Inflation accounting

Inflation accounting

Financial capital maintenance in units of constant purchasing power as authorized in the original Framework (1989), Par. 104 (a) as an alternative to financial capital maintenance in nominal monetary units during low inflation and deflation is not an inflation accounting model. The IASB´s inflation accounting model is specifically defined in IAS 29 Financial Reporting in Hyperinflationary Economies.

An inflation accounting model is generaly understood to be an accounting model specifically implemented only during very high inflation and hyperinflation. According to the IASB hyperinflation is cumulative inflation over three years approaching or exceeding 100 per cent, i.e., 26 per cent annual inflation for three years in a row. Under CIPPA financial capital maintenance in units of constant purchasing power is implemented at all levels of inflation and deflation, including during hyperinflation. Financial capital maintenance in units of constant purchasing power is the IASB-authorized alternative to financial capital maintenance in nominal monetary units at all non-hyperinflationary levels, i.e., the alternative to the traditional HCA model which is not an inflation accounting model.

The IASB´s inflation accounting model defined in IAS 29 is a failed inflation accounting model. The IASB even admitted that it was impossible to implement IAS 29 during the final severe hyperinflation in Zimbabwe. It was implemented during hyperinflation in Zimbabwe and had absolutely no effect on the economic conditions in that country during hyperinflation.

Brazil, on the other hand, very successfully implemented inflation accounting during 30 years from 1964 to 1994 by indexing non-monetary items in the economy in terms of a daily index supplied by the various governments during that period. This very successful use of inflation accounting in terms of a daily index was apparently completely ignored by the IASB in the formulation of IAS 29 in 1989. IAS 29 simply requires the restatement of HC or CC period-end financial statements in terms of the monthly published CPI.

Constant Purchasing Power Accounting (CPPA) is an inflation accounting model.

‘Constant Purchasing Power Accounting (CPP) is a consistent method of indexing accounts by means of a general index which reflects changes in the purchasing power of money.  It therefore attempts to deal with the inflation problem in the sense in which this is popularly understood, as a decline in the value of the currency. It attempts to deal with this problem by converting all of the currency unit measurement in accounts into units at a common date by means of the index.’

(Whittington, 1983: )

The CIPPA model under which only constant items (not variable items) are measured in units of constant purchasing power by applying the Daily Consumer Price Index at all levels of inflation and deflation is not an inflation accounting model although it is also to be implemented during hyperinflation. Variable items are not simply indexed daily in terms of a Daily CPI during non-hyperinflationary periods under CIPPA. They are valued daily in terms of IFRS, excluding the stable measuring unit assumption, and only updated daily in terms of the Daily CPI when they are not valued daily in terms of IFRS.

Under the stable measuring unit assumption it is considered that changes in the purchasing power of money are not sufficiently important to require financial capital maintenance in units of constant purchasing power – normally during low inflation and deflation.

Most entities in low inflationary and deflationary economies implement the Historical Cost Accounting model under which the stable measuring unit assumption is implemented. This means that all balance sheet constant items (e.g., owners´ equity, trade debtors, trade creditors, provisions, other non–monetary payables, other non–monetary receivables, etc.) and most (not all) income statement items are measured at their historical cost, i.e., financial capital maintenance is measured in nominal monetary units as authorized in IFRS. Some income statement items, e.g., salaries, wages, rentals, etc. are measured annually in units of constant purchasing power in terms of the annual CPI, but, are then paid on a monthly basis implementing the stable measuring unit assumption under HCA. It is impossible to maintain the real value of financial capital constant with financial capital maintenance in nominal monetary units per se during low and high inflation, deflation and hyperinflation. Financial capital maintenance in nominal monetary units during inflation and deflation, although authorized in IFRS, is still a popular accounting fallacy not yet extinct.

Valid inflation accounting, i.e., the use of an accounting model to automatically stop the erosion of real value in all non–monetary items (variable and constant items) in all entities that at least break even in real value during hyperinflation – ceteris paribus, is only possible with financial capital maintenance in units of constant purchasing power in terms of a daily non–monetary index or relatively stable daily hard currency parallel rate (not the monthly published CPI) to the valuation of (not the ‘restatement of’ period–end Historical Cost or Current Cost financial statements) all non–monetary items during hyperinflation.

This can be stated differently as follows: Only inflation accounting based on daily indexing of all non–monetary items in terms of a daily index or daily parallel rate automatically maintains the real value of all non–monetary items in all entities that at least break even in real value during hyperinflation – ceteris paribus; i.e., maintains the real or non–monetary economy stable during hyperinflation in the monetary unit.

The best example of successful inflation accounting was the use in Brazil of a daily government–supplied non–monetary index to index all non–monetary items daily during the 30 years of very high and hyperinflation in that country from 1964 to 1994.

The IFRS response to the erosion of real value in non–monetary items caused by the implementation of the HCA model, i.e., the implementation of the stable measuring unit assumption, during hyperinflation is IAS 29. IAS 29 requires entities operating in hyperinflationary economies, not to value or measure all non–monetary items in terms of a daily non–monetary index or a daily parallel rate, but to simply restate Historical Cost or Current Cost period–end financial statements in terms of the period–end monthly published CPI.

‘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)

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.’

(PricewaterhouseCoopers, 2006: 5)

The best example of the failure of the implementation of IAS 29 to have any effect at all on a hyperinflationary economy was its application, as required by the IASB, by listed companies on the Zimbabwean Stock Exchange during hyperinflation. The Zimbabwean real or non–monetary economy imploded in tandem with Zimbabwe´s monetary unit and monetary economy despite the implementation of IAS 29. The IASB actually officially admitted that it was impossible to implement IAS 29 during severe hyperinflation in Zimbabwe.

However, a daily relatively stable parallel rate was available till the last day of hyperinflation in Zimbabwe, which officially ended on 20 November 2008, when Gideon Gono, the governor of the Reserve Bank of Zimbabwe issued regulations that closed down the ZSE which stopped the daily Old Mutual Implied Rate (OMIR) being available in Zimbabwe. The (normally unofficial) parallel rate – usually the US Dollar parallel rate – is an excellent, not a perfect, substitute for a daily non–monetary index in a hyperinflationary economy. The US Dollar parallel rate was available 24/7, 365 days a year during Zimbabwe´s hyperinflation. Right at the end, during severe hyperinflation when the CPI was not being published any more and it was impossible to implement IAS 29, the OMIR was still available on a daily basis.

IAS 29 is fundamentally flawed by simply requiring the restatement of HC or CC period–end financial statements in terms of the period–end CPI instead of daily valuation / measurement of all non–monetary items in terms of a daily Brazilian–style Unidade Real de Valor index or parallel rate.

A number of entities are requesting a fundamental review of IAS 29 (2011). See  IFRS ´X’ Capital Maintenance in Units of Constant Purchasing Power.

Nicolaas Smith

Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Money versus real value

Money versus real value

In practice, money has a specific real value for one day at a time in an internal economy or monetary union during low inflation and deflation. It changes every time the Daily CPI changes. A monetary note or monetary coin has its nominal value permanently printed on it. Its nominal value does not and now (2012) cannot change.

National monetary units are mostly created in economies subject to inflation. The Japanese economy is sometimes in a state of deflation. The Japanese Yen, all monetary items and all constant items measured in fixed nominal monetary units (all items in owners´ equity, trade debtors, trade creditors, all non-monetary payables, all non-monetary receivables, provisions, fixed salaries, fixed pensions, fixed rentals, fixed wages, etc.) increase in real value inside the Japanese economy during deflation.

Money refers to a monetary unit used within the economy or monetary union in which it is created. This does not refer to the foreign exchange value of a monetary unit which is not the subject of this book. The foreign exchange value of a monetary unit refers to its exchange value in relation to another monetary unit normally the monetary unit of another country or monetary union.

The real value of a monetary unit would remain the same over time only at sustainable zero per cent annual inflation. Money would thus have an absolutely stable real value only at sustainable zero per cent annual inflation. This has never happened on a permanent basis in any economy in the past. Now and then countries achieve zero annual inflation for a month or two at a time. But never for a sustainable period of a year or more.

Real value is the most important fundamental economic concept although it is the lesser studied and understood compared to the study of money. Money and real value are, unfortunately, not one and the same thing during inflation and deflation. Money and other monetary items generally have lower real values during inflation and higher real values during deflation. Money and other monetary items inflation-adjusted daily have constant real values over time. Chile inflation-adjusts 20 to 25 per cent of its broad M3 money supply daily in terms of the Unidad de Fomento which is a monetized daily indexed unit of account (2011).

Money is an invention. Its existence can be terminated while real value is a fundamental economic concept, which exists, while we exist. The Zimbabwe Dollar´s existence was terminated on 20 November, 2008 when Gideon Gono, the Governor of the Reserve Bank of Zimbabwe issued instructions to shut down the activities of the Zimbabwe Stock Exchange which resulted in the end of trading in Old Mutual shares on the ZSE. This stopped the last exchangeability of the ZimDollar with the British Pound since the Old Mutual Implied Rate (OMIR) was being used as an implied exchange rate between the two currencies. That stopped the existence of the ZimDollar. No exchangeability with any foreign currency means no value for a monetary unit.

Economies have already functioned without money. Barter economies operated without a medium of exchange. Cuba in the past bought oil from Venezuela and paid part in money and part by the provision of the services of sports coaches and medical doctors. Corn farmers in Argentina stored their corn in silos and paid for new pick–up trucks and other expensive mechanized farm implements with quantities of corn – the unit of real value Adam Smith described as a very stable unit of real value.

There will always be real value while the human race exists. The need for a medium of exchange, which is money’s first and basic function, is equally true. Money is one of the greatest human inventions of all time. It ranks on par with the invention of the wheel and the Gutenberg press in terms of importance to human development. Without money modern human development would have been slower. 

Nicolaas Smith

Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.

The second enemy

The second enemy

There are two processes of systemic real value erosion in the economy although almost everybody thinks there is only one economic enemy. The one enemy is very well known. It is inflation. Inflation manifests itself in money´s store of value function and only erodes the real value of money and other monetary items in the monetary economy (the money supply). Inflation is the enemy in only the monetary economy and the governor of the central bank is the enemy of inflation.

Inflation has no effect on the real value of non–monetary items.

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

(Gucenme and Arsoy, 2005)

Inflation cannot erode the real value of variable real value non–monetary items or constant real value non–monetary items.  It is impossible. Inflation eroded the real value of money and other monetary items only in the SA monetary economy at the rate of 6 per cent per annum (March, 2012). The actual amount of value eroded in the real value of Rand notes and coins and other monetary items (capital amounts of capital and money market investments, bank loans, other monetary loans and deposits, etc.) over the twelve months to the end of March, 2012 amounted to about R132 billion.

The second process of systemic real value erosion – the second enemy – is a Generally Accepted Accounting Practice (GAAP), namely the stable measuring unit assumption: the unknowing, unintentional and unnecessary erosion by the stable measuring unit assumption (the HCA model) of the existing constant real value of only constant items never maintained constant only in the constant item economy.

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

(Walgenbach, Dittrich and Hanson, 1973: p. 429)

Increases in the general price level (inflation) erode the real value of only money and other monetary items with an underlying monetary nature (e.g., loans and bonds) only in the internal monetary economy. Inflation has no effect on the real value of variable items (e.g., land, buildings, goods, commodities, cars, gold, real estate, inventories, finished goods, foreign exchange, etc.) and constant items (e.g., issued share capital, retained profits, capital reserves, other shareholder equity items, salaries, wages, rentals, pensions, trade debtors, trade creditors, taxes payable, taxes receivable, deferred tax assets, deferred tax liabilities, etc.).

Entities generally choose the traditional HCA model which includes the stable measuring unit assumption during inflation and deflation.  They value constant items in nominal monetary units; i.e., they choose to measure financial capital maintenance in nominal monetary units which is a popular accounting fallacy authorized in IFRS. In fact, it is impossible to maintain the constant purchasing power of financial capital constant in nominal monetary units per se during inflation. Entities´ choice of implementing financial capital maintenance in nominal monetary units instead of in units of constant purchasing power, also authorized in IFRS, results in the real values of constant items never maintained constant being eroded by the stable measuring unit assumption at a rate equal to the annual rate of inflation.

It is not inflation doing the eroding as the IASB, the FASB and most people mistakenly believed. It is entities´ free choice of the very erosive stable measuring unit assumption during inflation as it forms part of the Historical Cost Accounting model – authorized in IFRS in the original Framework (1989), Par. 104 (a).

Entities would knowingly maintain the real value of all constant items constant for an indefinite period of time when they at least break even in real value – ceteris paribus – when they reject the stable measuring unit assumption and implement financial capital maintenance in units of constant purchasing power at all levels of inflation and deflation (CIPPA). The stable measuring unit assumption is, in principle, never implemented under financial capital maintenance in units of constant purchasing power (CIPPA).

Constant items never maintained constant are treated like monetary items when their nominal values are never updated as a result of the implementation of the stable measuring unit assumption during inflation and deflation.

In practice, it is assumed that the unit of measure (money) is perfectly stable during low inflation and deflation; that is, it is assumed that changes in money´s general purchasing power are not sufficiently important to require financial capital maintenance in units of constant purchasing power during inflation and deflation. In so doing, the implementation of the HCA model unknowingly, unintentionally and unnecessarily erodes the real values of constant items never maintained constant during low inflation to the amount of hundreds of billions of US Dollars in the world´s constant item economy each and every year while the stable measuring unit assumption is being implemented as part of the traditional HCA model.

The stable measuring unit assumption is a stealth enemy very effectively camouflaged by GAAP, IASB and FASB authorization as well as the generally accepted accounting fallacy that the erosion of companies´ capital and profits is caused by inflation. Hardly anyone knows or understands that when the very erosive stable measuring unit assumption is implemented, the HCA model is unknowingly, unintentionally and unnecessarily eroding the real values of constant items never maintained constant at a rate equal to the annual rate of inflation.

Almost everybody thinks the accounting profession can do nothing about it. They still believe that inflation is doing the eroding and financial reporting can do nothing about inflation: the monetary authorities, not the accounting profession, are responsible for controlling inflation. They do not realize that it is the very erosive stable measuring unit assumption doing the eroding in the real value of constant items never maintained constant during inflation.

There are thus two enemies eroding real value systematically in the economy. The first enemy, inflation, is a complex economic process. The second enemy, the stable measuring unit assumption, is a Generally Accepted Accounting Practice authorized in IFRS and US GAAP under the current Historical Cost paradigm.

This Generally Accepted Accounting Practice of systemic real value erosion operates only in the constant item part of the non–monetary or real economy when it is freely chosen to measure financial capital maintenance in nominal monetary units when entities implement the traditional HCA model during inflation as approved in IFRS in the original Framework (1989), Par. 104 (a).

Almost everyone makes the mistake of blaming the erosion of companies´ profits and capital by the stable measuring unit assumption on inflation.

The problem is known and identified: namely, the real value of companies´ profits and capital is being eroded over time when implementing the HCA model during inflation. The mistake is made of blaming inflation instead of the free choice of the stable measuring unit assumption. It is impossible for inflation to erode the real value of any non–monetary item. Companies´ issued share capital and retained profits (as well as all other items in owners´ equity) are constant real value non–monetary items. This erosion is very effectively camouflaged by IFRS approval in the original 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 stable measuring unit assumption is a stealth enemy in the constant item economy maybe wreaking more havoc than inflation in the monetary economy. The stable measuring unit assumption as authorized in IFRS and US GAAP - its convenient cover.

The US Financial Accounting Standards Board blamed inflation:

‘Conventional accounting measurements fail to capture the erosion of business profits and invested capital caused by inflation.’

(FAS 33, Par. 69)

Almost veryone only sees one enemy being responsible for all of the invisible and untouchable systemic real value erosion in the economy. It is mistakenly thought that inflation is responsible for all real value erosion in the economy. It is mistakenly thought that the cost of the stable measuring unit assumption - the erosion by the stable measuring unit assumption of the real value of constant items never maintained constant - is the same as the net monetary loss from holding an excess of monetary items assets over monetary item liabilities, i.e., the cost of inflation.

This second enemy is a stealth enemy almost perfectly camouflaged by IFRS and FASB approval since the way it operates is not generally understood. If it were understood, it would have been stopped by now (2012) with financial capital maintenance in units of constant purchasing power as authorized in IFRS in 1989.

Nicolaas Smith

Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.

'Price stability'

'Price stability'

When we discuss, write about, talk about or analyse this monetary item described above, we call it money and describe it using the term money with the implicit assumption that this money we are dealing with is stable – as in fixed – in real economic value in our low inflationary economies. We thus assume at the same time that prices are more or less stable in low inflationary economies too.

The term stable is generally accepted by the public at large to indicate a permanently fixed situation or position or state or price or value. A stable – as in fixed – price over time would be represented as a horizontal line on a chart.  A slowly increasing price over time would be drawn as a slightly rising line on a chart. A slowly decreasing value over time would be drawn as a slightly declining line on a chart. When we say production of a commodity is stable we accept that the absolute number of items being produced is not fluctuating but is the same all the time.

The term ‘price stability’ as used by economists, however, does not mean a fixed price or level, even though that is what the public in general thinks it means. The term stable in economics today means slowly increasing or slowly decreasing – depending on what it is being applied to. The term price stability as used by economists today does not mean that prices in general stay the same, but that prices in general are rising slowly, which is, as we are all taught, the popular definition of inflation.

The term stable money as used by economists equally does not mean that the real value of national monetary units they are talking about stays the same in the internal economy – even though that is what the public in general thinks it means. What they mean with stable money is that the real value of a national monetary unit is slowly being eroded by inflation over time in the internal economy.

When a central bank governor says that the central bank’s primary task or objective is price stability what she or he means is that the central bank would be fulfilling its primary task, in an economy with low levels of inflation, when prices in general are slowly rising over time, that well known definition of inflation again. The flip side of that statement is that the real value of national monetary units is slowly being eroded by inflation over time.

A central bank’s primary task being price stability is the same as saying a central bank’s main responsibility is ensuring that inflation is maintained at a very low level. This low level was generally accepted in first world economies to be two per cent per annum. The sub–prime mortgage crisis (2008) raised doubts about the two per cent level being sufficient in the event of large shocks to the economy.

‘In a world of small shocks, 2 per cent inflation seemed to provide a sufficient cushion to make the zero lower bound unimportant.’

‘Should policymakers therefore aim for a higher target inflation rate in normal times,

in order to increase the room for monetary policy to react to such shocks? To be concrete, are the net costs of inflation much higher at, say, 4 per cent than at 2 per cent, the current target range?’ 

(Blanchard, Dell´Ariccia and Mauro, 2010:  4 and 11)

The maintenance of a high degree of price stability generally (still) means that the primary task of a central bank in a first world economy is to limit the erosion of real value in money and other monetary items by inflation to a maximum of two per cent per annum within an economy or monetary union. Continuous two per cent annual inflation erodes two per cent of the real value of money and other monetary items per annum; i.e., 51 per cent over 35 years. Under the current Historical Cost paradigm it also means that the implementation of the very erosive stable measuring unit assumption as it forms part of the traditional HCA model unknowingly, unintentionally and unnecessarily erodes two per cent per annum of the real value of constant real value non–monetary items never maintained constant. This erosion by the HCA model is eliminated completely when it is freely chosen to measure financial capital maintenance in units of constant purchasing power during inflation (CIPPA).

Nicolaas Smith

Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.

CIPPA equals automatic zero erosion in the constant item economy

CIPPA equals automatic zero erosion in the constant item economy

We do not have stable – as in fixed real value – money. The real value of money is generally accepted by the public at large to be stable – as in fixed – in low inflation economies, but this is not true. The belief that we have stable – as in fixed real value – money is an illusion, namely the notorious money illusion.

Central banks and monetary authorities have monetary policies that often create the impression that money is stable in real economic value. They implement monetary policies that include the tolerance of low inflation limits of up to two per cent per annum. Then they assure everybody that ‘price stability’ is guaranteed and assured. The public at large mistakenly assume that this means stable – as in fixed – prices. We regularly read in inflation reports that low inflation targets have been met and that ‘price stability’ is assured.

‘The primary objective of monetary policy in South Africa is to achieve and maintain price stability in the interest of sustainable and balanced economic development and growth. Price stability reduces uncertainty in the economy and, therefore, provides a favourable environment for growth and employment creation.’

South African Reserve Bank

In a low inflationary economy this appears to be true. But in reality it is not true. Yes, money illusion makes us believe that our depreciating money maintains its real value stable, while it actually halves in real value over 35 years with constant two per cent per annum inflation – the generally accepted level of ‘price stability.’ All currently existing bank notes and coins will eventually arrive at a point of being completely worthless in real value during indefinite inflation. How quickly depends on the level of inflation.

Table 2

                               Real Value Table

            Per cent of Today’s Real Value Eroded

                                                                   Hyperinflation*

Annual Inflation     2%        6%        10%        26%

                   Years       %         %          %           %

                     5           10          27          41          78

                    10          18          46          65          95

                    16          28          63          84          99

                    20          33          71          88

                    30          45          84          96

                    35          51          89          98

                    44          59          93          99

                    75          78          99

                  114          90

                  228          99

*Cumulative inflation over three years equals or is more than 100 per cent: for example, inflation at 26 per cent per annum for three years in a row.

In Zimbabwe hyperinflation reached such high levels that the real value of the country’s entire money supply was wiped out when the ZimDollar had no exchangeability with any foreign currency in November 2008.  Towards the end of the hyperinflationary spiral the real value of the ZimDollar halved every 24.7 hours according to Steve Hanke from Cato Institute. There is no money illusion in hyperinflationary economies. People know that hyperinflation erodes the real value of their money very quickly.

Central bank governors aid and abet money illusion by regularly stating in their monetary policy statements that they are ‘achieving and maintaining price stability.’

‘The MPC remains fully committed to its mandate of achieving and maintaining price stability.’

(Mboweni, 2009)

It is not regularly pointed out by governors of central banks that the ‘price stability’ they mention, refers to their particular definition of ‘price stability’. Jean–Claude Trichet, the ex-President of the European Central Bank, was a central bank governor who regularly mentioned that two per cent inflation was their definition of price stability. Absolute price stability is a year–on–year increase in the Consumer Price Index of zero per cent. The SARB´s definition of ‘price stability’ ‘is for CPI inflation to be within the target range of 3 to 6 per cent on a continuous basis.’

The SARB would aid in reducing money illusion in the SA economy by stating:

The MPC remains fully committed to its mandate of achieving and maintaining the SARB´s chosen level of price stability which is for CPI inflation to be within the target range of 3 to 6 per cent per annum on a continuous basis. Absolute price stability is a year–on–year increase in the CPI of zero per cent. Current 6 per cent annual inflation eroded 6 per cent of the real value of every Rand and in total about R132 billion of the real value of the Rand money supply over the past 12 months to the end of March, 2012.

It has to be remembered that the stable measuring unit assumption (not inflation) as implemented as part of the traditional Historical Cost Accounting model used by South African companies unnecessarily eroded an additional about Rand 100 billion of the real value of constant items never maintained constant in SA companies at a rate equal to the 6 per cent (March, 2012) annual inflation rate.

A one per cent decrease in inflation (disinflation) would maintain about R22 billion per annum of real value only in the SA monetary economy as a result of the decrease in the level of inflation. At the same time, an additional R20 billion would be maintained in the SA constant item economy as a result of the reduction in the level of erosion by the traditional HCA model in the real value of constant items never maintained constant in consequence of the implementation of the stable measuring unit assumption; i.e. financial capital maintenance in nominal monetary units during low inflation in South Africa.

All that has to be done to completely stop this erosion of constant items by the stable measuring unit assumption is for all entities to freely change over to IFRS–approved financial capital maintenance in units of constant purchasing power during low inflation (CIPPA) in terms of a Daily CPI and the SA real economy would automatically be boosted by about R100 billion per annum for an indefinite period of time as long as the SARB maintains its chosen level of price stability at 6 per cent inflation per annum. This would require complete co-ordination although any individual company can start any time it wants since it was authorized in IFRS in 1989.

The SA economy would continue to suffer the erosion of R132 billion of the real value of the Rand money supply per annum – ceteris paribus – but would be boosted by the maintenance of about R100 billion per annum in the constant item economy for an indefinite period of time at continuous 6 per cent inflation when everybody is SA change over to financial capital maintenance in units of constant purchasing power (CIPPA).

The SA economy would be boosted by a further R132 billion per annum for an indefinite period of time at continuous 6 per cent inflation when SA inflation-adjusts the entire money supply.

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)

All SA entities changing over to CIPPA would mean automatic zero erosion of constant items´ real values for an indefinite period of time in the SA economy in all entities that at least break even during inflation and deflation – ceteris paribus. The same principle applies to all other economies.

Gill Marcus, the current (2012) governor of the SARB, would have to bring inflation down to zero per cent per annum on a permanent basis to have the same effect in the constant item economy. Financial capital maintenance in units of constant purchasing power (CIPPA) in terms of a Daily CPI would do this automatically at any level of inflation or deflation. Zero per cent inflation is not currently advisable in the monetary economy because governments and central banks still do not know how to run an economy at sustainable zero per cent annual inflation. It is relatively easy to automatically run the constant item economy in any country or monetary union at sustainable zero per cent erosion in constant items for an indefinite period of time: just choose the other option: real value maintaining financial capital maintenance in units of constant purchasing power (CIPPA). It is compliant with IFRS and has been authorized by the IASB in 1989.

Financial capital maintenance in units of constant purchasing power (CIPPA) is a basic accounting model that results in the automatic maintenance – without additional capital contributions or extra retained profits – of the real value of constant real value non–monetary items in the constant item economy for an unlimited period of time in all companies that at least break even in real value during inflation and deflation – ceteris paribus. The principle applies when any economy changes over to financial capital maintenance in units of constant purchasing power (CIPPA).

Nicolaas Smith

Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Items with an underlying monetary nature

Items with an underlying monetary nature

Utility, scarcity and exchangeability are the three basic attributes of an economic item which, in combination, give it economic value. All economic items are exchangeable and money is generally the generally accepted medium of exchange. All economic items thus have monetary values in an economy using money as the monetary unit of account. Both monetary items and non–monetary items are expressed in monetary terms; i.e., in terms of the monetary unit of account. The monetary unit is used as the unstable medium of exchange, unstable unit of account and unstable store of value. Variable real value non–monetary items, constant real value non–monetary items and monetary items are all expressed in terms of money and have monetary values.

There is, however, a difference between having a monetary value and being a monetary item. All economic items have monetary values, but, only money and items with an underlying monetary nature which are substitutes for money held are monetary items. Non–monetary items have monetary values: they have their economic values expressed in terms of money, but they are not monetary items.

Houses, cars, mobile phones, raw material, etc. have monetary values, but they are not monetary items. They are variable real value non–monetary items whose real values are expressed in terms of depreciating or appreciating money depending on whether the economy is in a state of inflation or deflation.

Likewise salaries, wages, rentals, pensions, interest, taxes, retained earnings, issued share capital, capital reserves, all other shareholder equity items, trade debtors, trade creditors, deferred tax assets and liabilities, taxes payable and receivable, etc. have depreciating or appreciating monetary values, but they are not monetary items. They are constant real value non–monetary items whose constant real non–monetary values are expressed in terms of depreciating or appreciating money. Constant real value non–monetary items´ real values are maintained constant with financial capital maintenance in units of purchasing power during inflation and deflation, i.e., with Constant Item Purchasing Power Accounting or with measurement in units of constant purchasing power.

Examples of items with an underlying monetary nature

Money loans

Mortgage bonds

Government Bonds

Commercial Bonds

Treasury Bills

Consumer loans

Bank loans

Car loans

Student loans

Credit card loans

They are monetary items lent or borrowed, normally payable or receivable in money.   Variable and constant items to be paid or received in money remain variable and constant items. Money is simply the monetary medium of exchange used to transfer the ownership of a variable item or constant item from one entity to another.

Items with an underlying monetary nature have exactly the same attributes as money held with the exception that they are not bank notes and coins.

Nicolaas Smith

Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Trade debtors and creditors are not monetary items

Trade debtors and creditors are not monetary items

Monetary items are defined incorrectly in IAS 21 The Effects of Changes in Foreign Exchange Rates, Par. 8:




‘Monetary items are units of currency held and assets and liabilities to be received or paid in a fixed or determinable number of units of currency.’



The capital amounts of all capital inflation-indexed bonds are monetary items. However, they are non-monetary items according to the above definition because they are not to be paid or received in a fixed or determinable number of units of currency during inflation. No-one can determine the final nominal payback value of a capital inflation-indexed bond during inflation at the date of issue. TIPS and other sovereign inflation-indexed bonds with a guarantee of a capital payback at least equal to the original nominal principal value if it should be lower than the issuance amount due to deflation, are thus monetary items only during deflation according to the IASB´s definition in IAS 21, Par. 8. The capital amounts of inflation-linked bonds are obviously not non-monetary items during inflation no matter that they could be defined as such according to the IASB: they are always and everywhere monetary items because they are items with an underlying monetary nature. They are substitutes for local currency held during inflation and deflation.



Not all assets and liabilities to be received or paid in a fixed or determinable number of units of currency are monetary items – per se. Non–monetary items are often paid in a fixed or determinable number of units of currency. Fixed salary, wage and rental payments do not transform these constant real value non–monetary items into monetary items. Salaries, wages, rentals, etc. are constant real value non–monetary items. They are not monetary items. They are simply paid in money as the generally accepted mutually agreed medium of exchange. They are, however, sometimes paid in a fixed or determinable number of units of currency because they are measured in nominal monetary units under the current Historical Cost paradigm under which the stable measuring unit assumption is implemented during inflation and deflation (and often even during hyperinflation). This does not transform them into monetary items simply because they are paid in fixed nominal historical cost values. They remain constant real value non–monetary items.



Trade debtors and trade creditors are defined incorrectly by the FASB and by PricewaterhouseCoopers (amongst most probably all others except (1) in Chile, (2) during hyperinflation in Brazil and (3) during 1995-7 in Auto-Sueco (Angola) where I worked) to be monetary items. Trade debtors and trade creditors are items with an underlying non-monetary nature; e.g., finished goods, stock, raw materials, plant, equipment, services rendered, etc. They are constant real value non–monetary items.



I posed the question whether trade debtors and trade creditors are monetary or non-monetary items in 2007 to Dr Gustavo Franco, former governor of Brazil’s Central Bank in 1997-99. He was one of the architects of the Unidade Real de Valor by which Brazil finally conquered hyperinflation in 1994.



I asked him: ‘> Were trade debtors and trade creditors treated as monetary items under the URV and not updated or were they treated as non-monetary items an updated in terms of the URV?

>

> What are trade debtors and trade creditors in your opinion? Are they monetary or non-monetary items?’



He replied:



‘Two observations are in order. First, for spot transactions the existence of the URV is imaterial, sums of means of payment are surrendered in exchange for goods, all delivered and liquidated on spot. Second, the unit of account enteres the picture only when at least one leg of a commercial transaction is defferred. In this case, the URV serves the purpose of defining the price at the day of the contract. The same quantity of URVs are to be paid at the payment day, though this should represent larger quantities of whatever means of payment is used.



It was essentil, in the Brazilian case, and this may be a general case, that the URV was defined as part of the monetary system. It has a lot to do with jurisprudence regarding monetary correction; URV denomiated obligation had to be treated as if they were obligations subject to monetary correction. In the URV law it was defined that the URV would be issued, in the form of notes, and when this would happen, the URV would have its name changed to Real, and the other currency, the old, the Cruzeiro, was demonetized.’



(Franco, 2007)



It is clear from Dr Franco´s reply that trade debtors and trade creditors are non-monetary items that have to be measured in units of constant purchasing power during inflation.



In principle, all fixed payments over time under HCA are regarded as monetary items because of the implementation of stable measuring unit assumption. When it is assumed, in practice, that money is perfectly stable during low and high inflation and deflation, then the classification of an item between being a monetary or non-monetary item depends on whether it is paid or received in a fixed nominal amount over time or not. Fixed payments are then assumed to be monetary items under HCA. In reality they may not be.



The stable measuring unit assumption means that changes in the purchasing power of money are regarded as not sufficiently important to require financial capital maintenance in units of constant purchasing power during low inflation and deflation. In practice the stable measuring unit assumption means that the real value of money is assumed to be perfectly stable during low and high inflation and deflation. The stable measuring unit assumption is simply an economic and accounting assumption. It is not based on fact. The fact is that the real value of money is never perfectly stable under inflation and deflation. The stable measuring unit assumption is thus based on a fallacy, namely the fallacy that money is stable in real value during low inflation and deflation. A fact will always eventually prevail over an assumption regarding that fact.



Trade debtors and trade creditors are constant real value non–monetary items but are treated like monetary items under the Historical Cost paradigm. Brazil measured trade debtors and trade creditors in units of constant purchasing power in terms of a daily index value during 30 years of very high inflation and hyperinflation.



I measured all trade debtors in units of constant purchasing power in terms of the daily US Dollar parallel rate in Auto–Sueco (Angola) in 1996. All our trade debtors accepted that and paid the updated amounts in Angolan Kwanzas. They knew that the underlying nature of their debt to us was non-monetary, namely, the new spare parts that were installed in their trucks in our workshops and the services of our mechanics installing those parts and servicing their trucks.



Trade debtors and trade creditors are incorrectly treated as monetary items in practice in terms of IAS 29 Financial Reporting in Hyperinflationary Economies. All calculations done since 1989 in terms of IAS 29 of net monetary losses and gains as well as profit / loss calculations are thus, in principle, wrong.


Nicolaas Smith

Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.