Unique attributes of Constant Item Purchasing Power Accounting

Unique attributes of Constant Item Purchasing Power Accounting

1.    It is the first work on the topic: IFRS authorized financial capital maintenance in units of constant purchasing power during LOW inflation and deflation in which the following new accounting concepts and terms are first identified, named, defined and described:

2.   The name of the new accounting model, namely, Constant Item Purchasing Power Accounting.

3.    The split of non-monetary items in the two new accounting concepts and terms: (i) Variable real value non-monetary items  and

4.   (ii) Constant real value non-monetary items resulting in the new terms

5.   Variable item economy and

6.   Constant item economy and giving origin to the two new accounting entries never before made:

7.   Net Constant Item Loss.

8.   Net Constant Item Gain.

9.   The fact that IFRS authorize not only the stated (in IFRS) and generally accepted two capital and capital maintenance concepts, namely, (A) physical and (B) financial capital and capital maintenance, but three (which is a big revelation to the accounting profession), namely (a) physical capital and capital maintenance, (b) financial capital and capital maintenance measured in nominal monetary units (traditional HCA) and (c) financial capital and capital maintenance measured in units of constant purchasing power during LOW inflation and deflation (CIPPA) since it was authorized in the original Framework (1989), Par 104 (a) [now Conceptual Framework (2010), Par 4.59 (a)] which states: “Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power”, is first stated in this work.

10.             Inflation Illusion, namely the mistaken belief that inflation causes the erosion of companies´ capital and profits as taught to and believed by all accountant and specifically stated in US Financial Accounting Standards by the US Financial Accounting Standards Board when it is in fact caused, not by inflation, but, by the very destructive stable measuring unit assumption since inflation has no effect on the real value of non-monetary items as specifically stated by two top Turkish academics and easily deduced from Milton Friedman´s now famous statement that inflation is always and everywhere a monetary phenomenon, is first defined and described in this work.

11.             The fact that the implementation of the Historical Cost Accounting model, more specifically the stable measuring unit assumption (and not inflation) causes the unknowing, unintended and unnecessary erosion of that portion of companies´ shareholders´ equity never maintained constant by sufficient revaluable fixed assets (revalued or not) during LOW inflation amounting to hundreds of billions of US Dollars eroded in constant item real value per annum in the world´s constant item economy is first stated in this work.

12.             The fact that CIPPA automatically maintains the constant real value of capital and profits constant forever in all entities that at least break even in real value during inflation – ceteris paribus – whether they own any revaluable fixed assets or not and that it would maintain hundreds of billions of US Dollars in constant real value per annum in the world´s constant item economy when implemented worldwide, is first stated in this work.

The single most important factor making all the above possible is the authorization of financial capital maintenance in units of constant purchasing power during LOW inflation and deflation in IFRS in the original Framework (1989), Par 104 (a) which means that there are three instead of the stated two concepts of capital authorized in IFRS - was first identified in this work in 2008.

The second most important factor is the split of non-monetary items in variable and constant items which was first defined in this work in about 2005. Financial capital maintenance in units of constant purchasing power during LOW inflation and deflation would not be accepted by the business community and accounting profession without the split. That is one of the main reasons why this model to be used during LOW inflation was not developed before. In this project I define variable and constant items directly. They are not identified and named in IFRS , but, they are, in fact, indirectly implied (defined) in IFRS.

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

Inflation

Inflation

Inflation is always and everywhere a monetary phenomenon – per Milton Friedman.

Inflation – being the economic process which erodes only the real value of money and other monetary items (not inflation simply meaning any price increase) – is a sustained rise in the general price level of goods and services inside a national economy or monetary union measured over a period of time. Prices and the values of all economic items are normally expressed in terms of unstable money (the unstable monetary unit of account).

The unstable monetary unit of measure is fixed in nominal value but unstable in real value during inflation, deflation and hyperinflation because it is currently impossible to inflation–adjust the nominal values of physical bank notes and coins.

All non–cash monetary items can be inflation–indexed or deflation–indexed on a daily basis during inflation and deflation. The entire money supply excluding actual bank notes and coins can be inflation–adjusted on a daily basis in terms of a Daily Consumer Price Index or a monetized daily indexed unit of account during inflation. Chile has been inflation–adjusting a portion of the country´s money supply since 1967 by means of the Unidad de Fomento which is now a monetized daily indexed unit of account. According to the Banco Central de Chile 20 to 25% of the broad M3 money supply in Chile is inflation–indexed on a daily basis in terms of the Unidad de Fomento.

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

The three fundamentally different basic economic items

The three fundamentally different basic economic items

They are defined and described in the order that they appeared in the economy.

A. Variable real value non-monetary items
B. Monetary items
C. Constant real value non-monetary items

A. Variable items

Definition: Variable items are non–monetary items with variable real values over time.

Examples of variable items are property, plant, equipment, inventories, quoted and unquoted shares, raw material stock, finished goods stock, patents, trademarks, foreign exchange, etc. Variable items are everything you see around you generally bought/sold/traded in markets and shops excluding money and anything to do with money, e.g. bank statements, loan statements, etc.

The first economic items were variable items. Their values were not yet expressed in terms of money because money was not yet invented at that time.

B. Monetary items

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

Examples of monetary items are bank notes and coins, bank loans, bank savings, other monetary savings, other monetary loans, bank account balances, treasury bills, commercial bonds, government bonds, mortgage bonds, student loans, car loans, consumer loans, credit card loans, notes payable, notes receivable, etc. Under Historical Cost Accounting monetary items are fixed in nominal terms while their real values change inversely with the rate of inflation, deflation and hyperinflation. The net monetary loss or gain from holding monetary items is not calculated and accounted under HCA. It is required to be calculated in terms of IAS 29 Financial Reporting in Hyperinflationary Economies during hyperinflation. It is also required to be calculated under financial capital maintenance in unit of constant purchasing power accounting as authorized in IFRS in the original Framework (1989), Par 104 (a) [Conceptual Framework (2010), Par 4.59 (a)] which states:

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

The entire money supply (excluding actual bank notes and coins) can be inflation–adjusted on a daily basis. According to the Banco Central de Chile 20 to 25% of the Chile´s broad M3 money supply is currently inflation–indexed daily in terms of the Unidad de Fomento which is a monetized daily indexed unit of account.

Money has the following three attributes during inflation and deflation:

a. Unstable medium of exchange

b. Unstable store of value

c. Unstable unit of account

Only unstable money and other unstable monetary items´ real values are continuously being eroded by inflation and hyperinflation over time. Inflation and hyperinflation have no effect on the real value of non–monetary items. Deflation increases the real value of only unstable money and other unstable monetary items over time. Deflation also has no effect on the real value of non–monetary items.

C. Constant items

Definition: Constant items are non–monetary items with constant real values over time.

Examples of constant real value non–monetary items are all income statement items as well as balance sheet constant items, e.g. issued share capital, retained earnings, capital reserves, share issue premiums, share issue discounts, revaluation surplus, all other shareholder’s equity items, trade debtors, trade creditors, provisions, taxes payable and receivable, deferred tax assets and liabilities, dividends payable and receivable, royalties payable and receivable, all other non–monetary payables and receivables, etc.

Constant items are fixed in terms of real value while their nominal values change daily in terms of the Daily Consumer Price Index.

Non-monetary items

Definition: Non–monetary items are all items that are not monetary items.

Non–monetary items in today’s economy are divided into two sub–groups:

a)           Variable real value non–monetary items

b)           Constant real value non–monetary items

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

The three fundamentally different parts of the economy

The three fundamentally different parts of the economy

The economy consists of economic entities and economic items. Economic items have economic value. Accounting does not simply record what happened in the past. Financial reporting is not simply a scorekeeping exercise. Economic items are valued every time they are accounted. Accounting is a measurement instrument – per David Mosso. Utility, scarcity and exchangeability are the three basic attributes of an economic item which, in combination, give it economic value.

It is generally accepted that there are only two basic, fundamentally different, economic items in the economy; namely, monetary and non–monetary items and that the economy is divided in the monetary and non–monetary or real economy. However, non–monetary items are not all fundamentally the same.

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 three parts:

1.            Monetary economy

2.            Variable item economy

3.            Constant item economy

1.   Monetary economy

          The monetary economy within a national economy or monetary union like the European Monetary Union (EMU) consists of the broad money supply (M3) of which about 7% is made up of actual bank notes and bank coins - based on the US money supply figures. The monetary economy is made up of money and other monetary items, e.g. bank notes, bank coins, bank loans, bank savings, credit card loans, car loans, home loans, student loans, consumer loans, commercial and government bonds, Treasury Bills, all capital market items, all monetary investments, etc. The monetary economy is the fiat money supply created in the banking system by means of fractional reserve banking.

             Bank notes and coins (cash) generally make up only about 7% of the money supply.  The other 93% of the money supply is made up of bank money (loan / overdraft / monetary application values in bank accounts) and other monetary items. They are non–cash monetary items. They have exactly the same attributes as physical bank notes and coins except that they are not present as cash. Their real values are being eroded by inflation and hyperinflation and increased by deflation in exactly the same way as with bank notes and coins.
            2. Variable item economy

The variable item economy is made up of non–monetary items with variable real values over time; for example, cars, groceries, houses, factories, books, property, plant, equipment, inventory, mobile phones, quoted and unquoted shares, computers, foreign exchange, TV´s, finished goods, raw material, etc.

           3. Constant item economy

The constant item economy consists of non–monetary items with constant real values over time, e.g. salaries, wages, rentals, all other income statement items, balance sheet constant items, e.g. issued share capital, share premiums, share discounts, capital reserves, revaluation reserves, retained earnings, all other items in shareholders´ equity, provisions, trade debtors, trade creditors, taxes payable, taxes receivable, all other non–monetary payables, all other non–monetary receivables, etc.

 

The variable item economy and the constant item economy make up the non–monetary. The monetary economy and the non–monetary economy constitute the economy.

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

CIPPA: What, how and why.

CIPPA: What, how and why.

What to do?

Stop the stable measuring unit assumption.

How?

Stop the Historical Cost Accounting model and implement financial capital maintenance in units of constant purchasing power as authorized in IFRS in the original Framework (1989), Par 104 (a) [Conceptual Framework (2010), Par 4.59 (a)] which states:

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

1. Value constant real value non-monetary items in units of constant purchasing power in terms of the Daily CPI as authorized in IFRs. The Net Constant Item Loss or Gain is calculated and accounted for constant items not measured in units of constant purchasing power.

2. Value variable real value non-monetary items in terms of IFRS and update them in terms of the Daily CPI. Impairment and revaluation gains and losses are treated in terms of IFRS.

3. Inflation-adjust monetary items in terms of the Daily CPI. The Net Monetary Loss or Gain is calculated and accounted for monetary items not inflation-adjusted.

Why?

The stable measuring unit assumption (Historical Cost Accounting) erodes hundreds of billions of US Dollars per annum in the real value of constant items never maintained constant in the world´s constant item economy. This is the result of the global implementation of financial capital maintenance in nominal monetary units during inflation which is a very popular accounting fallacy not yet extinct. It is impossible to maintain the real value of capital in nominal monetary units per se during inflation.

CIPPA automatically stops this erosion of constant item real value forever. Financial capital maintenance in units of constant purchasing power as authorized in IFRS automatically maintains the constant real value of capital constant forever in all entities that at least break even in real value during inflation and deflation - ceteris paribus- 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.

Foreign exchange

Foreign exchange

A foreign currency is not the monetary unit in a non–dollarized economy since it is not the generally accepted national monetary unit of account. The Rand is the monetary measuring unit of account in SA. The SA economy is not a Dollarized economy. The Rand is the monetary unit.

Money has three functions:

                                               1. Unstable medium of exchange

                                               2. Unstable store of value

                                               3. Unstable unit of account

A foreign currency like the US Dollar or the Euro is, however, a medium of exchange in SA. Most businesses and individuals would accept the USD or the Euro as a means of payment; that is, as a medium of exchange because they can easily sell the foreign currency amounts they would receive in transactions at their local banks for Rands.

A hard currency is also a store of value in SA. The USD and the Euro are hard currencies with daily changing market values. They are generally accepted world–wide as a relatively stable store of value. People know there are normal daily small changes in their foreign exchange values.

The USD and the Euro are, however, not national units of account in SA. You cannot normally do your SA accounts in US Dollars or Euros for tax purposes during low inflation and deflation. You have to do your accounting in Rand values in the SA economy during low inflation and deflation. The USD and the Euro are not functional currencies in SA since they do not fulfil all three functions of a monetary unit within the SA economy. A foreign currency like the USD or the Euro only fulfils two functions of money, namely, unstable medium of exchange and unstable store of value. They therefore are not money or the monetary unit in SA from a strictly technical point of view. They are not monetary items in SA.

Foreign currencies are variable real value non–monetary items in a non–dollarized economy. They have variable real values which are determined in the foreign exchange markets daily.

The US Dollar is only a functional currency unit outside the United States of America in countries like Ecuador, Panama and Zimbabwe which have Dollarized their economies. They use the US Dollar as their functional currency unit. They do not have their own national currencies. That is not the case in non–dollarized economies.

It just appears very strange to say that the US Dollar or the Euro is not money in SA. Technically speaking that is correct because an economic item can only be money in a non–dollarized economy if it fulfils all three functions of money. The Euro is only money in the European Monetary Union (EMU) and the USD is only money in the US and in countries which have Dollarized their economies using the US Dollar as their functional currency.

The man and woman in the street, however, regard anything that is a medium of exchange as “money” in very limited applications. Cigarettes are often used as a medium of exchange in prisons. Shells have been used way back in history as a medium of exchange.

The man and woman in the street in SA certainly regard the USD and the Euro as money in SA. SA entities, however, classify foreign exchange as a variable real value non–monetary item stated at its current market value and not the same as the SA Rand, that is, not as a monetary item when they choose to implement financial capital maintenance in units of constant purchasing power in terms of IFRS as authorized in the original Framework (1989), Par 104 (a) during low inflation and deflation, i.e. when they implement Constant Item Purchasing Power Accounting.

Dollarization can be in currencies other than the US Dollar too.

Nicolaas Smith 

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

Valuing revaluable fixed assets at HC does not erode their real values

Valuing revaluable fixed assets at HC does not erode their real values

The real values of revaluable fixed assets are not eroded by the stable measuring unit assumption when entities value these items at their original nominal HC values before the date that they are actually sold or exchanged during low inflation and deflation. They would be valued at their current market values on the date of exchange or sale in an open economy. During hyperinflation all non–monetary items (variable and constant real value non–monetary items) are required to be restated in terms of IAS 29 Financial Reporting in Hyperinflationary Economies to make these restated HC or Current Cost period-end financial reports more useful by applying the period-end CPI. A hard currency parallel rate – normally the US Dollar parallel rate – or a Brazilian-style index is applied on a daily basis when a country wishes to stabilize its real economy during hyperinflation.

This is not the case with constant items with real values never maintained constant during low inflation and deflation under the HCA model. The stable measuring unit assumption unknowingly, unintentionally and unnecessarily erodes the real values of constant items never maintained constant at a rate equal to the annual rate of inflation in a low inflationary environment when the HCA model is implemented.

Revaluable fixed assets, e.g., land and buildings´, real values are not being unknowingly eroded by the HCA model as a result of the implementation of IFRS since they exist independently of how we value them. Entities can value land and buildings in the balance sheet at their historical cost 50 years ago, but, when they are sold in the market today they would be transacted at the current market price. The real values of variable items are also not being eroded uniformly at, e.g., a rate equal to the annual inflation rate because of valuing them at original nominal HC. Inflation has no effect on the real values of non–monetary items.

Where real losses are made in dealing with variable items in the economy, these losses are the result of supply and demand or business or private decisions, e.g. selling at a bad price, obsolescence, stock market crashes, credit crunches, etc. They do not result from the implementation of the HC accounting model.

A house is a variable real value non–monetary item. Let us assume a house in Port Elizabeth, South Africa  is fairly valued in the PE market at say R 2 million on 1^st January in year one. With no change in the market a year later but with annual inflation at 6% in SA, the seller would increase his or her price to R2.12 million – all else being equal. The house’s real value remained the same. The depreciating monetary value of the house expressed in the depreciating Rand medium of exchange – all else being equal – was updated to compensate for the erosion of the real value of the depreciating Rand in the internal SA market by 6% annual inflation. It is clear that inflation does not affect the house’s variable non–monetary real value – all else being equal.

However much inflation rises, it can only erode the Rand´s real value at a higher rate and over a shorter period of time. As inflation rises the price of the house would rise to keep pace with inflation or value erosion in the real value of the Rand – all else being equal. The real value of the property will be updated as long as the house is valued as a variable real value non–monetary item at its market price, a measurement base dictated by IFRS and also practiced in all open markets.

The house´s real value is not a constant real value non–monetary item. It is only assumed in this example that only inflation changes with all else being equal. This is not normally the case in the market. The house´s real value is a variable real value non–monetary item.

When a property was valued at Historical Cost in the not so distant past in a company’s balance sheet it may have stayed at its original HC of, for example, R 100 000 for 29 years since January, 1981 in the company’s balance sheet. When it is eventually sold today for R 1.4 million we can see that inflation did not erode the property’s variable real non–monetary value – all else being equal. Inflation only eroded the real value of the depreciating Rand, the depreciating monetary medium of exchange, over the 29 year period – all else being equal. This was taken into account by the buyer and seller at the time of the sale. The selling price in Rand was increased to compensate for the erosion of the real value of the Rand by inflation. R1.4 million today (2010) is the same as R100 000 in January, 1981 – all else being equal.

As the two academics from Turkey state: “Purchasing power of non monetary items does not change in spite of variation in national currency value.”

Nicolaas Smith

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

Historical Cost Debate

Historical Cost Debate

The Historical Cost Debate is the debate over the last 100 years or so about the exclusive use of Historical Cost for all accounting purposes. The accounting profession has realized for a very long time that financial reports based on Historical Cost for all economic items do not fairly represent a company’s results and operations. As a result of this debate the pure Historical Cost Accounting model has been improved and changed dramatically during this time, so much so, that today we have a huge volume of IFRS where under variable real value non–monetary items are not all valued at HC but at, e.g., fair value or the lower of cost and net realizable value or market value or recoverable value or present value, etc. This debate has thus been a very valid and successful debate regarding the valuation of variable real value non–monetary items.

Unfortunately, the stable measuring unit assumption is still an IFRS–approved option that is used for the valuation of most constant real value non–monetary items (excluding annual valuation of salaries, wages, rents, etc.) during low inflation and deflation. Fortunately, the option of measuring financial capital maintenance in units of constant purchasing power during low inflation and deflation (CIPPA) has been approved in IFRS in the original Framework (1989), Par 104 (a).

Entities value variable real value non–monetary items in terms of IFRS when they implement both the traditional HCA model and when they measure financial capital maintenance in units of constant purchasing power during low inflation and deflation applying CIPPA. Inflation has no effect on the real values of variable real value non–monetary items. Inflation can only erode the real value of money and other monetary items: nothing else.

Nicolaas Smith

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

Daily US Dollar parallel rate or daily index required during hyperinflation

Daily US Dollar parallel rate or daily index required during hyperinflation

Hyperinflation is defined as an exceptional circumstance by the IASB. All non–monetary items – variable and constant items – in Historical Cost or Current Costs period-end financial statements are required to be restated in terms of IAS 29 Financial Reporting in Hyperinflationary Economies during hyperinflation by applying the period–end CPI to make the restated HC or CC financial reports more useful. This normally does nothing to the real values of the restated non–monetary items unless they are accepted by the tax authorities as the new real values for these companies.

The only way a country in hyperinflation can stabilize its real or non–monetary economy is by applying the daily US Dollar parallel rate or a Brazilian–style daily index supplied by the government in the valuing of all non–monetary items instead of the period–end CPI.

Nicolaas Smith

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

Measurement bases

Measurement bases

Measurement bases used in the valuation of variable items in terms of IFRS include – but are not limited to – the following:

Market value

Fair value

Historical Cost

Net realisable value

Present value

Recoverable value

Current cost

Carrying value

Residual value

Value in use

Settlement value

Replacement cost

Examples of variable real value non–monetary items

Property

Freehold Land

Buildings

Leasehold Improvements

Plant

Equipment

Equipment under Finance Lease

Investment Property

Other Intangible Assets

Capitalised Development Items

Patents

Trademarks

Licences

Investments in Associates

Joint Ventures  

Foreign currency forward contracts

Available–for–sale investments  

Quoted and Unquoted Shares

Inventories

Raw Materials

Work–in–progress

Finished Goods

Foreign currency

Nicolaas Smith

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

Books to be balanced in real terms

Books to be balanced in real terms

 Constant items would always and everywhere be measured in units of constant purchasing power in terms of a Daily Consumer Price Index or monetized daily indexed unit of account under Constant Item Purchasing Power Accounting; i.e., implementing financial capital maintenance in units of constant purchasing power during inflation and deflation. This would eliminate the total cost of the stable measuring unit assumption (currently hundreds of billions of US Dollars per annum) from the constant item economy only in the unlikely case of complete coordination right from the start of changing over to financial capital maintenance in units of constant purchasing power.

Constant items within an entity with no third parties involved would always and everywhere be measured in units of constant purchasing power. This would include all items in shareholders´ equity, provisions, all items in the income statement, accounts payable, all other non–monetary payables, etc.

A new accounting item, net constant item loss or gain would be calculated and accounted where trade debtors and other third party entities due to pay other non–monetary receivables initially do not agree to measurement in units of constant purchasing power in terms of a Daily Consumer Price Index or monetized daily indexed unit of account. The real value loss is not a net monetary loss because it is not caused by inflation in the real value of a monetary item, but, by the application of the stable measuring unit assumption causing a loss in the real value of a constant real value non-monetary item. The calculation and accounting of the net constant item loss or gain is required because there is no stable measuring unit assumption under financial capital maintenance in units of constant purchasing power: the books would – for the first time – be balanced in real terms.

Nicolaas Smith

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

Variable Items under CIPPA

Variable Items under CIPPA

    Variable items are valued and accounted in terms of IFRS. Variable item revaluation losses and gains are treated in terms of IFRS. Variable items when not valued daily in terms of IFRS would be updated in terms of a Daily Consumer Price Index or a monetized daily indexed unit of account because there is no stable measuring unit assumption under financial capital maintenance in units of constant purchasing power.

Selling prices of items in shops and restaurants, etc. are not updated on a daily basis during low inflation and deflation. They are not historical prices. They are set in a free market.  Keeping them the same during a period is a marketing strategy. Selling prices depend on demand and supply. McDonalds´ prices would not be updated daily in terms of a DCPI or a monetized daily indexed unit of account during low inflation and deflation.

They would be updated daily under financial capital maintenance in units of constant purchasing power during hyperinflation which requires daily updating of all non-monetary items (variable and constant items) in terms of a daily parallel rate (normally the daily US Dollar parallel rate), a Brazilian-style Unidade de Valor Real daily index or a monetized daily indexed unit of account like the UF in Chile. That happened at McDonalds in Harare, Zimbabwe; i.e., the daily updating, not the implementation of financial capital maintenance in units of constant purchasing power during hyperinflation. Implementing IAS 29 Financial Reporting in Hyperinflationary Economies did not result in financial capital maintenance in units of constant purchasing power in Zimbabwe.

IAS 29 simply requires the restatement of period end HC or Current Cost financial statements in terms of the CPI to supposedly make these statements more useful during hyperinflation. The implementation of IAS 29 had no effect on the economic collapse in Zimbabwe.

Nicolaas Smith

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

Monetary items under CIPPA - Part 2

Monetary items under CIPPA - Part 2

The full cost of or gain from inflation – net monetary loss or gain – would be recognized by these entities in their operations. It would be calculated and accounted in financial reports prepared under CIPPA. Under partial inflation–adjustment of monetary items – e.g. in Chile, the US, UK, Canada and all countries issuing inflation–indexed bonds – the net monetary loss or gain would be calculated and accounted for the part not inflation–indexed. This is presently not being done in Chile, the US, UK, Canada, etc. because these countries implement the HCA model under which net monetary losses and gains are not calculated and accounted.

The calculation and accounting of net monetary losses and gains are required under CIPPA because the stable measuring unit assumption is never applied under financial capital maintenance in units of constant purchasing power during inflation and deflation.

The constant purchasing power of capital can automatically be maintained constant by the real value of net assets in entities that at least break even during inflation and deflation – ceteris paribus – whether they own any revaluable fixed assets or not – only when they implement financial capital maintenance in units of constant purchasing power. Capital is equal to the real value of net assets.

Under HCA the cost of inflation in the monetary economy is not calculated and accounted because the books are not being balanced in real terms but in nominal monetary terms with the implementation of the very erosive stable measuring unit assumption under financial capital maintenance in nominal monetary units. The concept of capital being equal to net assets is also applied under HCA, but, in illusionary nominal monetary terms. Historical Cost illusion that it is possible to maintain the real value of capital in nominal monetary units per se during inflation and deflation makes Historical Cost Accounting a very erosive and – in principle – inappropriate accounting policy.

Entities, on the one hand, apply the stable measuring unit assumption under HCA in the valuation of their own shareholders´ equity in their own financial reports in nominal monetary units under which they may not take into account unreported hidden reserves for fixed assets not revalued when they apply the Historical Cost approach to the valuation of fixed assets in terms of IFRS. On the other hand, they always value third parties´ shareholders´ equity taking into account unreported hidden reserves for fixed assets not revalued, e.g. in the share price of listed companies which they value at market value in terms of IFRS, as well as in their valuations of unlisted companies.

This means that under HCA only entities with revaluable fixed assets (revalued or not) with an updated real value equal to 100% of the updated constant real value of shareholders´ equity maintain the real value of their capital under the concept of capital is equal to net assets measured in nominal monetary units during inflation and deflation. This may only be the case in property companies, hotel, hospital and other property–intensive entities. CIPPA maintains the constant purchasing power of capital constant forever in all entities that at least break even during inflation and deflation – ceteris paribus – whether they own any revaluable fixed assets or not. This requires the calculation and accounting of net monetary losses and gains as well as net constant item losses and gains (a new accounting term) because the books are being balanced in real terms; i.e. the stable measuring unit assumption is never applied.

This also means that, under HCA, the portion of shareholders´ equity never covered by sufficient revaluable fixed assets (revalued or not) has always been and is still currently  unnecessarily, unintentionally and unknowingly being eroded at a rate equal to the annual rate of inflation; not by inflation, but, by the implementation of the stable measuring unit assumption during inflation.

The erosion is equal to the annual rate of inflation because economic items are valued in terms of money which is the legal monetary unit of account and inflation erodes the real value of only money and other monetary items. Inflation has no effect on the real value of non–monetary items. Shareholders´ equity is a constant real value non–monetary item. This unnecessary erosion in constant item real value amounts to hundreds of billions of US Dollars per annum in the world´s constant item economy.

Financial capital maintenance in units of constant purchasing power (CIPPA) would stop that forever and would instead maintain hundreds of billions of US Dollars per annum in the world´s shareholders´ equity investment base for an unlimited period of time.

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.

Nicolaas Smith

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

Monetary items under CIPPA

Monetary items under CIPPA

Financial capital maintenance in units of constant purchasing power (CIPPA) never implementing the stable measuring unit assumption during inflation and deflation requires the following:

      All monetary items – historical and current period monetary items – are inflation–adjusted in terms of a Daily Consumer Price Index or monetized daily indexed unit of account like the Unidad de Fomento in Chile. This results in the complete elimination of the cost of inflation (not actual inflation in the monetary unit); i.e. there would be no net monetary loss or gain in the entire economy, only under complete coordination and with all money in the banking system which makes this only a theoretical assumption. There are always bank notes and coins outside the banking system even if all other monetary items in and outside the banking system were inflation–indexed as partially done in Chile since 1967 with the UF. There would thus always be net monetary losses and gains to be calculated and accounted only in the monetary economy. Inflation has no effect on the real value of non–monetary items.

Complete coordination in an economy would most probably not be that easy to achieve right from the start. Banks cannot be forced to inflation–adjust all monetary items in the banking system when entities do not yet understand all the benefits of financial capital maintenance in units of constant purchasing power. Chilean banks operate profitably with inflation–adjusting a portion (currently 20 to 25% of their broad M3 money supply) of deposits from clients since 1967. They inflation–index, for example, mortgages and car loans, which include their profit margins, to clients in terms of the UF.

However, entities may start financial capital maintenance in units of constant purchasing power, as authorized in IFRS, without any inflation–adjustment of monetary items at all. They may be motivated by the invisible hand of self–interest, shareholder pressure or more financial crises caused by continuously undercapitalized banks and companies. They may wish to immediately benefit from automatically maintaining the constant purchasing power of their own shareholders´ equity constant forever as long as they break even during inflation and deflation – ceteris paribus – whether they own any revaluable fixed assets or not. (See CIPPA increases a company´s net asset value.) [Link this to the blog article.]

There is much to be gained from moving away from reporting on the basis of Financial Capital Maintenance in Nominal Monetary Units.

           Prof Rachel Baskerville, Associate Professor of Accounting at the School of Accounting and Commercial Law at the Victoria University of Wellington, New Zealand in her publication 100 Questions(and Answers) about IFRS,  Question 38, 2010 on the Social Science Research Network.

Nicolaas Smith

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

Daily Consumer Price Index - Part 3

Daily Consumer Price Index - Part 3

“The UF is now a lagged daily interpolation of the monthly consumer price

index. The formula for computation of the UF on day t is:                                        

                                UF t = UF t–1 × (1+ π) to the power 1/d

 where π is the inflation rate for the calendar month preceding the calendar month in which t falls if t is between day ten and the last day of the month (and d is the number of days in the calendar month in which t falls), and π is the inflation rate for the second calendar month before the calendar month in which t falls if t is between day one and day nine of the month (and d is the number of days in the calendar month before the calendar month in which t falls).”

Robert J. Shiller, Indexed Units of Account: Theory and Assessment of Historical Experience, Cowles Foundation Discussion Paper No 1171, 1998, p3.
The above formula applies to the UF in Chile where the CPI for the current calendar month used to be available on the 10th of the next calendar month. The general case formula can be stated as follows:
On day t
                            DI t = DI t–1 X (1 + π) to the power 1/d

where π is the monthly inflation rate for the second calendar month before the calendar month in which t falls if t is on or between day one and the day of publication of the CPI of the previous calendar month (and d is the number of days in the calendar month before the calendar month in which t falls), and π is the monthly inflation rate for the calendar month preceding the calendar month in which t falls if t is on or between the day the CPI for the previous calendar month is published and the last day of the month (and d is the number of days in the calendar month in which t falls).

The monthly inflation rate for a calendar month is calculated using the CPI for that month and for the preceding month. The DCPIs within a given calendar month thus depend on the CPI for each of the three preceding months. For example, the July DCPIs depend before the day the June CPI is published on the CPI for April and May, and starting with the day the June CPI is published on the CPI for May and June.

A DCPI is very similar to, but, not exactly the same as a monetized daily indexed unit of account, e.g. the UF in Chile. The UF is monetized; i.e. it is stated in terms of the Chilean peso. That is not the case with a DCPI. A DCPI is not automatically monetized.
“The UF was and is an amount of currency related to the Indice de Precios al Consumidor (IPC), the consumer price index for Chile.” (Shiller, 1998, p3)

A DCPI is, like the monthly CPI on which it is based, a non–monetary index value. Monetization depends on generally accepted monetary practices in an economy: see the UF in Chile. A DCPI can be monetized and used as a monetized daily indexed unit of account with payments being made in the national monetary unit depending on users in an economy. Monetization is not a necessity.
“An exchange rate between the unit (the UF) and the true money or legal tender, in Chile the peso, is defined using an index number (such as the consumer price index), and payments are executed in money. Thus, the indexed units of account facilitate payments that are tied to the index number, without being a means of payment.” (Shiller, 1998, p2)

A DCPI is not a unit of account just like the CPI is not a unit of account for accounting purposes. The US Dollar, Euro, Yen, Yuan, etc are the nominally fixed monetary units of account, unstable in real value, used in their respective countries as the national monetary unit of account for accounting purposes during inflation, deflation and hyperinflation. The US, EU, Japanese and Chinese CPIs are not units of account for accounting purposes. They are non–monetary general price level indices. So are their DCPIs. Prices are not quoted in CPIs or in DCPIs – although they can be.

DCPIs based on the UF formula for Portugal and South Africa are available on this blog as from 1st July, 2011.


Nicolaas Smith

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

Daily Consumer Price Index - Part 2

Daily Consumer Price Index - Part 2

Daily inflation–indexing monetary items is thus not a new concept. Chile is the country which is closest to inflation–indexing its money supply. 30–Day deposits are not inflation–indexed. 20 to 25% of Chile´s broad M3 money supply is inflation–indexed on a daily basis in terms of the UF according to the Banco Central de Chile.


The Consumer Price Index is an example of a non–monetary general price level index. The annual percentage change in the CPI indicates the annual rate of inflation. The CPI for a particular calendar month is normally published in the second or third week of the next month.

A daily instead of a monthly general price level index is required to implement financial capital maintenance in units of constant purchasing power during inflation and deflation (Constant Item Purchasing Power Accounting). Using the CPI published monthly may result in sudden increases or decreases in values on the date the new CPI is published. A Daily CPI which is a lagged daily interpolation of the CPI solves this problem. The UF is a very successful monetized daily indexed unit of account used in Chile during the last 44 years and was copied by Ecuador, Mexico and Columbia. (See Shiller, 1998, p6.)

Constant Purchasing Power Accounting (CPPA) during hyperinflation requires either a daily parallel hard currency exchange rate – normally the daily US Dollar parallel rate – or a Brazilian style Unidade Real de Valor daily index primarily based on a daily parallel hard currency rate. The URV was an excellent daily index published by the government during hyperinflation in Brazil because it was mainly based on the US Dollar parallel rate (a hard currency parallel rate is essential during hyperinflation which is an exceptional circumstance), but, the CPI was also included in the formula.

The CPI is the weighted average index value of a typical basket of consumer goods purchased by a typical consumer statistically stated as a non–monetary initial index value of 100 at the start date. The CPI is thus fixed in real terms – not in nominal terms. It changes monthly in nominal terms, but, it stays fixed in real terms.

An example is the harmonized consumer price index of the Euro Area stated as the non–monetary index value of 100 in 2005. This fixed internal unit of real value is then compared to the weighted average price of the typical basket of consumer goods and services a year later in order to determine the annual rate at which inflation is eroding the real value of only money and other monetary items in only the monetary economy or deflation is creating real value in only money and other monetary items in only the monetary economy. Inflation and deflation have no effect on the real value of non–monetary items. The same is true for hyperinflation.

The stable measuring unit assumption (not inflation and hyperinflation) erodes the real value of constant items never maintained constant (never measured in units of constant purchasing power in a double–entry accounting model where the real value of capital is equal to the real value of net assets) during inflation and hyperinflation under the Historical Cost paradigm. Similarly, it is not deflation, but, the stable measuring unit assumption that creates real value in constant items never maintained constant (qualified as per the previous sentence) during deflation under HCA.

The annual percentage change in the CPI indicates the annual rate at which only the real value of the national (or monetary union, e.g. the European Monetary Union) monetary unit and other monetary items is being eroded by the economic processes of inflation and hyperinflation or being increased by the economic process of deflation.

A Daily Consumer Price Index is a lagged daily interpolation of the CPI based on the formula to calculate the daily price of a government inflation-indexed bond in a particular country, e.g., the formula used to calculate the Unidad de Fomento in Chile or the formula to calculate the daily price of TIPS in the US.



Every country which issues inflation-indexed government bonds has a Daily Consumer Price Index based on the respective CPI. In practice, a DCPI is used to inflation–adjust monetary items, to update historical variable items and to measure constant items in units of constant purchasing power under Constant Item Purchasing Power Accounting; i.e. financial capital maintenance in units of constant purchasing power during inflation and deflation as authorized in International Financial Reporting Standards (IFRS) in the original Framework (1989), Par 104 (a).

The Unidad de Fomento in Chile is the most successful monetized daily indexed unit of account to date.

A DCPI is calculated and published daily, for example, the UF published daily by the Banco Central de Chile. The monthly published CPI for the first day of any month is only available – at the earliest – round–about the tenth of the next month: up to 41 days later. The SA CPI for the first of the month can become available up to the 24th of the next month: i.e. up to 55 days later. This is very impractical for daily financial capital maintenance in units of constant purchasing power.

The Daily Consumer Price Index - Part 3

Nicolaas Smith

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