Price–level accounting does not prevail for balance sheet constant items during low inflation

Price–level accounting does not prevail for balance sheet constant items during low inflation


Price–level accounting as Harvey Kapnick hoped for in 1976 clearly does not prevail for balance sheet constant real value non–monetary items (e.g. equity) and most income statement items during low inflation. Income statement items are all constant real value non–monetary items. Price–level accounting does prevail as far as the income statement constant real value non–monetary items salaries, wages, rentals, etc are concerned since they are updated annually in units of constant purchasing power in terms of the annual change in the Consumer Price Index, but, they are then paid monthly applying the stable measuring unit assumption; i.e. they are not updated monthly in terms of the CPI.

In terms of the Historical Cost Accounting model the stable measuring unit assumption is implemented under which balance sheet constant real value non–monetary items are valued at historical cost, i.e. in nominal monetary units thus eroding the existing constant real value of these constant real value non–monetary items when their existing constant real non–monetary values are never maintained as a result of insufficient revaluable fixed assets (revalued or not) under the HC paradigm during low inflation.

Price–level accounting generally did prevail in the Brazilian economy during the 30 years from 1964 to 1994 when Brazil indexed all non-monetary items (variable real value non–monetary items and constant real value non–monetary items) in their non–monetary or real economy with daily indexation with a daily index value supplied by the different governments during that period. Brazil stopped that with the full implementation of the traditional HCA model, financial capital maintenance in nominal monetary units and the stable measuring unit assumption when they changed the Unidade Real de Valor into their latest currency, the Real, in 1994. Brazil stopped daily indexation during hyperinflation which is, in principle, continuous financial capital maintenance in units of constant purchasing power during hyperinflation. They should have changed from daily indexation of all non-monetary items (variable and constant real value non-monetary items) during hyperinflation to financial capital maintenance in units of constant purchasing power (CIPPA) during low inflation where under only constant items (not variable items) are measured in units of constant purchasing power by applying the monthly CPI.

US Professor William Paton noted in 1922, "the value of the dollar — its general purchasing power — is subject to serious change over a period of years... Accountants... deal with an unstable, variable unit; and comparisons of unadjusted accounting statements prepared at intervals are accordingly always more or less unsatisfactory and are often positively misleading.”

As quoted in FAS 33 p. 29.
Shareholder’s equity forms part of an entity’s financial resources.

“Management commentary should set out the critical financial and non–financial resources available to the entity and how those resources are used in meeting management’s stated objectives for the entity.” IASB Exposure Draft: Management Commentary, June 2009, Par 29.

Shareholders´ equity is a financial resource with a constant real non–monetary value expressed in terms of an unstable monetary unit of measure under the HCA model. The IASB statement in the Framework (1989), Par 104 (a) that “financial capital maintenance can be measured in nominal monetary units” is clearly a fallacy since it is impossible to maintain the existing constant real non–monetary value of capital constant “in nominal monetary units” during inflation and deflation.

There is no substance in the claim that the existence and value of economic resources, for example shareholders´ equity items, exists independently of how we measure them – and that the choice of the measuring unit does not affect their fundamental value, only how we choose to represent that value – and that we can use any monetary unit, Dollars of constant purchasing power, US Dollars, whatever we think best represents that value and will make sense to whoever is using the information produced. See Paton above. There is no substance in the claim that it is fine to represent value in terms of constant purchasing power and to argue that that would be a better method than using historic cost and maintaining a fiction as to the stability of the measuring unit – but that doesn't affect the nature of the underlying resources. There is no substance in the claim that the choices made in accounting will not change that value and will not affect the economy. Measuring constant real value non-monetary items in units of constant purchasing power does affect the economy. That is generally known and a fact.

If it were generally realized that the implementation of the stable measuring unit assumption during low inflation results in the unknowing, unnecessary and unintentional erosion by the implementation of the Historical Cost Accounting model (the stable measuring unit assumption) of hundreds of billions of US Dollars of real value in constant real value non–monetary items (e.g. banks´ and companies´ equity) never maintained in the world´s constant real value non–monetary item economy year in year out, the HCA model would have been rejected by now.


Nicolaas Smith

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

Accounting cannot and does not create real value out of nothing

Accounting cannot and does not create real value out of nothing

It must be clearly understood, however, that accounting per se cannot and does not create real value out of thin air – out of nothing. Accounting cannot and does not create real value or wealth by simply passing some update or financial capital maintenance in units of constant purchasing power accounting entries when no real value actually exists. Constant real value non–monetary items, e.g. salaries, wages, rentals, issued share capital, share premium, retained profits, capital reserves, other items in shareholders´ equity, trade debtors, trade creditors, provisions, taxes payable, taxes receivable, etc., first have to actually exist for the accounting model (CIPPA) to be able to automatically maintain the real values of those existing constant real value non–monetary items constant for an indefinite period of time in all entities that at least break even by continuously measuring financial capital maintenance in units of constant purchasing power as authorized in IFRS and by continuously valuing income statement constant real value non–monetary items in terms of units of constant purchasing power in order to determine profit or loss in units of constant purchasing power during low inflation and deflation.

The IASB has, amazingly, authorized the fallacy of financial capital maintenance in nominal monetary units per se during inflation and deflation as well as its remedy (CIPPA) during inflation and deflation in one and the same statement in 1989.

Obviously, at sustainable zero inflation constant real value non–monetary items will maintain their real values constant in all companies that at least break even. Sustainable zero inflation has never been achieved in the past and is not likely soon to be achieved in the future. Sustainable zero inflation is thus simply a theoretical option.

The IASB confirms the fact that the Historical Cost paradigm is firmly in place when it states in IAS 29 and in the Framework (1989) that companies´ primary financial reports are prepared in most economies based on the traditional Historical Cost Accounting model without taking changes in the general level of prices or specific price changes of assets into account, with the exception that investments, equipment, plant and properties can be revalued. The IASB does not mention the other exception, namely, that salaries, wages, rentals, etc. are generally measured in units of constant purchasing power when they are updated on an annual basis.

The IASB does not mention the erosion of the real value of balance sheet constant real value non–monetary items never maintained constant when the stable measuring unit assumption is implemented during low inflationary periods in companies that lack sufficient revaluable fixed assets (revalued or not) because this process of erosion of the real value of constant real value non–monetary items never maintained is not generally realized. The IASB, like the FASB and most others, mistakenly believe that the erosion of companies´ capital and profits is caused by inflation as specifically stated by the FASB and IASB. They also support the stable measuring unit assumption which is based on the fallacy that money is perfectly stable as well as the fallacy of financial capital maintenance in nominal monetary units during low inflation and deflation.

The erosion of real value of constant real value non–monetary items by implementation of the stable measuring unit assumption is very well understood – and compensated for by updating them by applying the annual CPI – in the case of the income statement constant real value non–monetary items salaries, wages, rentals, etc. The real value maintaining effect on balance sheet constant real value non–monetary items is not realized of freely choosing to continuously measure financial capital maintenance in units of constant purchasing power instead of in nominal monetary units – both models being approved in IFRS in the Framework (1989), Par 104 (a).

The International Accounting Standards Committee (the IASB predecessor body) blamed changing prices in IAS 15 Information Reflecting the Effects of Changing Prices for affecting an enterprise’s results of operation and financial position. They defined changing prices as (1) specific price changes and (2) changes in the general price level which changed the general purchasing power of money, i.e. they blamed specific price changes and inflation for affecting companies´ results and financial position. The FASB mentioned the stable measuring unit assumption in FAS 33 and FAS 89.

“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.” FAS 89, Par 4, 1986

“The integrity of the historical cost/nominal dollar system relies on a stable monetary system.” FAS 33, 1979

The IASB never mentioned the stable measuring unit assumption in either IAS 6 Accounting Response to Changing Prices or IAS 15. IAS 15 completely superseded IAS 6. IAS 15 was eventually withdrawn.

Nicolaas Smith

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


Nicolaas Smith

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

Capital deficiency during sub–prime crisis

Capital deficiency during sub–prime crisis


The world economy would be more robust today if only continuous financial capital maintenance in units of constant purchasing power were authorized in the Framework (1989), Par 104 (a). The implementation of the Constant Item Purchasing Power Accounting model would today automatically maintain the existing constant real values of all companies´ and banks´ shareholders´ equity and all other constant items constant since then in companies and banks that at least break even, instead of the erosive stable measuring unit assumption unknowingly, unintentionally and unnecessarily eroding their real values never maintained as it forms part of traditional Historical Cost Accounting at a rate equal to the annual rate of inflation year in year out during low inflationary periods. The stable measuring unit assumption is based on the fallacy that the erosion of the real value of the monetary unit (money) is not sufficiently important to implement continuous financial capital maintenance in units of constant purchasing power during low inflation. The HCA model is implemented because financial capital maintenance in nominal monetary units – a complete fallacy - was also approved in IFRS in the exact same Framework (1989), Par 104 (a).

If only real value maintaining financial capital maintenance in units of constant purchasing power (CIPPA) were approved in 1989 it would have made a significant difference over this period as verified by the huge capital injections required as a result of the capital deficiency problems caused by the continuous unknowing, unnecessary and unintentional erosion by the implementation of the very erosive stable measuring unit assumption of the existing constant real value of banks´ and companies´ shareholders´ equity never maintained constant under the HCA model as evidenced during the recent sub–prime financial crisis.


Nicolaas Smith

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

The school of thought that 2% inflation is completely unharmful

The school of thought that 2% inflation is completely unharmful


Also approving the traditional Historical Cost Accounting model in the Framework (1989), Par 4.59 (a) has been very costly for the world economy as amply illustrated by the deficiency in bank and company capital during the recent financial crisis. This clearly illustrates the very erosive effect of the stable measuring unit assumption on balance sheet constant real value non–monetary items (e.g. shareholders´ equity) during low inflationary periods.

The school of thought that the effects of 2% inflation are not more harmful than zero per cent inflation may have contributed to this. This school of thought is incorrect in two of the three valuation processes in our current HC economy and is also mistaken in one of the three valuation processes under continuous financial capital maintenance in units of constant purchasing power, i.e. a Constant Item Purchasing Power paradigm during low inflation. The three valuation processes in our economy under both the HC and Constant Item Purchasing Power paradigms are the valuation of monetary items, variable real value non–monetary items and constant real value non–monetary items.

Variable items are valued in terms of International Financial Reporting Standards under both the Historical Cost and Constant Item Purchasing Power paradigms with the stable measuring unit assumption being applied under HCA. The stable measuring unit assumption is rejected under the Constant Item Purchasing Power Accounting option.

In the first instance, the view that a high degree of price stability of a positive inflation rate of up to two per cent per annum is completely unharmful and that it has no disadvantages compared to absolute price stability is never true in the case of monetary items under any accounting model – either the HCA model or the Constant Item Purchasing Power Accounting model – since monetary items are incapable of being updated as a result of the current nature of fiat money. A high degree of price stability of two per cent per annum in this case erodes two per cent per annum of the real value of money and other monetary items that cannot be updated in any way or form; that equates to the erosion of 51 per cent of real value in all current monetary items over the next 35 years and will over a long enough time period lead to all current monetary items arriving at the point of being completely worthless in economies with continuous 2% inflation. See the Real Value Table for other levels of real value erosion over the respective time periods involved.

In the case of monetary items we can thus confidently disagree completely with those who assume that a high degree of price stability of above zero and up to two per cent per annum is unharmful in all respects and that it has absolutely no disadvantages compared to absolute price stability or zero inflation.

The assumption that 2% inflation is unharmful and that it has no disadvantages compared to zero inflation is acceptable in the case of variable real value non–monetary items valued continuously in terms of IFRS under both the HC model and the Constant Item Purchasing Power Accounting model. The nature of the valuing processes in valuing variable real value non–monetary items continuously, for example, at fair value or net realizable value or market value, etc., as applicable, in terms IFRS, allows this idea to be justifiable under both models.

The above view is acceptable in this instance, because, in principle, any level of inflation or deflation – high or low – is automatically adjusted for in determining the price of a variable real value non–monetary item in terms of IFRS excluding, of course, valuation at historical cost.

2% inflation erodes 2% per annum – i.e. 51% over 35 years – of the real value of constant real value non–monetary items never maintained, e.g. retained profits and issued share capital, under the current HC paradigm. The only constant items generally maintained constant with annual measurement in units of constant purchasing power under the HC paradigm are certain (not all) income statement items, namely, salaries, wages, rentals, etc. They are, however, paid monthly at the same value after being updated annually. All existing constant real value non–monetary items´ real values would be maintained constant with continuous measurement in units of constant purchasing power at any level of inflation or deflation under the Constant Item Purchasing Power paradigm for an unlimited period of time in companies that at least break even – all else being equal.

We can thus safely disagree in the case of constant real value non–monetary items under the HC paradigm too, that the effects of 2% inflation is completely unharmful. 2% inflation – in fact, any level of inflation or deflation – would be the same as zero inflation as far as the valuation of constant real value non–monetary items under the Constant Item Purchasing Power paradigm is concerned.



Nicolaas Smith

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

Financial capital maintenance in units of constant purchasing power

Financial capital maintenance in units of constant purchasing power


Constant Item Purchasing Power Accounting is a price–level accounting model where under only constant items (not variable items) are continuously measured in units of constant purchasing power, i.e., updated every time the real value of the unstable monetary unit of account (money) changes; namely, when the CPI changes - month after month during low inflation and deflation.

Value accounting has been defined in since 1976 via IFRS relating to variable items. Value accounting thus clearly prevails in the valuation and accounting of variable items in terms of IFRS during low inflation and deflation.

Continuous financial capital maintenance in units of constant purchasing power during low inflation and deflation has also been authorized by the IASC Board thirteen years after Harvey Kapnick´s 1976 prediction. The IASC Board approved the Framework (1989), Par 104 (a) which states that “Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power.” However, the enormous real value eroding effect of the very erosive stable measuring unit assumption when entities choose in terms of the exact same Framework (1989), Par 104 (a), the IASB–approved very popular accounting fallacy of financial capital maintenance in nominal monetary units (the traditional Historical Cost Accounting model) and apply it in the valuing of constant items never maintained, e.g. retained earnings in most entities, in low inflationary economies when they implement stable measuring unit assumption during inflation, is not generally realized. This is clearly verified by the fact that both financial capital maintenance in nominal monetary units (a popular accounting fallacy) as well as real value maintaining continuous financial capital maintenance in units of constant purchasing power during inflation and deflation were approved in IFRS in the Framework (1989), Par 104 (a). Entities can choose the one or the other and state that they have prepared primary financial statements in terms of IFRS. However, when the the traditional HCA model is chosen, the stable measuring unit assumption unknowingly, unintentionally and unnecessarily erodes hundreds of billions of US Dollars in real value in the world´s constant item economy during low inflation. When they choose IFRS–approved continuous financial capital maintenance in units of constant purchasing power they maintain the real values of all constant items constant during inflation and deflation in companies which at least break even, empowering and enriching those companies, their shareholders and the economy in general with the accompanying benefits to workers and employment for an unlimited period of time – all else being equal.

As the Deutsche Bundesbank stated:
“The benefits of price stability, on the other hand, can scarcely be overestimated, especially as these are, in principle, unlimited in duration and accrue year after year.”

Deutsche Bundesbank, 1996 Annual Report, P 83.

Financial capital maintenance in units of constant purchasing power during inflation and deflation results in absolute price stability only in constant items for an unlimited period of time in companies that at least break even – all else being equal – without the need for extra capital from capital providers or more retained earnings simply to maintain the existing constant real value of existing constant items constant. This happens whether these entities own any fixed assets or not.


Nicolaas Smith

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

Price-level accounting

Price–level accounting

Entities generally choose to measure financial capital maintenance in nominal monetary units and thus apply the very erosive stable measuring unit assumption as part of the traditional HCA model. They generally value balance sheet constant items (e.g. equity) as well as most income statement items – which are all constant items – at Historical Cost. They value them in nominal monetary units as a result of the fact that they assume that changes in the purchasing power of the monetary unit are not sufficiently important to require financial capital maintenance in units of constant purchasing power during low inflation and deflation. Entities do not regard changes in the real value of money during low inflation and deflation as important enough for them to maintain the real value of capital constant with financial capital maintenance in units of constant purchasing power as they have been authorized in IFRS in the original Framework (1989) Par. 104 (a). Entities, in principle, assume there has never ever been inflation or deflation in the past, there is no inflation and deflation in the present and there never will be inflation and deflation in the future as far as the valuation of most constant items is concerned. They only value certain income statement constant real value non-monetary items, e.g. salaries, wages, rentals, etc in real value maintaining units of constant purchasing power and update them annually by means of the annual CPI during low inflation. They then pay these annually updated values monthly again implementing the stable measuring unit assumption.

Complete price–level accounting also called Constant Purchasing Power Accounting (CPPA) is an inflation accounting model whereby all non–monetary items – variable and constant items – are measured / valued in units of constant purchasing power by means of the daily US Dollar or other relatively stable foreign currency parallel rate or a daily index rate in order to maintain the real or non-monetary economy relatively stable during hyperinflation. IAS 29 does not require the valuation of all non-monetary items in units of constant purchasing power at the time of the transaction or event. IAS 29 and PricewaterhouseCoopers (amongst most others) accept the implementation of Historical Cost Accounting or Current Cost Accounting during the accounting period. IAS 29 requires the restatement of the HC or CC financial statements in terms of the period–end CPI in order to make them more useful during hyperinflation. The non–monetary or real economy of a hyperinflationary economy can only be maintained relatively stable by applying the daily parallel US Dollar exchange rate or a Brazilian–style daily index to the valuation of all non–monetary items instead of simply the restatement of HC or CC financial statement in terms of the period–end CPI as required by IAS 29.
The Framework is applicable


The implementation of the concepts of capital, the capital maintenance concepts and the profit/loss determination concepts during non–hyperinflationary periods are not covered in IAS, IFRS or Interpretations. These concepts are covered in the Conceptual Framework (2010), Par 4.57 to 110. There are no specific IAS or IFRS relating to these concepts. The Framework is thus applicable as per IAS8.11.

Deloitte states:

"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."

IAS8 Par. 11 states:

“In making the judgement, management shall refer to, and consider the applicability of, the following sources in descending order: (a) the requirements and guidance in Standards and Interpretations dealing with similar and related issues; and (b) the definitions, recognition criteria and measurement concepts for assets, liabilities, income and expenses in the Framework.”

The valuation of the constant real value non–monetary items Issued Share capital, Retained Earnings, other items in Shareholders´ Equity and other constant items is thus covered in IFRS in the original Framework (1989), Pa. 104 (a).

Harvey Kapnick in the Sax Lecture in 1976 correctly predicted the course of the development of International Financial Reporting Standards:

“Confusion constantly arises between changes in value and changes in purchasing power. The fact is both are occurring and, while there may be an interrelationship, the effects of each should be accounted for separately. Thus, the debate concerning whether value accounting or price–level accounting should prevail is not on point, because in the long run both should prevail. The real changes in value should be segregated from changes resulting only from changes in price levels.”

Harvey Kapnick, Chairman, Arthur Andersen & Company, “Value Based Accounting – Evolution or Revolution”, Sax Lecture, 1976.

Nicolaas Smith

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

Value accounting

Value accounting


There is, on the other hand, also strong awareness in the accounting profession that accounting is actually about value and not simply about Historical Cost.

"...it is really values that are the basic data of accounting, and costs are important only because they are the most dependable measures of initial values of goods and services flowing into the enterprise through ordinary market transactions”

Paton W. A., "Accounting Procedures and Private Enterprise", The Journal of Accountancy, April 1948, p.288.

It is generally accepted that accounting should be value based. By value based it is meant that variable real value non-monetary items cannot always be valued at HC, but, are to be valued in terms of specific measurement bases defined in IFRS or GAAP; for example, market value, net realizable value, fair value, present value, recoverable value, etc.

Value accounting has been defined in International Standards since 1976 via International Accounting Standards and IFRS relating to variable items. Value accounting thus clearly prevails in the valuation and accounting of variable items in terms of IFRS.

Value accounting also prevails as far as the valuing and accounting of monetary items during the current accounting period are concerned. Monetary items are measured in nominal monetary units no matter which accounting model is used under whatever economic environment: low inflation, deflation and hyperinflation. The real value of monetary items is kept always current, i.e. generally lower by inflation, generally higher by deflation and generally very much lower by hyperinflation since the nominal value of monetary items is not and cannot be updated or measured in units of constant purchasing power during the current accounting period in an inflationary, a deflationary or a hyperinflationary economy.

The CPI which quantifies the erosion of the real value of only monetary items by low inflation and the creation of real value by deflation in only monetary items is published on a monthly basis. The hyper-erosion of the real value of only monetary items is normally known via the daily US Dollar parallel rate or daily index rate or even every 8 hours during hyperinflation. The nominal value of monetary items in actual accounts stays the same forever under any accounting model and under any economic environment, but, the real value is automatically adjusted by inflation, deflation and hyperinflation. The real value of monetary items can be halved every 24.7 hours as it happened recently during hyperinflation in Zimbabwe. According to Prof Steve Hanke from John Hopkins University prices halved every 15.6 hours during hyperinflation in Hungary in 1946.



The net monetary loss or net monetary gain in monetary items caused by inflation, deflation and hyperinflation resulting from holding net monetary item assets or net monetary item liabilities is calculated and accounted in terms of IAS 29 in hyperinflationary economies and in terms of CIPPA in low inflationary and deflationary economies. The calculation and accounting of net monetary losses and gains during low inflation and deflation have thus been authorized in IFRS since 1989. They are not calculated and accounted under the traditional Historical Cost Accounting model, although it can be done according to Harvey Kapnick.

"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.


Nicolaas Smith

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

The monetary nature of money

The monetary nature of money


Money is an economic item very different from the other two basic economic items because of its monetary nature, namely the unique combination of the following:

its three functions, namely

unstable medium of exchange,

unstable store of value and

unstable unit of account,

portability,

it is generally available in small change,

it is only money within (not outside) an economy (foreign exchange is a non-monetary item),

it is legal tender,

it is always automatically valued by inflation (hyperinflation) and deflation,

which affects all units of money evenly,

when it has no exchangeability it is worthless, etc.


Nicolaas Smith

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

Testimonials

Testimonials



"Good work."

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Chairman of the US Federal Accounting Standards Advisory Board (1997-2006)
US Financial Accounting Standards Board member (1979-1986)



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"Theoretically I totally agree with you."

Dr. Cemal Kucuksozen
Head of the Turkish International Accounting Standards Department, 2005

The three fundamentally different parts of the economy

The three fundamentally different, basic economic items in the economy are:

a) Monetary items
b) Variable real value non–monetary items
c) Constant real value non–monetary items

The economy consequently consists of not just two parts – the monetary and non–monetary economy, but, three parts:

1. Monetary economy
2. Variable item economy
3. Constant item economy

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Nicolaas Smith

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

Three popular accounting fallacies

Three popular accounting fallacies

Updated on 14-06-2016

The real values of many constant real value non–monetary items, for example, that portion of shareholders´ equity never maintained constant by sufficient revaluable fixed assets (revalued or not) under the HCA model, are not automatically maintained constant (as they are under Capital Maintenance in Units of Constant Purchasing Power in terms of the Daily CPI) in the world´s low inflation economies. This was clearly evident during the recent financial crisis that necessitated huge amounts of additional capital for under–capitalized banks and companies whose capital has been eroded by the stable measuring unit assumption (not inflation - as generally accepted) during low inflation. Inflation has no effect on the real value of non-monetary items. The constant real non–monetary values of their capital are still unnecessarily, unknowingly and unintentionally being eroded at a rate equal to the annual rate of inflation by the implementation of the very erosive stable measuring unit assumption as it forms part of the traditional HCA model. HCA is based on the accounting fallacy that financial capital maintenance can be measured (implied: maintained)  in nominal monetary units per se during inflation and deflation as originally authorized in IFRS in the Framework (1989), Par 104 (a) as well as approved in the FASB´s Statement of Financial Accounting Concepts No. 5, Recognition and Measurement in Financial Statements of Business Enterprises (1984).

Many people see financial reporting as simply providing historic economic information. It is not realized that it is a basic objective of accounting (financial reporting) to automatically maintain the constant purchasing power of capital constant in all entities that at least break even in real value for an indefinite period of time by continuously measuring all constant real value non–monetary items in units of constant purchasing power in terms of the Daily CPI during inflation, deflation and hyperinflation.

The reasons for this are:

(1) The Three Popular Accounting Fallacies.

(a) The stable measuring unit assumption based on the fallacy that changes in the purchasing power of money (the montary unit of measure) are not sufficiently important to require the measurement of financial capital maintenance in units of constant purchasing power in terms of the Daily CPI during low inflation, deflation and hyperinflation originally authorized in IFRS in the Framework (1989), Par 104 (a) and in the FASB´s FA Concepts No. 5.

(b) Financial capital maintenance in nominal monetary units per se (the belief that the real value of financial capital can be maintained in nominal monetary units per se) during low inflation and deflation originally authorized in IFRS in the Framework (1989), Par 104 (a) and in the FASB´s FA Concepts No. 5.

(c) The generally accepted belief that the erosion of companies´ profits and capital is caused by inflation fully supported in IFRS and by the FASB.

(2) It is not realized (understood) that it is the stable measuring unit assumption and not inflation that erodes the real value of constant real value non–monetary items never maintained constant when financial capital maintenance in nominal monetary units (the traditional HCA model) is implemented during low inflationary and hyperinflationary periods. Reject the stable measuring unit assumption, i.e., implement financial capital maintenance in units of constant purchasing power in terms of the Daily CPI) and the real value of capital is automatically maintained constant in all entities that at least break even in real value, ceteris paribus.

(3) It is not realized (understood) that continuous measurement of financial capital maintenance in units of constant purchasing power (Capital Maintenance in Units of Constant Purchasing Power in terms of the Daily CPI) automatically remedies this erosion by the stable measuring unit assumption during low inflation and hyperinflation.

If the above were generally understood then the stable measuring unit assumption / financial capital maintenance in nominal monetary units, i.e. the HCA model, would have been stopped during low inflation, deflation and hyperinflation by now.

Although the principle of financial capital maintenance in units of constant purchasing power in terms of the Daily CPI during inflation and hyperinflation was authorized in IFRS in 1989, it has not been implemented generally during low inflations and hyperinflation because the eroding effect of the stable measuring unit assumption on the real value of constant items never maintained constant is not recognized (understood) as such. It is generally believed that it is inflation doing the eroding in, for example, companies´ invested capital and profits – as specifically stated in FAS 89 - when this erosion in constant item real value is, in fact, caused by the stable measuring unit assumption. Inflation has no effect on the real value of non–monetary items. Capital and profits are constant real value non–monetary items.

Nicolaas Smith

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

Monetary meltdown

Monetary meltdown


The monetary economy (the total real value of a fiat money supply) can disappear completely. It happened three times during three months towards the end of hyperinflation in Yugoslavia. It happened at the end of hyperinflation in Zimbabwe in 2008, terminating hyperinflation in that country. Zimbabwe did not try hyperinflation again like Yugoslavia which has the distinction of having wiped out the real value of their entire monetary economy three times in three months. In Zimbabwe the economy dollarized spontaneously after a decision by the Reserve Bank of Zimbabwe to close the Zimbabwe Stock Exchange which stopped the Old Mutual Implied Rate being the final exchange rate of the Zimbabwe Dollar with a foreign currency – the British Pound. The Zimbabwean economy dollarized spontaneously after that because it was a sufficiently open economy right next to the stable South African and Botswana and other stable economies in the Southern African region. Those stable economies supplied the Zimbabwean economy with essential goods and services. Zimbabwe then had the opportunity to slowly recover from total monetary meltdown and the devastating effect of implementing the very erosive stable measuring unit assumption – the Historical Cost Accounting model - during hyperinflation as authorized in International Financial Reporting Standards and supported by Big Four accounting firms like PricewaterhouseCoopers. Zimbabwe spontaneously adopted a multi-currency dollarization model using the US Dollar, the Euro, the SA Rand, the British Pound and the Botswana Pula as relatively stable foreign currencies in the Zimbabwean economy.

The variable real value non-monetary item economy (property, plant, equipment, inventory, etc) cannot disappear because of wrong monetary policies. Inflation is always and everywhere a monetary phenomenon. Inflation and hyperinflation have no effect on the real value of non-monetary items. After monetary meltdown in Zimbabwe the properties, plant, equipment, raw materials, finished goods, etc., were still there. The variable item economy can be destroyed by natural disasters like earth quakes and tsunamis and by man-made events like war.

The constant item economy (shareholders´ equity, trade debtors, trade creditors, salaries, wages, rentals, etc.) also cannot be eroded by inflation and hyperinflation because inflation and hyperinflation have no effect on the real value of non-monetary items: both variable and constant real value non-monetary items. However, the stable measuring unit assumption (i.e. the Historical Cost Accounting model or financial capital maintenance in nominal monetary units per se during inflation and hyperinflation) erodes the constant real non-monetary value of constant items not maintained constant during inflation and hyperinflation, e.g. trade debtors, trade creditors, salaries, wages, rentals, that portion of shareholder´s equity never maintained constant as a result of insufficient revaluable fixed assets (revalued or not), all other non-monetary payables and receivables, etc., at a rate equal to the annual rate of inflation or hyperinflation.

Equity is equal to net assets; i.e., the constant real non-monetary value of shareholders´ equity is equal to the constant real value of net assets. Under Constant Item Purchasing Power Accounting (CIPPA) the constant real non-monetary value of equity is automatically maintained constant in all entities that at least break even for an unlimited period of time (forever) during low inflation and deflation whether these entities own any revaluable fixed assets or not.

Only capital maintenance in units of constant purchasing power in terms of the daily US Dollar or other hard currency parallel rate or a daily Brazilian-style index under Constant Purchasing Power Accounting (CPPA) will automatically maintain the constant real value of constant items constant for an indefinite period of time in all entities that at least break even during hyperinflation. This includes shareholders´ equity whether these entities own any revaluable fixed assets or not.

The monetary economy can be totally eroded like in the case of the Zimbabwe Dollar, not simply as a result of hyperinflation, but, as a result of a monetary meltdown after a period of severe hyperinflation. Hyperinflation is defined by Cagan as 50% monthly inflation and in International Financial Reporting Standards as cumulative inflation approaching or equal to 100% over three years; i.e. 26% annual inflation for three years in a row. The IFRS definition is followed in this book. Severe hyperinflation is normally the final stage of a devastating hyperinflationary spiral with a continuously super-increasing rate of hyperinflation when hyperinflation reaches millions of percent per annum. Exchangeability of the monetary unit, under those conditions, becomes limited to very few or just one single foreign currency like in the case of the Zimbabwe where the Zimbabwe Dollar only had exchangeability with the British Pound via the Old Mutual Implied Rate as derived from continued trade in Old Mutual shares on the Zimbabwe Stock Exchange even during severe hyperinflation. A monetary meltdown takes place when a monetary unit stops having exchangeability with all foreign currencies normally after, first, a period of hyperinflation and then a period of severe hyperinflation.

Hyperinflation only erodes the real value of the monetary unit extremely rapidly. Hyperinflation has no effect on the real value of non-monetary items. All non-monetary items (variable and constant items) maintain their real values during hyperinflation when they are updated (measured in units of constant purchasing power) daily in terms of a daily parallel rate (a black market or street rate) normally the daily unofficial US Dollar or other hard currency exchange rate or a daily non-monetary index normally almost totally based on the daily US Dollar exchange rate as Brazil did during 30 years of very high and hyperinflation.

The stable measuring unit assumption (Historical Cost Accounting) – not hyperinflation – unknowingly, unnecessarily and unintentionally erodes the real value of constant real value non-monetary items, e.g. salaries, wages, rents, shareholders´ equity, trade debtors, trade creditors, etc. not maintained constant as fast as hyperinflation erodes the real value of the local currency and other monetary items, e.g. loans stated in the local currency. A monetary meltdown erodes all real value only in the monetary economy; i.e. in the local currency money supply.

Hyperinflation is not always stopped with first a period of severe hyperinflation in the final stage and then a complete monetary meltdown. Hyperinflation was successfully overcome by various countries, e.g. Turkey, Brazil and Angola, without dollarization or a monetary meltdown. However, severe hyperinflation (hyperinflation at millions of per cent per annum) would normally lead to a complete monetary meltdown as happened in Zimbabwe in 2008.

Brazil actually grew their non-monetary economy in real value during 30 years of very high and hyperinflation of up to 2000 per cent per annum from 1964 to 1994 and never had severe hyperinflation followed by a complete monetary meltdown at the end. Brazil managed to have positive GDP growth during 30 years of very high and hyperinflation because the various governments during those three decades supplied the population with a daily non-monetary index based almost entirely on the daily US Dollar exchange rate with their monetary unit which was used to update all non-monetary items (variable and constant real value non-monetary items), e.g. goods, services, equity, trade debtors, trade creditors, salaries, wages, taxes, etc., in the economy daily.

Brazil would not have been able to do that if they had applied the IASB´s IAS 29 Financial Reporting in Hyperinflationary Economies simply because IAS 29 does not provide for continuous daily updating of all non-monetary items during hyperinflation. IAS 29 was authorized in 1989. IAS 29 does not provide for continuous daily updating in terms of the US Dollar parallel rate or a Brazilian-style daily index rate. IAS 29 simply requires restatement of Historical Cost and Current Cost financial statements during hyperinflation applying the monthly Consumer Price Index at the end of the reporting period (monthly, quarterly, six monthly or annual) - generally available a month or two months after the current month - to make these financial statements more useful. It is not the intention of IAS 29 to, and in its current form it cannot, stop the continuous daily rapid erosion of the real value of constant real value non-monetary items as Brazil did for 30 years of high and hyperinflation generating positive economic growth.

This daily very rapid erosion of constant items is caused, not by hyperinflation, but, by the implementation of the stable measuring unit assumption (HCA) during hyperinflation. Applying the monthly CPI a month or two months after the current month is very ineffective during hyperinflation as far as the constant real value of salaries, wages, rentals, equity, trade debtors, trade creditors, positive economic growth, economic stability, the maintenance of internal demand and the continuous daily maintenance of the constant real value of these items are concerned. All non-monetary items (variable and constant items) have to be updated daily in terms of the parallel US Dollar rate or a Brazilian-style daily index rate in order to maintain the real economy relatively stable during hyperinflation in the monetary unit. That is financial capital maintenance in units of constant purchasing power during hyperinflation as originally authorized in IFRS in the Framework (1989), Par 104 (a).

The Framework (1989), Par. 104 (a) states:

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

The original Framework (1989), Par 104 (a) authorizes financial capital maintenance in units of constant purchasing power during low inflation and deflation (Constant Item Purchasing Power Accounting - CIPPA) under which only constant real value non-monetary items (not variable real value non-monetary items) are measured in units of constant purchasing power by applying the monthly change in the annual CPI during low inflation and deflation. It is also applicable during hyperinflation (Constant Purchasing Power Accounting - CPPA) where under all non-monetary items - constant and variable real value non-monetary items - are updated daily in terms of the US Dollar parallel rate or a Brazilian-style daily index rate. IFRS authorize financial capital maintenance in units of constant purchasing power at all levels of inflation and deflation.

The stable measuring unit assumption (HCA or financial capital maintenance in nominal monetary units, also originally authorized in IFRS in the Framework (1989), Par 104 a ) assumes, in principle, that there was, is and never ever will be inflation, deflation or hyperinflation as far as the valuation of constant real value non-monetary items never maintained constant are concerned. The stable measuring unit assumption (HCA) assumes, in principle, that money was forever in the past, is and will always in the future be perfectly stable under all levels of inflation, hyperinflation and deflation.

Various authoritative commentators in the accounting profession are requesting a fundamental revision of IAS 29.

Severe hyperinflation is defined as a period at the end of completely uncontrolled hyperinflation when exchangeability between the hyperinflationary monetary unit and most relatively stable foreign currencies does not exist. However, at least one exchangeability has to exist for prices to be established in the hyperinflationary monetary unit; i.e. for hyperinflation to exist. Severe hyperinflation is only possible when there is exchangeability with at least one relatively stable foreign currency in order for prices to continue to be set in the hyperinflationary monetary unit in terms of this final exchangeability. The one exchange rate that lasted till the end of hyperinflation in Zimbabwe was the Old Mutual Implied Rate (OMIR).

The ratio of the Old Mutual share price in Harare to that in London equals the Zimbabwe dollar/sterling exchange rate. p8 1

Severe hyperinflation stops the moment exchangeability between the currency and all foreign currencies does not exist.

Zimbabwe’s hyperinflation came to an abrupt halt. The trigger was an intervention by the Reserve Bank of Zimbabwe. On November 20, 2008, the Reserve Bank’s governor, Dr. Gideon Gono, stated that the entire economy was “being priced via the Old Mutual rate whose share price movements had no relationship with economic fundamentals, let alone actual corporate performance of Old Mutual itself” (Gono 2008: 7–8). In consequence, the Reserve Bank issued regulations that forced the Zimbabwe Stock Exchange to shut down. This event rapidly cascaded into a termination of all forms of non-cash foreign exchange trading and an accelerated death spiral for the Zimbabwe dollar. Within weeks the entire economy spontaneously “dollarized” and prices stabilized. p 9-10 2

There was severe hyperinflation in Zimbabwe while there was exchangeability (prices could still be set in the ZimDollar) with at least one relatively stable foreign currency – the British Pound in this case as it was made possible via the OMIR. When this last exchangeability stopped it was not possible to set prices in the ZimDollar anymore and severe hyperinflation stopped: no exchangeability means no hyperinflation. That was a monetary meltdown. The entire ZimDollar money supply had no value as from that moment. Monetary items expressed in the ZimDollar had no value as from that moment. All variable real value non-monetary items maintained their real values despite the monetary meltdown. The IASB authorized an addition to IAS 1 in 2011 to allow for the fair value valuation of all non-monetary items in the opening balance sheet of companies after severe hyperinflation and a monetary meltdown. Inflation and hyperinflation have no effect on the real value of non-monetary items.

No exchangeability with all relatively stable foreign currencies means no exchange rates which means no severe hyperinflation (no prices being set in the local currency) and vice versa: no exchange rate with any relatively stable foreign currency means no exchangeability which means no hyperinflation (no prices being set in the local currency).

No prices being set in the local currency means monetary meltdown: the total money supply and all money and other monetary items stated in the local currency have no value.

The real or non-monetary economy (houses, properties, buildings, infrastructure, inventories, finished goods, consumer goods, trademarks, goodwill, logos, copyright, trade debtors, trade creditors, royalties payable, royalties receivable, taxes payable, taxes receivable, all other non-monetary payables, all other non-monetary receivables, etc,) cannot be eroded by hyperinflation or a total monetary meltdown: inflation is always and everywhere a monetary phenomenon. Inflation and hyperinflation have no effect on the real value of non-monetary items.


Nicolaas Smith

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

Measurement during low inflation

Measurement during Low inflation

 The real values of many constant real value non-monetary items, for example, that portion of shareholders´ equity never covered by sufficient revaluable fixed assets (revalued or not) under the HCA model, are not automatically maintained constant (as they should be) in the world´s low inflation economies as demonstrated during the recent financial crisis that necessitated huge amounts of additional capital for under-capitalized banks and companies. To the contrary: their constant real non-monetary values are unnecessarily, unknowingly and unintentionally being eroded at a rate equal to the annual rate of inflation by the implementation of the very erosive stable measuring unit assumption as it forms part of the traditional HCA model. HCA is based on the accounting fallacy that financial capital maintenance can be measured in nominal monetary units per se during inflation and deflation as originally authorized in IFRS in the Framework (1989), Par 104 (a) as well as approved in the FASB´s Statement of Financial Accounting Concepts No. 5, Recognition and Measurement in Financial Statements of Business Enterprises (1984).
Many people see financial reporting as simply providing historic economic information. It is not realized that it is a basic objective of accounting (financial reporting) to automatically maintain the constant purchasing power of capital constant in all entities that at least break even for an indefinite period of time by continuously measuring all constant real value non-monetary items in units of constant purchasing power during inflation and deflation.

The reasons for this are:

(1) The Three Popular Accounting Fallacies.


(a) The stable measuring unit assumption based on the fallacy that changes in the purchasing power of money are not sufficiently important to measure financial capital maintenance in units of constant purchasing power during low inflation and deflation.

(b) Financial capital maintenance in nominal monetary units per se during low inflation and deflation.

(c) The generally accepted belief that the erosion of companies´ profits and capital is caused by inflation fully supported in IFRS and by the FASB.
(2) It is not realized that it is the stable measuring unit assumption and not inflation that erodes the real value of constant real value non-monetary items never maintained constant when financial capital maintenance in nominal monetary units (the traditional HCA model) is implemented during low inflationary periods .

(3) It is not realized that continuous measurement of financial capital maintenance in units of constant purchasing power during low inflation (CIPPA) automatically remedies this erosion by the stable measuring unit assumption.

If the above were realized then the stable measuring unit assumption / financial capital maintenance in nominal monetary units, i.e. the HCA model, would have been stopped during low inflation, deflation and hyperinflation by now.

Although the principle of financial capital maintenance in units of constant purchasing power during inflation and deflation was authorized in IFRS in 1989, it has not been implemented generally because the eroding effect of the stable measuring unit assumption on the real value of constant items never maintained is not recognized as such. It is generally believed that it is inflation doing the eroding in, for example, companies´ invested capital and profits when this erosion in constant item real value is actually caused by the stable measuring unit assumption. Inflation has no effect on the real value of non-monetary items. Capital and profits are non-monetary items.

Nicolaas Smith

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

Real estate and a mortgage are not one and the same thing

Real estate is a variable real value non-monetary item. Inflation has no effect on the real value of non-monetary items, never had in the past and never will in the future. The same is true for deflation and hyperinflation. As Milton Friedman so correctly stated: inflation is always and everywhere a monetary phenomenon. That is also true for deflation and hyperinflation.

A buyer normally negotiates a mortgage with a bank or other credit institution. The mortgage is not the same as the real estate. The real estate is one thing: a variable real value non-monetary item. The mortgage is a completely different thing/item: another item/thing. It is a monetary item, not a non-monetary item. It is not the same as the real estate. You can live in a house. You cannot live in a mortgage. A mortgage is normally a contract written on paper. Real estate is normally a house or an apartment or other physical property. The contract is also written on physical paper. That does not make the real estate and the mortgage the same thing.

Only the capital amount of a mortgage is a monetary item. The real value of the capital amount of a mortgage is eroded by inflation and hyperinflation and increased by deflation.

The interest paid and received on a mortgage are constant real value non-monetary items once accounted in the income statement.
Interest paid and received on a mortgage are generally immediately claimed or paid by banks - claimed from or paid into bank accounts which are monetary items. The entries in the bank accounts are part of the monetary item balances of the bank accounts.

A bank balance is one thing/item: a monetary item. Interest is another thing/item: a constant real value non-monetary item once payable or receivable or accounted in the income statement.

The money in the bank accounts is the monetary medium of exchange by which the constant real value non-monetary items interest paid and interest received are mutually agreed to be settled.

The interest paid and interest received entries in the bank accounts are simply the descriptions of what the money paid or received relates to, the same as the entries for deposits and withdrawals or bank charges, for example.

Interest payable or receivable (not yet paid or received) are constant real value non-monetary items and have to measured in units of constant purchasing power, i.e. updated over time under the constant item purchasing power paradigm, i.e. financial capital maintenance in units of constant purchasing power as authorized in IFRS.

Under the Historical Cost paradigm, i.e. financial capital maintenance in units of nominal monetary units - also authorized in IFRS in the same statement that authorized financial capital maintenance in units of constant purchasing power, interest paid, received, payable and receivable are all treated as if they are monetary items.

Real estate is a non-monetary item and a mortgage is a monetary item under both paradigms authorized in IFRS.

Inflation only affects the real value of the capital amount of the mortgage. Inflation has no effect, never had in the past and will never in the future have an effect on the real value of the real estate.

Nicolaas Smith

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

Historical Cost Accounting should be banned during hyperinflation

Historical Cost Accounting should be banned during hyperinflation

Valuation in units of constant purchasing power is required for all non-monetary items (variable and constant real value non-monetary items) in IFRS during hyperinflation as per the Constant Purchasing Power Accounting (CPPA) inflation accounting model defined in IAS 29 Financial Reporting in Hyperinflationary Economies. The only way a hyperinflationary country can maintain its non-monetary or real economy relatively stable (at a rate of real value erosion by the stable measuring unit assumption in constant real value non-monetary items never maintained constant limited to a rate equal to the annual rate of inflation of the hard currency used for determining the parallel rate – normally the US Dollar) during hyperinflation is by continuously measuring all non-monetary items (variable and constant real value non-monetary items) in units of constant purchasing power.  However, not by restating HC and Current Cost financial statements at the end of the reporting period in terms of the period-end CPI to make them more useful as required by IAS 29, but, by applying the daily parallel US Dollar exchange rate,  or -  as was done in Brazil during the 30 years from 1964 to 1994 - with daily indexation which is, in principle, the better than measurement in units of constant purchasing power by applying the daily US Dollar parallel rate since Brazilian-style indexation, theoretically, keeps the constant item economy perfectly stable: the erosion of the real value of constant items never maintained caused by the stable measuring unit assumption as applied to the US Dollar is eliminated in the formulation of the index value.

Zimbabwe

The implementation of IAS 29 Financial Reporting in Hyperinflationary Economies by Zimbabwean listed companies as required by the Zimbabwean Stock Exchange made no difference to the Zimbabwean economy during the final stages of the hyperinflationary erosion of the real value of the monetary unit in Zimbabwe, i.e. the Zimbabwe Dollar. The IASB has agreed that it was not possible to implement IAS 29 during severe hyperinflation at the end of the hyperinflationary period in Zimbabwe since there was no CPI available. The daily Old Mutual Implied Rate (OMIR) was, however, available till 20^th November, 2008, the day Gideon Gono, the governor of the Reserve Bank of Zimbabwe issued regulations that closed down the Zimbabwe Stock Exchange and effectively led to the end of the Zimbabwe Dollar.

         Severe hyperinflation is only possible when there is exchangeability with at least one relatively stable foreign currency. The one exchange rate that lasted till the end of hyperinflation in Zimbabwe was the Old Mutual Implied Rate (OMIR).

“The ratio of the Old Mutual share price in Harare to that in London equals the

Zimbabwe dollar/sterling exchange rate." P 8  ¹

Severe hyperinflation stops the moment exchangeability between the currency and all foreign currencies does not exist.

“Zimbabwe’s hyperinflation came to an abrupt halt. The trigger was an intervention by the Reserve Bank of Zimbabwe. On November 20, 2008, the Reserve Bank’s governor, Dr. Gideon Gono, stated that the entire economy was “being priced via the Old Mutual rate whose share price movements had no relationship with economic fundamentals, let alone actual corporate performance of Old Mutual itself” (Gono 2008: 7–8). In consequence, the Reserve Bank issued regulations that forced the Zimbabwe Stock Exchange to shut down. This event rapidly cascaded into a termination of all forms of non-cash foreign exchange trading and an accelerated death spiral for the Zimbabwe dollar. Within weeks the entire economy spontaneously “dollarized” and prices stabilized.” P 9-10 ²

¹,² Hanke, S. H. and Kwok, A. K. F., On the Measurement of Zimbabwe’s Hyperinflation,

Cato Journal, Vol. 29, No. 2 (Spring/Summer 2009), pp. 353-64 Available at

http://www.cato.org/pubs/journal/cj29n2/cj29n2-8.pdf

There was severe hyperinflation in Zimbabwe while there was exchangeability with at least one relatively stable foreign currency – the British Pound in this case as made possible via the OMIR. When this last exchangeability stopped it was not possible to set prices in the ZimDollar any more and hyperinflation stopped: no exchangeability means no hyperinflation.

Valuing all non-monetary items as required by the IAS 29 CPPA inflation accounting model in terms of the period-end Consumer Price Index which was published a month or more after the month to which it related when the real value of the Zimbabwe Dollar halved every day, obviously, had no effect at all.

“The Zimbabwe government last published an official Zimbabwe dollar inflation index in July 2008. This, combined with the complexities of not having a stable currency due to the phenomenon described above, meant that there were severe limitations to accurate financial reporting in the period from August 2008 to when the Zimbabwe dollar was abandoned in early 2009. During this period the Institute of Chartered Accountants in Zimbabwe set up a technical subcommittee to address these challenges, as it was impossible to apply IAS 29 “Financial Reporting in Hyperinflationary Economies” without a general price index, or IAS 21 “Exchange Rates” without a single spot rate.”  Inflation Gone Wild, Gordon Whiley, Accountancy SA, March 2010.

http://www.accountancysa.org.za/resources/ShowItemArticle.asp?ArticleId=1885&Issue=4.640

The stable measuring unit assumption as it forms part of the Historical Cost Accounting model - as accepted by the IASB and PricewaterhouseCoopers (amongst others) as an appropriate accounting model to be restated during hyperinflation - unnecessarily, unknowingly and unintentionally eroded Zimbabwe´s real economy by implementing HCA during the financial year, as required by the IASB in IAS 29, and then restated their year-end HC financial statements of their very much hyper-eroded companies in terms of the year-end CPI (while the CPI was made available in Zimbabwe) to make them more useful for comparison purposes. That did not stop them from unknowingly eroding their real or non-monetary economy with HCA - as supported by the IASB and PricewaterhouseCoopers - during the course of the financial year 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.

           IAS 29 states: The financial statements of an entity whose functional currency is the currency of a hyperinflationary economy, whether they are based on a historical cost approach or a current cost approach shall be stated in terms of the measuring unit current at the end of the reporting period. IAS 29, Par 8.

How anyone can use or recommend the use of the HCA model during hyperinflation is completely incomprehensible. The use of the HCA model during hyperinflation should specifically be banned by law.

Nicolaas Smith

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

Valuing the three basic economic items - Part 2

Valuing the three basic economic items - Part 2

Monetary items

(1) Accountants value and account monetary items at their original historical cost nominal values in nominal monetary units during the current accounting period under all accounting models and under all economic models: during low inflation, hyperinflation and deflation. Low inflation, deflation and hyperinflation determine the always current real value of the monetary unit (US Dollar, Euro, British Pound, Bolívar, Yen, Yuan, etc.) and other monetary items within a monetary economy or monetary union like the European Monetary Union. This is the result of the fact that the real value of money and other monetary items cannot be updated or inflation-adjusted or valued in units of constant purchasing power during the current accounting period because of the monetary nature of money. The real value of the monetary unit and other monetary items in the monetary economy changes equally (all monetary units are affected evenly) normally on a monthly basis during low inflation and deflation. The change is confirmed or quantified with the monthly publication of the new CPI value. Currently, the applicable CPI value can become available up to a month and a half after the date of a transaction in many low inflationary economies. The daily black market or parallel US Dollar exchange rate or street rate is generally constantly (24/7, 365 days a year) available in a hyperinflationary economy. The CPI is the internal exchange rate between the real value of a unit of the monetary unit and real value in an economy. The daily parallel US Dollar (or other hard currency) exchange rate or a Brazilian-style daily index rate fulfils this role in a hyperinflationary economy. 

Variable items 

(2) Variable real value non-monetary items in a national economy are valued and accounted in terms of IFRS or GAAP at, for example, fair value, market value, net realizable value, recoverable value, present value, etc. These prices change all the time: even minute by minute in many markets.  

Constant real value non-monetary items 

(3) The real values of constant real value non-monetary items in the constant real value non-monetary item economy have to be continuously maintained constant under Constant Item Purchasing Power Accounting during low inflation and deflation by means of continuous financial capital maintenance in units of constant purchasing power, i.e. valuing / measuring them in units of constant purchasing power monthly during low inflation and deflation by means of the CPI as originally authorized in IFRS in the Framework (1989), Par 104 (a). Annual measurement in units of constant purchasing power is only currently being done under the Historical Cost Accounting model, generally in the case of certain (not all) income statement items, e.g., salaries, wages, rentals, etc. in non-hyperinflationary economies.  

Harvey Kapnick was correct when he stated in the Saxe Lecture in 1976: “In the long run both value accounting and price-level accounting should prevail.”

Nicolaas Smith

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

Valuing the three basic economic items

Valuing the three basic economic items

 Economic items are made up of monetary items, variable real value non-monetary items and constant real value non-monetary items. Accountants value, record, classify, summarize and report transactions and events involving economic items in terms of depreciating functional currencies during inflation and appreciating functional currencies during deflation.

 Monetary items

 (1) The real value of the monetary unit and all other monetary items in the monetary economy generally changes every month during low inflation and deflation when the new CPI value is published. Months of zero annual inflation are rare and not sustained over a significant period of time. During hyperinflation the real value of the monetary unit and all other monetary items generally changes once per day, but, during severe hyperinflation it can change every 8 hours or so.

 Variable items

 (2) The real value of variable real value non-monetary items may change all the time, e.g. the price of foreign currencies, precious metals, quoted shares, commodities, properties, finished goods, services, raw materials, etc.

 Constant real value non-monetary items

 (3) The real values of constant real value non-monetary items stay the same (or are supposed to stay the same) all the time – all else except inflation and deflation being equal – e.g. salaries, wages, rentals, issued share capital, retained profits, shareholders equity, trade debtors, trade creditors, taxes payable, taxes receivable, etc.

Accountants have to take all three scenarios - occurring simultaneously - into account over time when they account economic activity and prepare and present financial reports.

Nicolaas Smith

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

Financial reporting does not simply report on what took place

             Financial reporting does not simply report on what took place

            There is no substance in the statement that financial reporting simply reports on what took place. It can be correctly stated that the above statement has no substance when we refer to the IFRS-approved basic accounting option of continuous financial capital maintenance in units of constant purchasing power which requires the valuing of only constant real value non-monetary items in units of constant purchasing power during low inflation and deflation as orginally authorized 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.”

The first option in Par 104 , namely, financial capital maintenance in nominal monetary units during inflation and deflation is a fallacy: it is impossible to maintain the real value of capital constant in nominal monetary units per se during inflation and deflation. Continuous financial capital maintenance in units of constant purchasing power during low inflation and deflation is generally applicable in the economy as a result of the absence of specific IFRS as per IAS 8, Par 11. However, that is not the same as comprehensive CPI-based adjustment of accounts themselves as accountants and accounting authorities automatically assume when financial capital maintenance in units of constant purchasing power during low inflation and deflation is suggested. Only constant real value non-monetary items (not variable real value non-monetary items) are continuously valued in units of constant purchasing power by continuously applying the CPI on a monthly basis during low inflation and deflation to implement a constant purchasing power capital concept of invested constant purchasing power and a constant purchasing power financial capital maintenance concept with measurement in units of constant purchasing power which includes a constant purchasing power profit or loss determination concept with the continuous valuation of only constant real value non-monetary items in units of constant purchasing power during low inflation and deflation.

The real values of banks´ and companies´ existing constant real value non-monetary items never maintained constant, e.g. retained profits, are unnecessarily, unknowingly and unintentionally being eroded at a rate equal to the annual rate of inflation when companies´  boards of directors choose to apply the stable measuring unit assumption as it forms part of the traditional HCA model during low inflation.

It is a fact that continuous financial capital maintenance in units of constant purchasing power (CIPPA) as originally authorized in IFRS in the Framework (1989), Par 104 (a), i.e. measurement of only constant real value non-monetary items (not variable items) in the economy in units of constant purchasing power during low inflation automatically remedies this unknowing, unintentional and unnecessary erosion by the application of the stable measuring unit assumption as it forms part of the HCA model in companies that at least break even whether they own revaluable fixed assets or not and without the requirement of extra capital from capital providers in the form of extra money or extra retained profits simply to maintain the existing constant real value of quity constant.

Nicolaas Smith

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

Accountants value everything they account

            Accountants value everything they account

            The debate concerning whether value accounting or price-level accounting should prevail is not on point, because in the long run both should prevail.

 Harvey Kapnick, Chairman, Arthur Andersen & Company, “Value Based Accounting – Evolution or Revolution”, Sax Lecture, 1976.

 Accounting is a measurement instrument.

David Mosso, Comment letter, Proposal for a Principles-based Approach to US Standard Setting, 2002, p1.

http://www.fasb.org/cs/BlobServer?blobcol=urldata&blobtable=MungoBlobs&blobkey=id&blobwhere=1175818119471&blobheader=application%2Fpdf

 Economic items have economic value. Accountants deal with economic items all the time. They deal with economic values when they account economic items and prepare financial reports. Accountants value economic items when they account economic transactions and events. Financial reporting does not simply report on what took place in the past. Accountants are not just scorekeepers of what happened in the past. Accountants value everything they account in the economy.

 The three fundamentally different basic economic items in the economy, namely variable real value non-monetary items, monetary items and constant real value non-monetary items, have economic values expressed in terms of money; i.e. the monetary unit. Accountants account economic transactions and events involving these three basic economic items in an organized manner when they implement the double entry accounting model: journal entries, general ledger accounts, trial balances, cash flow statements, income and expenses in the income statement, assets and liabilities in the balance sheet plus other financial, management and costing reports.

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

Many accountants still think that accounting is simply a recording exercise during which they merely record past economic activity. That is not correct. Accountants value economic items when they account them. Financial reporting / accounting – under CIPPA –  is, firstly, the automatic maintenance of the constant purchasing power of capital in all entities that at least break even for an indefinite period of time and, secondly, the  provision of continuously updated decision-useful financial information about the reporting entity to capital providers and other users.

 It includes the valuing, recording, classifying, summarizing and reporting of an entity’s economic activity.

Nicolaas Smith

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