framework (2010), paragraph 4.57 give rise to the following three concepts of capital during low inflation and deflation:

(A) Physical capital. See Par 4.57 & 4.58

(B) Nominal financial capital. See Par 4.59 (a).

(C) Constant purchasing power financial capital. See Par 4.59 (a).

The concepts of capital in Par 4.57 give rise to the following three concepts of capital maintenance during inflation and deflation:

(1) Physical capital maintenance: optional during low inflation and deflation. Current Cost Accounting model prescribed by IFRS. See Par 4.61.

(2) Financial capital maintenance in nominal monetary units (Historical Cost Accounting): authorized in IFRS but not prescribed—optional during low inflation and deflation. See Par 4.59 (a). Financial capital maintenance in nominal monetary units per se during inflation and deflation is a fallacy: it is impossible to maintain the constant real non-monetary value of financial capital constant with measurement in nominal monetary units per se during inflation and deflation.

(3) Financial capital maintenance in units of constant purchasing power (Constant Item Purchasing Power Accounting – CIPPA – during low inflation and deflation): authorized in IFRS but not prescribed—optional during low inflation and deflation. See Par 4.59 (a). Financial capital maintenance in units of constant purchasing power is, however, prescribed in IAS 29 during hyperinflation: i.e. Constant Purchasing Power Accounting (CPPA) which is mostly unsuccessfully attempted via the restatement of Historical Cost of Current Cost financial statements during hyperinflation.

Only financial capital maintenance in units of constant purchasing power can automatically maintain the existing constant real non-monetary value of financial capital constant during low inflation, deflation and hyperinflation in all entities that at least break even—ceteris paribus—for an indefinite period of time. This would happen whether these entities own revaluable fixed assets or not and without the requirement of more capital in the form of more money or additional retained profits simply to maintain the real value of shareholders´ equity constant.

Financial capital maintenance in nominal monetary units (HCA) per se during inflation and deflation is impossible. It is a very popular accounting fallacy. It was originally authorized by the IASB in IFRS in the Framework (1989), Par 104 (a). It is based on the 3000 years old stable measuring unit assumption under which it is assumed that money is, in principle, stable in real vale. It is a Generally Accepted Accounting Practice. It is the concept of capital maintenance and one of the measurement bases used in traditional Historical Cost Accounting generally implemented worldwide. It still is an accounting fallacy that costs the world economy hundreds of billions of US Dollars per annum in existing constant real non-monetary value unknowingly, unnecessarily and unintentionally eroded by the implementation of the very erosive stable measuring unit assumption.

Financial capital maintenance in nominal monetary units during low inflation is only possible in entities that continuously invest at least 100% of the updated original real  value of all contributions to equity in revaluable fixed assets with an updated equivalent fair value (revalued or not)  .

Only CIPPA automatically maintains the real value of all constant real value non-monetary items constant in all entities that at least break even, including banks´ and companies´ capital base, for an unlimited period of time (forever) - all else being equal - whether these entities own revaluable fixed assets or not and without the requirement of additional capital from capital providers in the form of extra money or extra retained profits simply to maintain the real value of equity. This is opposed to the traditional HCA model under which the stable measuring unit assumption unknowingly, unnecessarily and unintentionally erodes the real value of that portion of shareholders´ equity never maintained constant as a result of insufficient revaluable fixed assets (revalued or not) during low inflation.

Continuous financial capital maintenance in units of constant purchasing power (CIPPA) automatically maintains the constant purchasing power of all constant items constant for an indefinite period of time in all entities that at least break even by continuously applying the monthly change in the annual CPI to the valuation of only constant items during low inflation and deflation. The daily parallel US Dollar (or other hard currency) exchange rate is continuously applied in the valuation of all non-monetary items (variable and constant items) during hyperinflation (CPPA) which only results in automatically maintaining the real or non-monetary economy relatively – not absolutely – stable. The constant item economy in a hyperinflationary economy is still subject to real value erosion at a rate equal to the annual inflation rate applicable to the hard currency (normally the US Dollar) used in supplying the parallel rate. The real economy would theoretically be completely stable during hyperinflation when a Brazilian-style daily index (which allows for the elimination of the stable measuring unit assumption in the parallel hard currency rate too) is used in the valuing of all non-monetary items (variable and constant items) during hyperinflation.
      

            Variable items are continuously valued in terms of IFRS excluding the stable measuring unit assumption during low inflation and deflation under CIPPA. Variable items are continuously valued in units of constant purchasing power (CPPA) by applying the daily parallel US Dollar (or other hard currency) exchange rate or a Brazilian-style daily index rate when it is intended to keep the real economy stable during hyperinflation.

Monetary items are money held and items with an underlying monetary nature valued in nominal monetary units during the current reporting period. The net monetary loss or gain from holding monetary items is calculated and accounted in the income statement under both CIPPA and CPPA, i.e. during low inflation, deflation and hyperinflation in terms of IFRS.

¹ “It is the overall objective of reporting for price changes to ensure the maintenance of the business as an entity.”

Accounting for Price Changes: An Analysis of Current Developments in Germany, Adolf G Coenenberg and Klaus Macharzina, Journal of Business Finance & Accounting, 3.1 (1976), P 53.

² Framework (1989), Par 104 (a): "Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power.”

³ It is essential to the credibility of financial reporting to recognize that the recovery of the real cost of investment is not earnings — that there can be no earnings unless and until the purchasing power of capital is maintained.

FAS 33 (1979), p 24

Nicolaas Smith

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

Brazilian indexation compared to accounting dollarization

Brazil indexed all non-monetary items (variable and constant items) during the 30 years from 1964 to 1994 by means of a daily non-monetary index supplied by the various governments over that period for everybody in the economy to use daily. Although the Brazilian indexes used during those 30 years were almost entirely based on the daily US Dollar exchange rate with the Brazilian currency, it was not a parallel rate used parallel to another “official” US Dollar exchange rate arbitrarily set by the government as happens in most cases where a parallel market for the US Dollar develops in hyperinflationary economies. However, the daily index supplied by the government was not the actual daily US Dollar exchange rate. Thus, although the Brazilian indexation was financial capital maintenance in units of constant purchasing power during those 30 years, and very similar to accounting dollarization, it was not exactly the same. It was better than accounting dollarization.
 

Brazilian indexation theoretically maintained the constant real value non-monetary item economy perfectly stable whereas there is still real value erosion in the constant real value non-monetary item economy as a result of the stable measuring unit assumption at a rate equal to the inflation rate in the US Dollar when accounting dollarization is employed. Brazilian-style indexation is thus better than accounting dollarization since real value erosion because of the use of the stable measuring unit assumption is completely eliminated with financial capital maintenance in units of constant purchasing power in terms of the daily index rate.

Nicolaas Smith

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

Accounting dollarization

Accounting dollarization is not the same as normal dollarization of an economy. An economy is dollarized when the national monetary unit is physically substituted with a relative stable foreign currency, normally the US Dollar. That is how the phrase “dollarization” originated. The national currency is not used anymore. There is no national currency in use in the economy. Its legal tender is legally terminated. Dollarization is generally adopted after a period of severe hyperinflation, e.g. in Zimbabwe in 2008.

Accounting dollarization as opposed to functional currency dollarization is doing all your daily business operations and accounting in US Dollars or in a any other relatively stable foreign currency during hyperinflation in your national monetary unit in an economy that does not use the US Dollar as a functional currency. It most probably never means that you do all your actual business transaction in US Dollars. You normally do some business in US Dollars and some in the local hyperinflationary currency. You may even do no business in actual US Dollars.

You simply note down the daily – normally unofficial - parallel US Dollar rate and use it in all your daily accounting and business operations. The existence of a parallel rate is essential for the application of accounting dollarization. When there is only one official US Dollar rate and no parallel rate the economy will normally not be in hyperinflation and accounting dollarization will not be required. Sometimes the US Dollar parallel rate changes more than the normal once per day. It can change every 8 hours, for example, during severe hyperinflation.

Accounting dollarization is the same as Constant Purchasing Power Accounting as defined in IAS 29 which requires financial capital maintenance in units of constant purchasing power during hyperinflation under which all non-monetary items (variable and constant items) are measured in units of constant purchasing power, but, not applying the period-end CPI, as required in IAS 29, but the daily US Dollar parallel rate.

I implemented it for the first time in Auto-Sueco (Angola), the Volvo agents in Angola, starting in January, 1996. Auto-Sueco (Angola) is the subsidiary of Auto-Sueco in Portugal.

 Accounting dollarization is also not the same as the US GAAP requirement that US companies with subsidiaries in hyperinflationary economies simply translate the year-end HCA financial statements prepared in the hyperinflationary local currency into US Dollars at the year-end rate before consolidation into the controlling US company´s consolidated accounts. Accounting dollarization is running any local business in a hyperinflationary economy in US Dollars on a daily basis applying the daily parallel rate in all accounting and business operations. This eliminates the hyper-eroding effect of the stable measuring unit assumption only as far as the local hyperinflationary currency is concerned as implemented under HCA on the existing real value of all non-monetary items (variable and constant real value non-monetary items) in a hyperinflationary economy.

    Accounting dollarization is a price-level accounting model applying financial capital maintenance in units of constant purchasing power as originally authorized in IFRS in the Framework (1989), Par 104 (a).

Nicolaas Smith

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

Capital is a variable or monetary item in the economy

Capital is a constant real value non-monetary item.

However, there is currently no constant real value capital in the world economy under HCA during low inflation and deflation. The portion of the original real value of all contributions to Shareholders´ Equity in companies covered by revaluable fixed assets is, in fact, treated as a variable real value non-monetary item under HCA during low inflation. This existing constant real non-monetary value is not maintained constant under the HCA model during low inflation and deflation. Its real value depends on the variable real non-monetary value of the fixed assets determined at fair value from time to time in terms of IFRS and US GAAP during low inflation since equity is equal to net assets under HCA with financial capital maintenance measured in nominal monetary units.

The portion of the original real value of all contributions to Shareholders´ Equity not covered by revaluable fixed assets is unknowingly, unnecessarily and unintentionally  being eroded by the stable measuring unit assumption (mistakenly believed to be inflation) at a rate equal to the annual rate of inflation as part of financial capital maintenance in nominal monetary units when the traditional HCA model is implemented during low inflation. This unknowing erosion by the stable measuring unit assumption amounts to about R200 billion in the SA constant real value non-monetary item economy and hundreds of billions of US Dollars in the world´s constant item economy each and every year.

When companies have no revaluable fixed assets at all under HCA, Capital is, in principle, treated the same as a monetary item (money or cash) and the stable measuring unit assumption erodes its real value at a rate equal to the annual rate of inflation in low inflationary economies.

Capital  will only – for the first time ever during low inflation and deflation - correctly be treated as a constant item and its existing constant value maintained constant in entities that at least break even for an unlimited period of time – ceteris paribus - when financial capital maintenance in units of constant purchasing power as authorized in IFRS in the Conceptual Framework (2010), Par 4.59 (a) is freely chosen by entities. There is no other way during low inflation and deflation.

Financial capital maintenance in units of constant purchasing power during low inflation and deflation was originally authorized in the IASB´s Framework for the Preparation and Presentation of Financial Statements in 1989.

Nicolaas Smith

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

Money illusion

Definition: Money illusion is the mistaken belief that money is stable in real value over time.

 Money illusion is primarily evident in low inflation countries. In hyperinflationary countries there is absolutely no money illusion as far as the hyperinflationary national currency is concerned. Everyone knows as a fact that the local hyperinflationary currency loses value day by day and even hour by hour. In low inflationary countries people are vaguely aware that money loses value over a long period of time. Money in a low inflationary economy is often used as if its real value is completely stable over the short term. That is money illusion.

Money illusion is evident everywhere in low inflationary economies. TV presenters reporting on historical events regularly quote Historical Cost values as the most natural thing to do. “Marble Arch was built for 10 000 Pounds” the TV reporter states with sincere knowledge that his audience is being well entertained with correct facts and figures. It is a figure very difficult to instantaneously value today. 10 000 British Pounds was the original cost in historical terms but we live today and absolutely no-one can immediately imagine what the construction cost of Marble Arch was in current terms. It is the same as saying that something cost one Pound 300 years ago. It is impossible to immediately value it now. We live now and not 300 years in the past. We don’t know what some-one could have bought for a Pound 300 years ago. People in the United Kingdom know what a person can buy for one Pound now – and the Pound’s value changes month after month within the UK economy as indicated by the monthly change in the CPI.

Companies report an unending stream of information about their performance and results. Sales increased by 5 per cent over last year’s figures, for example. Are these historical cost comparisons or real value comparisons? It is more never than hardly ever stated.

Money illusion is very, very common in our low inflationary economies. Another example: The BBC ran a program about the fantastic E-Type Jaguar. The presenter stated that one of the many reasons why the E-type Jag - the best car ever, according to the presenter - was such a success, was its original nominal price of 2 500 Pounds at the time of its first introduction into the market. Towards the end of the program it is then stated that a number of years later these same original E-Type Jags sold at a nominal price at that time of 25 000 Pounds. It is thus implied to be 10 times more than the original price of 2 500 Pounds. In nominal terms, yes. We all agree. Certainly not in real terms and we are interested in real values. Nominal profits - however fantastic they may look - are misleading the longer the time period and the higher the rate of inflation or hyperinflation in the transaction currency during the time period involved.

In this example we are all led to believe that the E-Type Jag was sold at a real value 10 times its original real value. It is notorious money illusion at work. The real value in a sale like that certainly would not be 10 times the original real value once the original nominal price is adjusted for the effect of the stable measuring unit assumption – the assumption that money is stable in real value over time – as related to the British Pound over the years in question.

Nicolaas Smith

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

Deflation

Deflation is a sustained absolute annual decrease in the general price level of goods and services.

Deflation happens when the annual inflation rate falls below zero percent (a negative annual inflation rate), resulting in an increase in the real value of money and all other monetary items. Deflation allows one to buy more goods with the same amount of money. This should not be confused with disinflation, a slow-down in the annual inflation rate (i.e. when annual inflation decreases, but still remains positive). Disinflation is a decrease in the annual rate of increase in the general price level. Annual inflation erodes the real value of money over time; conversely, annual deflation increases the real value of money in a national or regional economy over a period of time.

Inflation and deflation are both undesirable economic processes. As far as the understanding of inflation and deflation allows us at the moment, it can be stated that whatever level of deflation - however low - is to be avoided completely. A low level of inflation in an economy with financial capital maintenance in units of constant purchasing power (CIPPA) as the fundamental model of accounting implementing IFRS, is the best practice: A low level of inflation (best practice is currently regarded as 2% annual inflation) to limit the erosion of real value in money and other monetary items; IFRS for the correct valuation of variable real value non-monetary items and, thirdly, financial capital maintenance in units of constant purchasing power (CIPPA)  as authorized in IFRS for automatically maintaining the existing constant real values of existing constant real value non-monetary items constant for an indefinite period of time during low inflation and deflation in all entities that at least break even without the requirement for extra capital or extra retained profits simply to maintain the existing constant real value of existing constant real value non-monetary items (e.g. equity) constant.

Net monetary losses and gains are calculated and accounted in the income statement during low inflation and deflation when CIPPA is implemented: basically, the cost of inflation is accounted as a loss and deducted from profit before tax. Reducing the holding of monetary items (cash and other monetary items) over time would reduce the net monetary loss to a minimum during low inflation. Entities do their best to compensate for the net monetary loss from holding cash and other monetary items by trying to invest them at rates higher than the expected inflation rate. Obviously, it is not possible before the event to know what the inflation rate will be during any future period. It is possible to invest money in some economies in inflation-proof investments: the interest paid is stated at the start of the contract to be equal to the inflation rate plus 2 or 3 or 4 per cent to give a real return on the investment.

Nicolaas Smith

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

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

The cost of the stable measuring unit assumption

It is clearly known and admitted that there is real value being eroded in non-monetary items, namely in companies´ profits and capital: “the erosion of business profits and capital caused by inflation” as it is so generally accepted. It is just not realized that the stable measuring unit assumption - not inflation - is doing the eroding during inflation.

Everybody knows the actual cost of inflation – the net monetary loss from holding a net monetary balance of monetary item assets during the accounting period – is not calculated and accounted under HCA during low inflation and deflation. It is thought that it is the central bank´s task to reduce inflation which reduces the cost of inflation and “the erosion of business profits and invested capital caused by inflation”.

First of all, the erosion of business profits and invested capital is not caused by inflation but by the stable measuring unit assumption during low inflation. Yes, reducing inflation reduces the actual cost of inflation (the net monetary loss) and it also reduces the cost of the stable measuring unit assumption during inflation. However, sustained zero annual inflation - required to eliminate the cost of the stable measuring unit assumption completely in this manner - has never been achieved in the past in any economy using money and is not likely to be achieved any time soon in the future. So, central bankers will, most probably, never eliminate the cost of the stable measuring unit assumption completely in the world’s constant item economy, namely, the hundreds of billions of US Dollars being eroded unnecessarily by the stable measuring unit assumption during inflation.

On the other hand, continuous financial capital maintenance in units of constant purchasing power during low inflation and deflation (CIPPA) will automatically eliminate the entire cost of the stable measuring unit assumption forever at any level of inflation in all entities that at least break even and would prevent economic instability during deflation caused by the appreciation in the real value of constant items under HCA. Accountants would then knowingly maintain hundreds of billions of US Dollars per annum in the world’s real economy for an unlimited period of time during indefinite low inflation – all else being equal – in all entities that at least break even.

The cost of the stable measuring unit assumption is considered to be the same as the cost of inflation which is not calculated and accounted under HCA during low inflation. Everybody is consequently satisfied that a generally accepted accounting practice of not accounting the net monetary loss or gain from inflation during low inflation is correctly followed when “the erosion of business profits and invested capital caused by inflation” is referred to, which is in fact, not the cost of inflation, but, the cost of the very erosive stable measuring unit assumption. The erosion of the existing constant real value of companies´ profits and capital (the erosion of the existing constant real value of constant items never maintained constant under HCA) is not seen as separate from the erosion of the real value of money and other monetary items actually caused by inflation. The net monetary loss from holding a net balance of monetary item assets and the “erosion of business profits and invested capital caused by inflation” are seen as both being the same thing – both caused by inflation and not required to be calculated and accounted. That is a fundamental mistake.

Consequently, no-one looks for a solution in IFRS: the IFRS-authorized option in the Framework, Par 104 (a), namely, continuous financial capital maintenance in units of constant purchasing power during low inflation and deflation (CIPPA) has until now been ignored mainly because the split in non-monetary items in variable and constant items has only been identified in 2005.

Not only one, but, two enemies in the economy

The one very well known; the other a stealth enemy camouflaged by general acceptance in US GAAP and authorization in IFRS. The one – inflation - seen as an enemy in most instances; the other – the free choice of the stable measuring unit assumption - wreaking possibly even more damage in the real economy than inflation in the monetary economy. The stable measuring unit assumption is a very erosive stealth enemy perfectly camouflaged by US GAAP and IFRS authorization during low inflation and IFRS acceptance during hyperinflation as supported by Big Four accounting firms like PricewaterhouseCoopers which states: “Inflation adjusted financial statements are an extension to and not a departure from historic cost accounting.”  Understanding IAS 29

In most companies annual erosion would be at least equal to the weighted average annual value of Retained Earnings times the average annual inflation rate. This cost can be calculated to know its constant real value and the magnitude of real value eroded like this (or to be gained per annum in all entities at least breaking even for an unlimited period of time – all else being equal - from freely changing over to financial capital maintenance in units of constant purchasing power - CIPPA), but, it is never accounted as a loss in the Profit and Loss account at any time under the HCA model – similar to the non-accounting of the cost of inflation during low inflation. Because Retained Profits never maintained are, in principle, in this manner treated the same as monetary items under HCA during low inflation, this erosion of real value operates similar to – but it is not the same as - the cost of inflation in monetary items, but in Retained Profits and other constant items never maintained.  Most people mistakenly think it is also caused by inflation when it is in fact caused by the stable measuring unit assumption: stop the stable measuring unit assumption and there is no erosion of real value in constant items in all entities that at least break even.

In the case of companies with no revaluable fixed assets at all implementing HCA during low inflation this results in their total equity being valued in nominal monetary units thus being eroded by the stable measuring unit assumption over time at a rate equal to the annual rate of inflation.

Nicolaas Smith 

Copyright © 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Constant Item Purchasing Power Accounting - Abstract - Part 4 of 5

Both HC variable and HC constant items are considered to be simply HC non-monetary items under HCA.


Non-monetary items under the HCA model include HC items based on the stable measuring unit assumption. Both variable real value non-monetary items (e.g. inventory and fixed property) valued at HC in terms of IFRS and US GAAP, as well as constant real value non-monetary items (e.g. shareholders´ equity items) also valued at HC in terms of IFRS and US GAAP, are valued in nominal monetary units applying the very erosive stable measuring unit assumption during non-hyperinflationary periods. Both HC variable and HC constant items are thus considered to be simply HC non-monetary items. There is no split under HCA.

The very erosive stable measuring unit assumption means it is simply assumed under the HCA model that changes in the real value or purchasing power of money are not sufficiently important to continuously measure financial capital maintenance in units of constant purchasing power in low inflationary and deflationary economies for the purpose of valuing most constant items which are valued as HC items.

It is a generally accepted accounting practice not to apply the stable measuring unit assumption to the valuing of only certain income statement constant items, namely salaries, wages, rentals, etc. which are generally inflation-adjust annually. All other income statement items (all income statement items are constant items) and all balance sheet constant items are valued in nominal monetary units when the stable measuring unit assumption is applied during low inflation and deflation.

It is impossible to maintain the real value of financial capital constant with financial capital maintenance in nominal monetary units per se applying the very erosive stable measuring unit assumption during inflation and deflation. The monetary measuring unit (money) is not perfectly stable during inflation and deflation. Inflation erodes the real value of only money and other monetary items while deflation creates more real value in only money and other monetary items over time. Sustainable zero annual inflation has never been achieved in the past and is not likely to be achieved any time soon in the future. Financial capital maintenance in nominal monetary units per se during inflation and deflation as authorized in IFRS and US GAAP is a popular accounting fallacy. IFRS and US GAAP should not be based on popular accounting fallacies as they currently are.

“Under a financial concept of capital, such as invested money or invested purchasing power, capital is synonymous with the net assets or equity of the entity.” Framework (1989)

Shareholders´ equity’s constant real value can only be maintained constant (excluding continuous additions of fresh capital) with financial capital maintenance in nominal monetary units during inflation when at least 100% of the updated original real value of all contributions to shareholders´ equity are invested in revaluable fixed assets with an equivalent updated fair value – revalued or not. This is generally the case only in, for example, hotel, hospital and property groups. Valuing a revaluable fixed asset at HC does not erode its real value. It would normally be revalued when it is eventually sold or exchanged. It can also be revalued via the revaluation reserve before it is finally sold / exchanged.

However, the portion of shareholders´ equity’s real value, under HCA, that is never maintained constant with sufficient revaluable fixed assets during low inflation, is being treated the same as a monetary item (e.g. cash). Its real value is eroded at a rate equal to the annual rate of inflation because it is freely chosen in terms of US GAAP and the Framework, Par 104 (a) to implement financial capital maintenance in nominal monetary units and apply the very erosive stable measuring unit assumption during low inflation.

The stable measuring unit assumption

The stable measuring unit assumption is based on the fallacy that changes in the purchasing power of money are not sufficiently important to require the continuous measurement of financial capital maintenance in units of constant purchasing power during low inflation and deflation. Hyperinflation is defined in IFRS as a cumulative inflation rate approaching or equal to 100% over three years, i.e. 26% annual inflation for 3 years in a row. Financial capital maintenance in units of constant purchasing power is required in IFRS in IAS 29 during hyperinflation: it is thus required at 26% annual inflation for 3 years in a row. It is, however, left as an option at 20% or 15% or 6% or 2% for three years in a row or any number of years. Real value erosion in constant items never maintained constant by the implementation of the stable measuring unit assumption at continuous 20% inflation (which would wipe out 100% of the real value of shareholders´ equity never maintained constant in 4 years, e.g. in all companies with no revalueable fixed assets) is currently considered as not sufficiently important for the implementation of continuous financial capital maintenance in units of constant purchasing power (CIPPA). The stable measuring unit assumption currently erodes 51% of the real value of shareholders´ equity and all other constant items never maintained constant over 35 years in all economies with continuous 2% annual inflation implementing traditional HCA as authorized in US GAAP and IFRS. CIPPA automatically stops this forever in all entities that break even during inflation whether they own any revaluable fixed assets or not.

Nicolaas Smith

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

Constant Item Purchasing Power Accounting - Abstract - Part 3 of 5

Three concepts of capital maintenance in IFRS

There are not only two concepts of capital - as generally accepted and specifically stated in IFRS - authorized in IFRS, namely, physical and financial capital.

The three concepts of capital authorized in IFRS during low inflation and deflation are:

• (1) Physical capital. See the Framework (1989), Par 102.

• (2) Nominal financial capital. Par 104 (a).

• (3) Constant purchasing power financial capital. Par 104 (a) and 108.

The three concepts of capital maintenance authorized in IFRS during low inflation and deflation are:

• (a) Physical capital maintenance: optional during low inflation and deflation. The Current Cost basis of measurement is prescribed in the Framework, Par 106 when the physical capital maintenance concept is chosen.

• (b) Financial capital maintenance in nominal monetary units (traditional Historical Cost Accounting): authorized in IFRS but not prescribed - optional during low inflation and deflation. See Par 104 (a). It is adopted by most entities in preparing their financial statements. It is a popular accounting fallacy: it is impossible to maintain the real value of financial capital constant during inflation and deflation with measurement in nominal monetary units per se. It requires the implementation of the stable measuring unit assumption which is also based on a fallacy.

• (c) Financial capital maintenance in units of constant purchasing power: authorized in IFRS but not prescribed - optional during low inflation and deflation. See Par 104 (a) and 108. Only constant real value non-monetary items (not variable items) are continuously measured/valued in units of constant purchasing power by applying the monthly change in the annual CPI during low inflation and deflation (CIPPA). Variable items are measured in terms of specific IFRS or US GAAP during low inflation and deflation. Monetary items are and can only be measured in nominal monetary units. The net monetary loss or gain from holding net monetary item assets or net monetary item liabilities is calculated and accounted in the income statement during low inflation and deflation. The stable measuring unit assumption is rejected under this concept.

Accounting cannot and does not create real value out of nothing.

CIPPA is the only accounting model that automatically maintains the real value of all existing constant items constant forever in all entities that at least break even – ceteris paribus – whether they own revaluable fixed assets or not and without the need for extra capital in the form of extra money or extra retained profits simply to maintain the existing constant real value of existing shareholders´ equity constant during low inflation and deflation.

Constant Purchasing Power Accounting (CPPA) is the IASB´s inflation accounting model defined in IAS 29 which requires the restatement of all non-monetary items – constant and variable items – in HC or Current Cost financial statements by applying the period-end CPI during hyperinflation in order to make these statements more meaningful. This book is not about CPPA inflation accounting during hyperinflation as required in IAS 29 or any other inflation accounting model. CIPPA is not an inflation accounting model. Inflation accounting is used during hyperinflation. CIPPA is used during low inflation and deflation.

The difference between CIPPA and CPPA:

CPPA

In terms of IAS 29 CPPA is required only during hyperinflation: All non-monetary items are measured in units of constant purchasing power.

CIPPA

In terms of the Framework (1989), Par 104 (a) CIPPA is optional during low inflation and deflation: only constant items are measured in units of constant purchasing power. Variable items are measured in terms of US GAAP or IFRS.

Nicolaas Smith

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

Constant Item Purchasing Power Accounting - Abstract - Part 2 of 5

Abstract - Part 2 of 5


Three economic items

It is generally accepted that there are only two basic, fundamentally different economic items in the economy: monetary items and non-monetary items. That is not correct. There are three basic, fundamentally different economic items in the economy:

(i) Monetary items: money held and other monetary items with an underlying monetary nature, e.g. bank notes and coins, bank account balances, the capital amount of money loans, bonds, notes payable, notes receivable, housing loans, car loans, credit card loans, consumer loans, student loans, etc. Despite the FASB´s and PricewaterhouseCoopers´ statements to the contrary, trade debtors and trade creditors are not monetary items as confirmed in this book by the prominent Brazilian economist, Dr. Gustavo Franco, ex-governor of the Central Bank of Brazil and one of the architects of the Real Plan that stopped 30 years of very high and hyperinflation in Brazil in 1994. Monetary items can only be valued in nominal monetary units during the current accounting period under all accounting models and under all economic models.

(ii) Variable real value non-monetary items, e.g. property, plant, equipment, raw materials, finished goods, shares, foreign exchange, etc. valued in terms of IFRS or US GAAP during low inflation and deflation at for, example, fair value, net realizable value, present value, recoverable value, etc. Variable items, being non-monetary items, are required in terms of IAS 29 Financial Reporting in Hyperinflationary Economies to be restated in terms of the measuring unit current at the balance sheet date by applying the period-end Consumer Price Index during hyperinflation. This does not maintain the stability of the real economy during hyperinflation. That can only be done by valuing all non-monetary items (variable and constant items) at the official or unofficial daily US Dollar parallel rate or a Brazilian-style daily index value during hyperinflation.

(iii) 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 other non-monetary payables, all other non-monetary receivables, all items in the income statement, etc. Only constant items are continuously valued in units of constant purchasing power by applying the monthly change in the annual CPI in terms of continuous financial capital maintenance in units of constant purchasing power (CIPPA) during low inflation and deflation. The only way to maintain the non-monetary or real economy stable during hyperinflation (like Brazil did for 30 years from 1964 to 1994) is when all non-monetary items (variable and constant items) are valued daily at the official or unofficial daily US Dollar parallel rate or a Brazilian-style daily index value. Only certain (all income statement items are constant items) income statement items, e.g. salaries, wages, rentals, etc., are generally inflation-adjusted under HCA during low inflation. Other income statement items and all balance sheet constant items are currently valued in nominal monetary units, i.e. at Historical Cost, by applying the stable measuring unit assumption under HCA during low inflation and deflation.

The split of non-monetary items in variable and constant items is critical for financial capital maintenance in units of constant purchasing power during low inflation and deflation (CIPPA). That was what was missing at the time of FAS 89.

The split of non-monetary items is implied and authorized in IFRS with the authorization of financial capital maintenance in units of constant purchasing power during low inflation and deflation. Measurement in units of constant purchasing power implies that certain economic items have constant real values over time during low inflation and deflation. They certainly are not monetary items. Certain non-monetary items are thus constant real value non-monetary items. Non-monetary items which do not have constant real values are thus variable real value non-monetary items.

“In the absence of a Standard or an Interpretation that specifically applies to a transaction, management must use its judgement in developing and applying an accounting policy that results in information that is relevant and reliable. In making that judgement, IAS 8.11 requires management to consider the definitions, recognition criteria, and measurement concepts for assets, liabilities, income, and expenses in the Framework. This elevation of the importance of the Framework was added in the 2003 revisions to IAS 8.” Deloitte.

There are no specific Standards or Interpretations applicable to the concepts of capital, the concepts of capital maintenance and the valuation of constant items. The definitions and concepts in the Framework (1989) are thus applicable.

Nicolaas Smith

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

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).

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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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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.

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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.

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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.

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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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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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