Inflation-indexed bonds

Inflation-indexed bonds

Inflation-indexed bonds also known as inflation-linked bonds are government and commercial bonds indexed to inflation. The first known inflation-indexed bond was issued by The Massachusetts Bay Company in 1780.

The capital amount or principal of the bond is indexed to inflation. Inflation-indexed bonds are thus money loans to governments and companies designed to eliminate the risk of inflation eroding the real value of the principle and interest payments. The corporate inflation-indexed bond market is quite small compared to the sovereign market. The British government began issuing inflation-linked Gilts in 1981. The market for inflation-linked bonds has grown rapidly since then. Sovereign inflation-indexed bonds comprised over $2.68 trillion of the international debt market at the end of 2009. Private sector issued inflation-linked bonds make up a small portion of the international inflation-indexed bond market.

Interest is paid my means of coupon payments. A coupon payment on a bond is a periodic interest payment to the bondholder during the period between the bond issue date and when the bond matures. The coupon is equal to the product of the nominal coupon rate and the inflation index for the period involved. The Fisher equation presents the relationship between real interest rates, coupon payments and breakeven inflation. An increase in real rates, inflation expectations, or both, results in a rise in coupon payments.

The underlying principal of the bond is inflation-indexed for most bonds, such as in the case of Treasury Inflation-Protected Securities (TIPS), which results in a higher interest payment when multiplied by the same rate. The interest rate is adjusted according to inflation for some bonds, such as the Series I Savings Bonds in the US.

The most liquid markets are US TIPS, the UK Index-linked Gilts and the French OATi/OAT€I market. Japan, Germany, Italy, Canada, Australia, Sweden, Iceland, Portugal, Greece, Finland, Netherlands, Spain, Saudi Arabia, Qatar, Kuwait, UAE, South Korea New Zealand and Hong Kong also issue inflation-indexed bonds, as well as a number of Emerging Markets such as Brazil, Turkey, Chile, Mexico, Colombia, Argentina and South Africa.

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

Daily Consumer Price Index (DCPI) - Part 1

The Daily Consumer Price Index – DCPI

(i)          Introduction

      Unstable money is the unstable medium of exchange, unstable store of value and unstable unit of account in the economy. Pre–monetary economies had units of account without money being available in the economy. (See Robert J. Shiller, Indexed Units of Account: Theory and Assessment of Historical Experience, Cowles Foundation Discussion Paper No 1171, 1998, p4).

      Today the economic values of all economic items are stated in terms of unstable money. Prices are expressed in unstable monetary units. Unstable money is the generally accepted unstable monetary unit of account used to value and account all economic activity by entities applying the stable measuring unit assumption as part of the traditional Historical Cost Accounting model under which they implement financial capital maintenance in fixed nominal monetary units with unstable real values in the world economy during inflation, deflation and hyperinflation.

      Unstable money is not fixed in constant real value. Unstable money is fixed in nominal value in economies subject to inflation, deflation and hyperinflation. Unstable money is a fixed nominal unit of account with a daily changing real value (purchasing power).  Financial capital maintenance in nominal monetary units, although approved in IFRS and by the United States Financial Accounting Standards Board (FASB) and implemented worldwide, is a very popular accounting fallacy not yet extinct because it is impossible to maintain the real value of capital in nominal monetary units per se during inflation and hyperinflation.

      Bank notes and bank coins cannot currently be inflation–indexed or deflation-indexed which makes it impossible for money or the monetary unit of account to be a perfectly stable unit of constant real value during inflation, deflation and hyperinflation.

(ii)        Unidad de Fomento

      Notwithstanding or despite the above, monetary items in the form of certain time deposits  – not the actual bank notes and coins – and other monetary items, e.g. government and commercial capital market bonds, have been inflation–indexed in Chile since 1967 by means of the Unidad de Fomento which is now a monetized daily indexed unit of account.

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

IAS 29 needs to be totally reviewed by the IASB

IAS 29 needs to be totally reviewed by the IASB

This CIPPA project is about financial capital maintenance in units of constant purchasing power during low inflation and deflation.

As a secondary issue, the project also clearly demonstrates the futility of implementing IAS 29 during hyperinflation as required by IFRS and describes the solution: daily updating of all non-monetary items in terms of the daily US Dollar parallel rate or a Brazilian style Unidade de Valor Real index as was done in Brazil during 30 years from 1964 to 1994.  

This supports the current request by many accounting authorities for a total review of IAS 29 by the International Accounting Standards Board.

CIPPA clearly demonstrates that simple restatement of Historical Cost and Current Cost financial statements in terms of the period-end monthly Consumer Price Index during hyperinflation as required by IAS 29 makes absolutely no difference to the destruction of a country´s constant item economy, not by hyperinflation, but, by the stable measuring unit assumption as it forms part of the HCA model as it happened in Zimbabwe over the 14 years of hyperinflation in that country till final monetary meltdown in 2008. IAS 29 was implemented in Zimbabwe since 2002 and made absolutely no difference.

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

Problems CIPPA can help solve

Problems CIPPA can help solve

1.    It would automatically solve the problem of the erosion of companies´ capital and profits by the stable measuring unit assumption (the HCA model) during low inflation amounting to hundreds of billions of USD p.a. on a worldwide basis and instead would automatically maintain that amount p.a. for and unlimited period of time in all entities that at least break even in real value during low inflation – ceteris paribus – whether they own any revaluable fixed assets or not.

2.    It would solve the problem of the very rapid destruction a country´s non-monetary economy by the implementation of the stable measuring unit assumption (HCA) during hyperinflation by means of daily measurement of all non-monetary items in units of constant purchasing power in terms of the daily US Dollar parallel rate or a Brazilian style daily index.

3.    It would solve the problem of economic instability caused by the implementation of the stable measuring unit assumption (HCA) during deflation.

4.    It corrects the fallacy that the erosion of companies´ capital and profits is caused by inflation: it is caused by the stable measuring unit assumption during inflation.

5.    It corrects the fallacy that financial capital can be measured in nominal monetary units per se as stated in IFRS: it is impossible to maintain the real value of financial capital in nominal monetary units per se during inflation.

6.    It corrects the fallacy that changes in the purchasing power of money are not sufficiently important to require financial capital maintenance in units of constant purchasing power during low inflation. The implementation of the stable measuring unit assumption causes the erosion of hundreds of billions of US Dollars in real value p.a. worldwide in that portion of entities´ shareholders´ equity not backed by sufficient revaluable fixed assets (revalued or not) during low inflation.

7.    It corrects the generally accepted belief that there are only two concepts of capital and capital maintenance authorized in IFRS; there are three concepts of capital authorized in IFRS: (i) physical capital (ii) financial capital measured in units of constant purchasing power (CIPPA) and (iii) financial capital measured in nominal monetary units (HCA).

8.    It corrects the generally accepted belief that there are only two basic economic items in the economy; there are three: monetary, variable and constant items.

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

The value of CIPPA

The value of CIPPA

a.)  The principle treated in the topic, namely, financial capital maintenance in units of constant purchasing power, was originally authorized in IFRS in the Framework, Par 104 (a) in 1989.

b.)  In developing the topic, CIPPA introduces several new accounting concepts and terms for the first time, e.g.:

(i)           Financial capital maintenance in units of constant purchasing power during LOW inflation and deflation – not only during very high and hyperinflation.

(ii)          The split of non-monetary items in variable and constant items making this model possible during low inflation and deflation.

(iii)        Not just 2 but three basic economic items.

(iv)        Variable item economy.

(v)          Constant item economy.

(vi)        Net Constant Item Loss.

(vii)       Net Constant Item Gain.

(viii)     Daily Consumer Price Index.

(ix)        Inflation Illusion.

(x)          Accounting-Dollarization.

c.)   The fact that IFRS authorize three instead of the generally accepted two concepts of capital and capital maintenance was first published on this blog.

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

Time line for CIPPA

Time line for CIPPA

CIPPA concludes the process of how to automatically eliminate the very destructive effect of the stable measuring unit assumption (mistakenly believed to be caused by inflation) in entities´ constant real value non-monetary items, e.g. shareholders´ equity, forever in all entities that at least break even in real value during low inflation – ceteris paribus. This process was prematurely stopped in 1986 when the implementation of a form of financial capital maintenance in units of constant purchasing power required by US Financial Accounting Standard 89 was made voluntary.

The high inflationary 1970´s and 80´s

During the 1970´s and 80´s the monetary units of the major world economies were subject to very high inflation. Constant Purchase Power Accounting (CPPA) [not CIPPA] under which all non-monetary items (variable and constant items) are measured in units of constant purchasing power in terms of the monthly Consumer Price Index during very high and hyperinflation was attempted in many of these economies. There was no split of non-monetary items in variable and constant items and the CPPA model thus failed during that period.

Businesses were affected by the specific price changes of the products with which they were dealing; changes that bore little relationship to a general price index like the CPI. It therefore made little practical sense to introduce CPI-based adjustments. Eventually, with inflation abating in the UK and US, the use of CPI-adjusted numbers was abandoned.

1986   FAS 89 made voluntary.

The US FASB issued FAS 33 Financial Reporting and Changing Prices in 1979 which was superseded by FAS 89 Financial Reporting and Changing Prices in 1986, the application of which was made voluntary.

David Mosso, Chairman of the US Federal Accounting Standards Advisory Board (1997-2006) and US Financial Accounting Standards Board member (1979-1986) and two other FASB members dissented to this ruling.

FAS 89 stated: “Relative to most changes in financial reporting, the changes required by Statement 33 were monumental.”  

FAS stated regarding David Mosso: “He believes that accounting for the interrelated effects of general and specific price changes is the most critical set of issues that the Board will face in this century.”

1989   The Framework (1989) and IAS 29 published

The International Accounting Standards Committee Board then authorized financial capital maintenance in units of constant purchasing power during LOW inflation and deflation in the Framework (1989). The Board also authorized IAS 29 Financial Reporting in Hyperinflationary Economies in 1989 which requires the restatement of all non-monetary items in Historical Cost and Current Cost financial statements in terms of the period end CPI during hyperinflation.

There was no split of non-monetary items in variable and constant items; all accountants believed there were only two concepts of capital, namely physical and financial capital (HCA) and measuring items in units of constant purchasing power was generally regarded as inflation-accounting: only implemented during hyperinflation.

1994 to 1997

I went to work in Angola´s hyperinflationary economy. In 1996 I implemented accounting-dollarization in the company where I worked in Angola and I started my research regarding changing prices in financial reporting. It started as simply explaining how I accounting-dollarized our company´s operations during hyperinflation. The project then changed completely over the next 16 years of researching the effect of the stable measuring unit assumption in the economy.

2005 Non-monetary items split

By 2005 I identified and defined the split of non-monetary items in variable real value non-monetary items and constant real value non-monetary items.

Dr. Cemal Kucuksozen, Head of the Turkish International Accounting Standards Department in 2005 read that year´s version of the project and stated publicly:

“Theoretically I totally agree with you."

2007  Blog started plus Accounting SA article published

I started my blog Constant Item Purchasing Power Accounting on which I published all my work on this topic in 2007.

The South African Institute of Chartered Accountant´s journal Accounting SA published my article Financial Statements, Inflation and the Audit Report in September, 2007. The article was peer reviewed by Chartered Accountants three times due to delays in publication. The terms variable real value non-monetary item and constant real value non-monetary item were first published in this article.

2008

By 2008 I identified the fact that there are not just two, but, three concepts of capital and capital maintenance already authorized in IFRS.

2010

In 2010 Prof Rachel Baskerville, Associate Professor, School of Accounting and Commercial Law at the Victoria University in Wellington, New Zealand, changed her publication 100 Questions (and Answers) about IFRS on the Social Science Research Network to confirm that there are there concepts of capital maintenance authorized in IFRS after I pointed it out to her. Prof Baskerville discussed this with her colleague Prof Kevin Simpkins. He is the current Chairman of the New Zealand Accounting Standards Review Board. She then also pointed her readers to my SA blog and added this conclusion: “There is much to be gained from moving away from reporting on the basis Financial Capital Maintenance in Nominal Monetary Units."

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

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.