1.0 Three basic economic items
The economy consists of economic items and economic entities. Economic items have economic value. Accountants value economic items when they account them. Utility, scarcity and exchangeability are the three basic attributes of an economic item which, in combination, give it economic value. Economic items consist of monetary and non-monetary items. The economy is divided in the monetary and non-monetary or real economy. Non-monetary items are sub-divided in variable real value non-monetary items and constant real value non-monetary items. The three fundamentally different basic economic items in the economy are monetary items, variable items and constant items.
Variable real value non-monetary items
Variable items are non-monetary items with variable real values normally traded in markets.
Examples of variable items in today’s economy are property, plant, equipment, inventory, quoted and unquoted shares, raw materials, finished goods, patents, trademarks, foreign exchange, etc.
There are markets for all the above items. All the above items can be bought or sold in a myriad of different markets world wide.
The first economic items were variable real value items. Their real values were determined by supply and demand. Their values were not yet expressed in terms of money because money was not yet invented at that time.
The first economies were barter economies. People bartered economic items they possessed or produced in excess of their own personal needs for other products they desired from other people who had an excess of the products they in turn possessed or produced or wished to exchange.
There was no inflation because there was no money. There was no monetary medium of exchange. There was no monetary unit of account. There was no monetary store of wealth. There was no money illusion.
There was no double entry accounting model at that time.
There were no Historical Cost Accounting model, no stable measuring unit assumption, no historical cost items and no nominal monetary units.
There was no value based accounting.
There was also no Consumer Price Index at that time. Consequently there were no units of constant purchasing power and no price-level accounting. There was no inflation accounting. There was no Constant Purchasing Power Accounting model under which all non-monetary items (variable and constant items) are inflation-adjusted by means of the CPI during hyperinflation.
There was also no Constant Item Purchasing Power Accounting under which only constant items are inflation-adjusted by means of the CPI during non-hyperinflationary periods in order to implement a financial capital concept of invested purchasing power by measuring financial capital maintenance in units of constant purchasing power and determining profit/loss in constant purchasing power units while variable items are valued in terms of specific rules at, for example, market value, fair value, present value, recoverable value or net realizable value.
There were no financial reports: e.g. no income statements, no balance sheets, no cash flow statements and no statements of changes in shareholders´ equity.
There were no monetary items. There were variable real value items not yet expressed in monetary terms.
Monetary items
Money was then invented over a long period of time as a response to the limitations imposed by the barter economy. Eventually money came to fulfil the following three functions:
a. Medium of exchange
b. Store of value
c. Unit of account
Non-monetary items were only defined in monetary terms after the invention of money. The economy came to be divided in the monetary economy and the non-monetary or real economy. There were monetary items and non-monetary items.
Monetary items are money held and items with an underlying monetary nature.
Examples of monetary items in today’s economy are bank notes and coins, bank 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.
Money and other monetary items´ real values are continuously being destroyed by inflation.
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
Inflation has no effect on the real value of non-monetary items.
There were still no units of constant purchasing power because there was still no CPI at that time. There were still no HCA model and still no stable measuring unit assumption. There were still no price-level accounting, no CPP inflation accounting model and no Constant Item Purchasing Power Accounting model. There were still no financial reports.
Inflation
Inflation is always and everywhere a monetary phenomenon: Milton Friedman.
Inflation is a rise in the general price level of goods and services in an economy over a period of time. Inflation destroys the real value of money and other monetary items over time. Disinflation is a decrease in inflation’s rate of increase. Inflation still destroys the real value of money and other monetary items during disinflation, just at a slower rate than before. Deflation creates real value in money and other monetary items over time. Deflation is a sustained decrease in the general price level after it has passed below zero per cent inflation.
Inflation reared its ugly head soon after the invention of money. It only destroyed the real value of money and other monetary items at that time as it does today. Inflation did not and can not destroy or erode (which is the same as destroy) the real value of non-monetary items – either variable or constant real value non-monetary items. 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."
Prof. Dr. Ümit GUCENME, Dr. Aylin Poroy ARSOY, Changes in financial reporting in Turkey, Historical Development of Inflation Accounting 1960 - 2005, Page 9.
Changes in financial reporting in Turkey, Historical Development of Inflation Accounting 1960 - 2005
There was only one systemic economy-wide process of real value destruction at that time. The economic process of inflation destroyed the real value of money and other monetary items equally throughout the monetary economy at that time as it does today in economies subject to inflation.
There was no second systemic economy-wide HCA practice destroying the real value of constant real value non-monetary items never or not fully updated as we experience today because the real value destroying traditional HCA model, which includes the very destructive stable measuring unit assumption, was not yet invented at that time. Today South African accountants unknowingly destroy the real values of constant real value non-monetary items never or not fully updated because they generally measure financial capital maintenance in SA banks and companies in nominal monetary units. They generally implement the very destructive stable measuring unit assumption as part of the real value destroying traditional HCA model.
Accountants at Johannesburg Stock Exchange listed companies as well as accountants at unlisted SA companies who prepare financial statements in terms of International Financial Reporting Standards generally choose to measure financial capital maintenance in nominal monetary units in terms of the International Accounting Standard Board’s Framework for the Preparation and Presentation of Financial Statements, Par. 104 (a) which they apply in the absence of Standards relating to the valuation of capital, the maintenance of capital and the determination of profit or loss. The Framework, Par. 104 (a) states that financial capital maintenance can be calculated in either units of constant purchasing power or in nominal monetary units. Accountants at JSE listed companies have to prepare financial reports in terms of IFRS while accountants at unlisted SA companies can prepare financial statements either in terms of IFRS or South African Generally Accepted Accounting Practice.
Accountants preparing financial reports of SA unlisted companies in terms of SA GAAP generally also choose to measure financial capital maintenance in nominal monetary units and implement the HCA model since it is the generally accepted traditional accounting model.
Constant items
Constant items are non-monetary items with constant real values over time normally not traded in a market.
There are markets, namely stock markets, for company shares represented in the form of share certificates which are not constant items but variable real value non-monetary items, but, there is no market for the constant real value non-monetary item Issued Share Capital on a company’s balance sheet. Likewise there is no market for the specific individual constant items retained income, share premium, share discount, capital reserves or revaluation reserves, etc. There is no market for the individual constant items deferred tax assets or deferred tax liabilities. There is no market for taxes payable, taxes receivable, royalties payable, royalties receivable, etc. There is no market for trade creditors.
There is, however, a market for trade debtors when they are treated as monetary items. Trade debtors can be sold to a debt collecting company. Trade debtors are generally treated as monetary items in this case as can be seen from the IASB´s partially incorrect definition of monetary items as money held – which is correct and “items to be received or paid in money” which is incorrect. All items to be paid or received in money are not monetary items. Settlement values for most non-monetary items are to be paid or received in money.
The double entry accounting model was first comprehensively codified by the Italian Franciscan monk, Luca Pacioli in his book Summa de arithmetica, geometria, proportioni et proportionalita, published in Venice in 1494.
The Consumer Price Index allows accountants to maintain the real values of certain income statement constant items, e.g., salaries, wages, rents, etc during inflationary periods with the constant purchasing power measurement basis while they implement the overall HCA model during non-hyperinflationary periods and with the inflation accounting CPPA model during hyperinflation. Constant Purchasing Power Accounting as defined in International Accounting Standard IAS 29 Financial Reporting In Hyperinflationary Economies is an inflation accounting model where under both variable and constant real value non-monetary items are inflation-adjusted by means of the CPI during hyperinflation.
Only the Constant Item Purchasing Power Accounting model as approved by the IASB in the Framework, Par. 104 (a), enables accountants to maintain the real values of both income statement and balance sheet constant items during non-hyperinflationary periods. The Framework, Par. 104 (a) states that financial capital maintenance can be calculated in either units of constant purchasing power or in nominal monetary units. Maintaining the real value of all constant items in the SA economy where accountants use the double entry accounting model to account economic activity is only possible with the real value maintaining Constant Item Purchasing Power Accounting+ model as authorized by the IASB in the Framework, Par. 104 (a) which is read in conjunction with International Financial Reporting Standards during inflation and deflation. It is not possible, at present, while SA accountants implement the real value destroying traditional HCA model because of their application of the very destructive stable measuring unit assumption during inflation. SA accountants unknowingly destroy real value on a massive scale in the real economy during inflation.
The specific choice of measuring financial capital maintenance in units of constant purchasing power (the Constant Item Purchasing Power Accounting model) at all levels of inflation and deflation as contained in the Framework for the Preparation and Presentation of Financial Statements, was approved by the International Accounting Standards Board’s predecessor body, the International Accounting Standards Committee Board, in April 1989 for publication in July 1989 and adopted by the IASB in April 2001.
“In the absence of a Standard or an Interpretation that specifically applies to a transaction, management must use its judgement in developing and applying an accounting policy that results in information that is relevant and reliable. In making that judgement, IAS 8.11 requires management to consider the definitions, recognition criteria, and measurement concepts for assets, liabilities, income, and expenses in the Framework. This elevation of the importance of the Framework was added in the 2003 revisions to IAS 8." IAS Plus, Deloitte.
IAS8, 11: “In making the judgement, management shall refer to, and consider the applicability of, the following sources in descending order:
(a) the requirements and guidance in Standards and Interpretations dealing with similar and related issues; and
(b) the definitions, recognition criteria and measurement concepts for assets, liabilities, income and expenses in the Framework.”
There is no applicable International Financial Reporting Standard or Interpretation regarding the valuation of the constant real value non-monetary items issued share capital, retained earnings, capital reserves, share issue premium, share issue discount, all other items in Shareholders Equity, the maintenance of financial capital and the determination of profit or loss. The Framework is thus applicable. There are Standards for trade debtors, trade creditors, other non-monetary payables, other non-monetary receivables, deferred tax assets, deferred tax liabilities, taxes payable and taxes receivable. In terms of IAS8.11 the Standards take precedence over the Framework in the case of these items.
The scope of the Framework includes dealing with defining, recognizing and measuring the items in financial statements and dealing with the concepts of capital and capital maintenance.
The Framework, Par. 110 states that the choice of the measurement bases and the concept of capital maintenance will decide the accounting model applied in the preparation of the financial reports. The Framework applies to different accounting models and is a guide to the preparation and presentation of the financial reports under the chosen accounting model.
The Framework is the IASB approved basis for accountants to choose, in terms of Par. 102, to implement a financial capital concept (instead of a physical capital concept) of invested purchasing power (instead of invested money) where under they choose, in terms of Par. 104 (a), to measure financial capital maintenance in units of constant purchasing power – the Constant Item Purchasing Power Accounting model - instead of in traditional HC nominal monetary units during non-hyperinflationary periods.
In terms of the Framework Par. 110, accountants choose the Constant Item Purchasing Power Accounting model when they choose, in terms of Par. 104 (a), to measure financial capital maintenance in units of constant purchasing power during non-hyperinflationary periods. They choose to implement the constant purchasing power financial capital concept of invested purchasing power, the constant purchasing power financial capital maintenance concept and they choose to determine profit or loss in terms of units of constant purchasing power during non-hyperinflationary periods instead of the traditional HC financial capital concept of invested money and the HC financial capital maintenance concept and the HC profit or loss determination concept in nominal monetary units non-hyperinflationary periods.
The Framework, Par. 102 states that most companies choose a financial concept of capital instead of a physical capital concept. Capital is the same as the company’s shareholders´ equity or its net assets when a financial concept of capital is adopted; either in invested purchasing power or in invested money.
The maintenance of capital being shareholders´ equity or net assets is as important as its recognition and definition. Capital maintenance is an accounting practice implementing a chosen concept of capital: either physical capital maintenance or financial capital maintenance. Financial capital maintenance can be calculated in either units of constant purchasing power or in nominal monetary units. Both methods are compliant with IFRS.
The Framework states that the needs of the users of financial reports should be the basis for choosing the correct concept of capital by a company. When the users of financial reports are mainly concerned with the preservation of the purchasing power of the invested capital or its nominal value, then a financial concept of capital should be used.
According to the Framework, the choice of the measurement bases and the concept of capital maintenance will decide the accounting model applied in the preparation of the financial reports. A profit is made under the financial capital maintenance concept only when the period-end financial (or money) net asset value is greater than at the start of the period, after subtracting distributions and contributions to and from shareholders during the accounting period. Financial capital maintenance can be calculated in either units of constant purchasing power or in nominal monetary units during non-hyperinflationary periods.
The real value maintaining Constant Item Purchasing Power Accounting model is an IASB approved price-level accounting alternative to the real value destroying traditional HCA model also approved by the IASB in Par. 104 (a).
The Framework states that the capital maintenance concept deals with how companies define the capital they want to preserve. It is the link between the concept of capital and the concept of profit or loss since it gives the point of reference for calculating profit or loss.
Examples of constant real value non-monetary items in today’s economy are income statement constant items like salaries, wages, rentals, taxes, duties, fixed interest payments, all other items in the income statement as well as balance sheet constant items like retained earnings, issued share capital, capital reserves, share issue premiums, share issue discounts, provisions, capital reserves, all other shareholder’s equity items, trade debtors, trade creditors, other non-monetary debtors and creditors, taxes payable and receivable, deferred tax assets and liabilities, dividends payable and receivable, royalties payable and receivable, etc.
Saturday, 25 April 2009
Sunday, 15 March 2009
No substance in the statement that choices SA accountants make won't affect the economy.
The debate of how to account for value has been around for decades.
Robert Kemp, CPA Professor, University of Virginia
The three fundamentally different basic economic items in the economy
1. variable items
2. monetary items and
3. constant items
are economic values. Each economic item is an economic value expressed in terms of money, i.e. the functional currency. SA accountants account economic transactions involving these three economic items in an organized manner when they implement a double entry accounting model: journal entries, general ledger accounts, trial balances, cash flow statements, income and expenses in the Profit and Loss Account, assets and liabilities in the Balance Sheet plus other financial, management and costing reports.
SA accountants value economic items when they account economic activity in the accounting records and prepare financial reports of SA economic entities based on the double entry accounting model. Accounting entries are valuations of the economic items (the debit items and the credit items) being accounted.
SA accountants do not simply record economic activity. Accounting is not just a scorekeeping or recordkeeping of economic events. That concept of financial reporting has no substance. SA accountants value economic items when they account them. Subsequent accounting entries are part of generally accepted accounting practice of continuous valuation of the economic items originally valued and accounted over time as required by SA Generally Accepted Accounting Practice and IFRS implemented in conjunction with the IASB´s Framework.
The measurement basis and concept of financial capital maintenance SA accountants choose - either real value destroying traditional Historical Cost nominal monetary units (their current choice) or real value maintaining units of constant purchasing power (the CPPA model) - to value constant real value non-monetary items determine whether they unknowingly destroy or maintain their real values during low, high and hyperinflation. SA accountants are required by the IASB to implement IAS 29 Financial Reporting in Hyperinflationary Economies during hyperinflation. IAS 29 is based on the Constant Purchasing Power Accounting model. Inflation, being a uniquely monetary phenomenon, can not, by definition, destroy the real value of constant real value non-monetary items or variable real value non-monetary items. It is SA accountants’ choice of capital maintenance concept (accounting model) that determines whether they carry on currently unintentionally destroying real value in constant items never or not fully updated or maintain those values for an unlimited period of time – all else being equal.
When SA accountants apply the very destructive stable measuring unit assumption as part of the real value destroying traditional HCA model and value constant items at their HC nominal monetary values and these items are never or not fully updated or inflation-adjusted by means of the CPI over time in SA´s non-hyperinflationary environment, they unknowingly destroy their constant real non-monetary values at a rate equal to the rate of inflation. This is the case with all constant items never or not fully inflation-adjusted including the unintentional destruction by SA accountants of the real value of issued share capital in SA banks and companies which do not have variable real value non-monetary fixed property, plant and equipment that can be revalued at least equal to the updated original real value of all capital contributions under the HC paradigm.
When SA accountants choose to measure financial capital maintenance in real value maintaining units of constant purchasing power (the CPPA model) – as they can freely do in terms of the IASB´s Framework, Par. 104 (a) - they will maintain all constant item real values over time including issued share capital, whether entities have fixed property, plant and equipment to revalue or not.
When SA accountants value constant items in HC nominal monetary units – as they all currently do – they unknowingly destroy their real values at a rate equal to the inflation rate when they are never updated under the HC paradigm.
Variable Items
SA accountants value variable real value non-monetary items in terms of IFRS or SA GAAP. “Listed companies use IFRS and the unlisted companies could use either IFRS or Statements of GAAP.”
IAS 16 deals with Property Plant & Equipment. It allows two methods of valuation or measurement; either historical cost or revaluation based on fair value. The charge for depreciation relates to the carrying value, whether historical cost or fair value. It is not acceptable under HCA to index up the original cost of an asset by reference to subsequent inflation or to base the depreciation charge on that indexed amount.
There are similar requirements in respect of intangible assets (IAS 38) and inventories (IAS 2).
IAS 39 requires fair values to be applied in valuing investments and derivative financial instruments. A historical cost basis of accounting is not acceptable for these items.
The real values of variable real value non-monetary items, e.g. property, are not destroyed when accountants value them at Historical Cost in terms of IFRS or GAAP. These items will be valued at their market prices when they are eventually sold.
Monetary items
Low inflation is what long term sustainable economic growth is built on. Alan Greenspan.
SA accountants value monetary items at their original nominal monetary values; that is, at their original HC values since monetary items can not be updated or indexed during the current financial period for the purpose of
1. accounting their values during the reporting period,
2. determining the profit or loss for the reporting period, and
3. measuring financial capital maintenance in either nominal monetary units or constant purchasing power units
during inflation or deflation.
Inflation – not SA accountants - destroys the real value of SA monetary items over time. The internal real value of the Rand is automatically adjusted downwards as it is being destroyed by the economic process of inflation in SA´s inflationary economy as indicated by the rate of change in the CPI. Inflation destroys the real value of monetary items under any accounting model and also when no accounting model is implemented; that is, when a business does not account its economic activities; for example, street vendors. The accounting model has no affect on the real value of monetary items during the reporting period.
Double entry accounting cannot maintain the real value of monetary items during the reporting period. It is not an attribute of double entry accounting to maintain the real value of monetary items during the reporting period. Inflation destroys the real value of monetary items no matter which accounting model is used. That is why low inflation is so critical for long term sustainable economic growth.
Constant items
SA accountants can choose to measure financial capital maintenance in either nominal monetary units (the HCA model) or in real value maintaining units of constant purchasing power (the CPPA model) as authorized by the IASB in the Framework, Par. 104 (a).
It is very obvious that how SA accountants choose to measure financial capital maintenance does make a big difference to the real value of constant items. There is absolutely no substance in the statement that the choices accountants make won't affect the economy.
The accounting model SA accountants choose in terms of the Framework, Par. 104 (a) is of critical importance. When they choose to measure financial capital maintenance in real value maintaining units of constant purchasing power they will maintain the real values of, for example, all SA banks´ and companies´ retained income values constant over time, all else being equal, instead of unknowingly destroying them, as the currently do. The ONLY way SA accountants can maintain the real value of constant real value non-monetary items during inflation and deflation is by choosing a Constant Purchasing Power Accounting model as per the IASB´s Framework, Par. 104 (a).
Not a single SA accountant in SA chooses to measure financial capital maintenance in real value maintaining units of constant purchasing power as authorized by the IASB in the Framework, Par. 104 (a). SA accountants, unfortunately, choose to measure financial capital maintenance in nominal monetary units and thereby, unknowingly, destroy the real values of constant items at a rate equal to the rate of inflation when they are never or not fully updated over time when they implement the very destructive stable measuring unit assumption as part of the real value destroying HCA model. SA accountants are unknowingly killing the real economy at the rate of about R200 billion per annum – each and every year - as long as they carry on choosing to measure financial capital maintenance in nominal monetary units.
© 2005-2010 by Nicolaas J Smith. All rights reserved
No reproduction without permission
Robert Kemp, CPA Professor, University of Virginia
The three fundamentally different basic economic items in the economy
1. variable items
2. monetary items and
3. constant items
are economic values. Each economic item is an economic value expressed in terms of money, i.e. the functional currency. SA accountants account economic transactions involving these three economic items in an organized manner when they implement a double entry accounting model: journal entries, general ledger accounts, trial balances, cash flow statements, income and expenses in the Profit and Loss Account, assets and liabilities in the Balance Sheet plus other financial, management and costing reports.
SA accountants value economic items when they account economic activity in the accounting records and prepare financial reports of SA economic entities based on the double entry accounting model. Accounting entries are valuations of the economic items (the debit items and the credit items) being accounted.
SA accountants do not simply record economic activity. Accounting is not just a scorekeeping or recordkeeping of economic events. That concept of financial reporting has no substance. SA accountants value economic items when they account them. Subsequent accounting entries are part of generally accepted accounting practice of continuous valuation of the economic items originally valued and accounted over time as required by SA Generally Accepted Accounting Practice and IFRS implemented in conjunction with the IASB´s Framework.
The measurement basis and concept of financial capital maintenance SA accountants choose - either real value destroying traditional Historical Cost nominal monetary units (their current choice) or real value maintaining units of constant purchasing power (the CPPA model) - to value constant real value non-monetary items determine whether they unknowingly destroy or maintain their real values during low, high and hyperinflation. SA accountants are required by the IASB to implement IAS 29 Financial Reporting in Hyperinflationary Economies during hyperinflation. IAS 29 is based on the Constant Purchasing Power Accounting model. Inflation, being a uniquely monetary phenomenon, can not, by definition, destroy the real value of constant real value non-monetary items or variable real value non-monetary items. It is SA accountants’ choice of capital maintenance concept (accounting model) that determines whether they carry on currently unintentionally destroying real value in constant items never or not fully updated or maintain those values for an unlimited period of time – all else being equal.
When SA accountants apply the very destructive stable measuring unit assumption as part of the real value destroying traditional HCA model and value constant items at their HC nominal monetary values and these items are never or not fully updated or inflation-adjusted by means of the CPI over time in SA´s non-hyperinflationary environment, they unknowingly destroy their constant real non-monetary values at a rate equal to the rate of inflation. This is the case with all constant items never or not fully inflation-adjusted including the unintentional destruction by SA accountants of the real value of issued share capital in SA banks and companies which do not have variable real value non-monetary fixed property, plant and equipment that can be revalued at least equal to the updated original real value of all capital contributions under the HC paradigm.
When SA accountants choose to measure financial capital maintenance in real value maintaining units of constant purchasing power (the CPPA model) – as they can freely do in terms of the IASB´s Framework, Par. 104 (a) - they will maintain all constant item real values over time including issued share capital, whether entities have fixed property, plant and equipment to revalue or not.
When SA accountants value constant items in HC nominal monetary units – as they all currently do – they unknowingly destroy their real values at a rate equal to the inflation rate when they are never updated under the HC paradigm.
Variable Items
SA accountants value variable real value non-monetary items in terms of IFRS or SA GAAP. “Listed companies use IFRS and the unlisted companies could use either IFRS or Statements of GAAP.”
IAS 16 deals with Property Plant & Equipment. It allows two methods of valuation or measurement; either historical cost or revaluation based on fair value. The charge for depreciation relates to the carrying value, whether historical cost or fair value. It is not acceptable under HCA to index up the original cost of an asset by reference to subsequent inflation or to base the depreciation charge on that indexed amount.
There are similar requirements in respect of intangible assets (IAS 38) and inventories (IAS 2).
IAS 39 requires fair values to be applied in valuing investments and derivative financial instruments. A historical cost basis of accounting is not acceptable for these items.
The real values of variable real value non-monetary items, e.g. property, are not destroyed when accountants value them at Historical Cost in terms of IFRS or GAAP. These items will be valued at their market prices when they are eventually sold.
Monetary items
Low inflation is what long term sustainable economic growth is built on. Alan Greenspan.
SA accountants value monetary items at their original nominal monetary values; that is, at their original HC values since monetary items can not be updated or indexed during the current financial period for the purpose of
1. accounting their values during the reporting period,
2. determining the profit or loss for the reporting period, and
3. measuring financial capital maintenance in either nominal monetary units or constant purchasing power units
during inflation or deflation.
Inflation – not SA accountants - destroys the real value of SA monetary items over time. The internal real value of the Rand is automatically adjusted downwards as it is being destroyed by the economic process of inflation in SA´s inflationary economy as indicated by the rate of change in the CPI. Inflation destroys the real value of monetary items under any accounting model and also when no accounting model is implemented; that is, when a business does not account its economic activities; for example, street vendors. The accounting model has no affect on the real value of monetary items during the reporting period.
Double entry accounting cannot maintain the real value of monetary items during the reporting period. It is not an attribute of double entry accounting to maintain the real value of monetary items during the reporting period. Inflation destroys the real value of monetary items no matter which accounting model is used. That is why low inflation is so critical for long term sustainable economic growth.
Constant items
SA accountants can choose to measure financial capital maintenance in either nominal monetary units (the HCA model) or in real value maintaining units of constant purchasing power (the CPPA model) as authorized by the IASB in the Framework, Par. 104 (a).
It is very obvious that how SA accountants choose to measure financial capital maintenance does make a big difference to the real value of constant items. There is absolutely no substance in the statement that the choices accountants make won't affect the economy.
The accounting model SA accountants choose in terms of the Framework, Par. 104 (a) is of critical importance. When they choose to measure financial capital maintenance in real value maintaining units of constant purchasing power they will maintain the real values of, for example, all SA banks´ and companies´ retained income values constant over time, all else being equal, instead of unknowingly destroying them, as the currently do. The ONLY way SA accountants can maintain the real value of constant real value non-monetary items during inflation and deflation is by choosing a Constant Purchasing Power Accounting model as per the IASB´s Framework, Par. 104 (a).
Not a single SA accountant in SA chooses to measure financial capital maintenance in real value maintaining units of constant purchasing power as authorized by the IASB in the Framework, Par. 104 (a). SA accountants, unfortunately, choose to measure financial capital maintenance in nominal monetary units and thereby, unknowingly, destroy the real values of constant items at a rate equal to the rate of inflation when they are never or not fully updated over time when they implement the very destructive stable measuring unit assumption as part of the real value destroying HCA model. SA accountants are unknowingly killing the real economy at the rate of about R200 billion per annum – each and every year - as long as they carry on choosing to measure financial capital maintenance in nominal monetary units.
© 2005-2010 by Nicolaas J Smith. All rights reserved
No reproduction without permission
Sunday, 8 March 2009
Constant Item Purchasing Power Accounting
Constant Purchasing Power Accounting as defined in International Accounting Standard IAS 29 Financial Reporting in Hyperinflationary Economies is the IASB´s inflation accounting model required to be implemented during hyperinflation.
Constant Item Purchasing Power Accounting is an International Accounting Standards Board approved basic accounting model alternative to traditional Historical cost accounting during low inflation. IAS 29 requires the updating of all non-monetary items (both variable and constant real value non-monetary items) by means of the Consumer Price Index during hyperinflation. Constant Item Purchasing Power Accounting as approved by the IASB in the Framework, Par. 104 (a) only requires the updating of constant real value non-monetary items during non-hyperinflationary periods. In terms of the Framework, Par. 104 (a), accountants can choose CIPPA to implement a financial capital concept of invested purchasing power instead of the traditional Historical Cost concept of invested money. They will thus implement a constant purchasing power financial capital maintenance concept by measuring financial capital maintenance in units of constant purchasing power instead of the traditional Historical Cost nominal monetary units and they will implement a constant purchasing power profit/loss determination concept. It simply means inflation-adjusting only constant real value non-monetary items, e.g. issued share capital, retained income, shareholders´ equity, trade debtors, trade creditors, deferred tax assets and liabilities, salaries, wages, rentals, etc, by means of the Consumer Price Index while valuing variable real value non-monetary items, e.g. property, plant, equipment, shares, inventory, etc in terms of International Financial Reporting Standards or Generally accepted accounting practice during non-hyperinflationary periods. Monetary items are valued at their original nominal values during the accounting period under all accounting models.
Monetary items, variable items and constant items are the three fundamentally different basic economic items in the economy.
Constant Item Purchasing Power Accounting will automatically maintain instead of continually erode - as the Historical Cost Accounting model is currently doing - the real value of all constant items never or not fully updated, including banks´ and companies´ capital base, for an unlimited period of time - all else being equal. Constant Item Purhcasing Power Accounting was authorized by the IASB in 1989 as an alternative to the traditional historical cost accounting model at all levels of inflation and deflation in the Framework for the Preparation and Presentation of Financial Statements and forms part of International Financial Reporting Standards. [http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=CELEX:32003R1725:EN:NOT]
The Framework, Par. 104 (a)
"Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power."
Discredited 1970-style CPPA was a form of inflation accounting which tried unsuccessfully - by updating all non-monetary items (variable as well as constant real value non-monetary items) equally by means of the Consumer Price Index during high inflation - to allow for the effect of inflation in an attempt to make corporate accounts more informative when comparing current transactions with previous transactions.
Nevertheless, almost all accountants and accounting authorities - excluding the IASB - still regard Constant item purchasing power accounting as a discredited and failed 1970-style CPPA inflation accounting model. They ignore the Constant Item Purchasing Power Accounting model´s substantial benefits, for example, automatically maintaining banks´ and companies´ capital base, when accountants choose to inflation-adjust only constant items by means of the CPI thus maintaining their real values while they value variable items in terms of IFRS. Monetary items cannot be inflation-adjusted or updated and accountants value them at their original nominal values during the accounting period.
Certain income statement constant real value non-monetary items, most notably salaries, wages and rentals, are inflation-adjusted by means of the CPI, that is, valued or measured in units of constant purchasing power, in most economies.
The IASB specifically requires the CPPA inflation accounting model to be used during hyperinflation as per International Accounting Standard IAS 29 Financial Reporting in Hyperinflationary Economies. [http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=CELEX:32003R1725:EN:NOT][http://www.pwc.com/gx/eng/about/svcs/corporatereporting/IAS29Publication06.pdf]PricewaterhouseCoopers, Financial Reporting in Hyperinflationary Economies, Understanding IAS 29
1970-style CPPA was a failed inflation accounting model
International Accounting Standard 29, Par. 6:
"In most countries, primary financial statements are prepared on the historical cost basis of accounting without regard either to changes in the general level of prices or to increases in specific prices of assets held, except to the extent that property, plant and equipment and investments may be revalued. Some entities, however, present financial statements that are based on a current cost approach that reflects the effects of changes in the specific prices of assets held.
The following quote from Geoffrey Whittington's book Inflation Accounting - An Introduction to the Debate, published in 1983, reflects the above position:
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.
Inflation Accounting: An Introduction to the Debate, Geoffrey Whittington, Cambridge University Press, 1983, ISBN 0521270553, ISBN 9780521270557, P. 73.[http://books.google.com/books?hl=en&id=-5Dz0JtXM9sC&dq=inflation+accounting+by+geoffrey+whittington&printsec=frontcover&source=web&ots=vrKex7Mpzp&sig=b6JGICF8YHoHzzAXESioFwOieBc&sa=X&oi=book_result&resnum=1&ct=result#PPA73,M1]
Constant Item Purchasing Power Accounting as a financial capital maintenance concept
The specific choice of measuring financial capital maintenance in units of constant purchasing power (the CIPPA model) at all levels of inflation and deflation as contained in the Framework, was approved by the International Accounting Standards Board’s predecessor body, the International Accounting Standards Committee Board, in April 1989 for publication in July 1989 and adopted by the IASB in April 2001.
“In the absence of a Standard or an Interpretation that specifically applies to a transaction, management must use its judgement in developing and applying an accounting policy that results in information that is relevant and reliable. In making that judgement, IAS 8.11 requires management to consider the definitions, recognition criteria, and measurement concepts for assets, liabilities, income, and expenses in the Framework. This elevation of the importance of the Framework was added in the 2003 revisions to IAS 8."
IAS Plus, Deloitte [http://www.iasplus.com/standard/framewk.htm]
IAS8. 11:
“In making the judgement, management shall refer to, and consider the applicability of, the following sources in descending order:
(a) the requirements and guidance in Standards and Interpretations dealing with similar and related issues; and
(b) the definitions, recognition criteria and measurement concepts for assets, liabilities, income and expenses in the Framework.”
[http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=CELEX:32003R1725:EN:NOT]
There is no applicable International Financial Reporting Standard or Interpretation regarding the valuation of constant real value non-monetary items, e.g. issued share capital, retained earnings, capital reserves, all other items in Shareholders Equity, trade debtors, trade creditors, deferred tax assets and liabilities, taxes payable and receivable, all other non-monetary receivables and payables, Profit and Loss account items such as salaries, wages, rents, etc. The Framework is thus applicable.
Despite being part of IFRS Constant Item Purchasing Power Accounting is almost completely ignored by accountants in non-hyperinflationary economies even though it would maintain instead of diminish the real values of not only all income statement constant items but also all balance sheet constant real value non-monetary items for an unlimited period of time. This is because the CIPPA model is generally viewed by almost all accountants and accounting authorities, excluding the IASB, as a 1970-style failed CPPA inflation accounting model that requires all non-monetary items - variable real value non-monetary items and constant real value non-monetary items - to be inflation-adjusted by means of the Consumer Price Index. They - including the IASB - fail to introduce the substantial real value maintaining benefits, which last for an unlimited period of time (all else being equal), of measuring financial capital maintenance in units of constant purchasing power in companies and the economy in general.
The IASB did not approve Constant Item Purchasing Power Accounting in 1989 as an inflation accounting model. CIPPA by measuring financial capital maintenance in units of constant purchasing power incorporates an alternative capital concept, financial capital maintenance concept and profit determination concept to the Historical Cost capital concept, financial capital maintenance concept and profit determination concept. CIPPA only requires all constant real value non-monetary items, e.g. issued share capital, retained income, all other items in Shareholders Equity, trade debtors, trade creditors, deferred tax assets and liabilities, taxes payable and receivable, all items in the profit and loss account, etc to be valued in units of constant purchasing power. Variable real value non-monetary items, e.g. property, plant, equipment, listed and unlisted shares, inventory, etc are valued in terms of IFRS and are not required in terms of the Framework, Par. 104 (a) to be valued in units of constant purchasing power.
CIPPA is authorized by the IASB during low inflation
The statement "Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power," in the IASB´s Framework, Paragraph 104 (a), means that Constant Item Purchasing Power Accounting has been authorized by the International Accounting Standards Board since 1989 as an alternative to the traditional Historical Cost Accounting model, including during periods of low inflation. This means that the international accounting profession has been in agreement regarding the use of Constant Purchase Power Accounting for financial capital maintenance in units of constant purchasing power during low inflation since 1989. It also means that Constant Item Purchasing Power Accounting and the inflation-adjustment of constant real value non-monetary items to maintain their real values in a low inflationary environment are authorized by International Financial Reporting Standards since the Framework is part of IFRS.
Constant real value non-monetary items like salaries, wages, rents, pensions, utilities, transport fees, etc are normally valued by accountants in terms of Constant Purchasing Power units during low inflation in most economies. Payments in money for these items are normally inflation-adjusted by means of the Consumer Price Index to compensate for the erosion of the real value of the monetary medium of exchange by inflation. Inflation is always and everywhere a monetary phenomenon and can only erode the real value of money (the functional currency inside an economy) and other monetary items. Inflation can not erode the real value of non-monetary items. Constant real value non-monetary items´ real values can be maintained by accountants choosing the Constant Item Purchasing Power Accounting model as per the Framework during low inflation as authorized in IFRS since 1989 instead of currently being eroded by the implementation by accountants of the traditional Historical Cost Model when they apply the stable measuring unit assumption. It is thus accountants´ choice of accounting model and not inflation that maintains or erodes the real value of constant real value non-monetary items like retained earnings, issued share capital (banks´ and companies´ capital base), capital reserves, other shareholder equity items, trade debtors, trade creditors, deferred tax assets and liabilities, other taxes payable and receivable, etc.
Implementing the CIPPA model means accountants choose to reject the stable measuring unit assumption which they implement when they choose to measure financial capital maintenance in nominal monetary units. Accountants world wide currently choose the traditional Historical Cost Accounting model except during hyperinflation when they are required by IFRS to implement IAS 29 which is based on the CPPA model.
Net monetary gain or loss
Accountants have to calculate the net monetary loss or gain from holding monetary items when they choose the CIPPA model and measure financial capital maintenance in units of constant purchasing power.
CIPPA as per the IASB's Framework
Framework for the Preparation and Presentation of Financial Statements
Concepts of Capital and Capital Maintenance
Concepts of Capital
Par. 102
A financial concept of capital is adopted by most entities in preparing their financial statements. Under a financial concept of capital, such as invested money or invested purchasing power, capital is synonymous with the net assets or equity of the entity. Under a physical concept of capital, such as operating capability, capital is regarded as the productive capacity of the entity based on, for example, units of output per day.
Par. 103
The selection of the appropriate concept of capital by an entity should be based on the needs of the users of its financial statements. Thus, a financial concept of capital should be adopted if the users of financial statements are primarily concerned with the maintenance of nominal invested capital '''or the purchasing power of invested capital'''. If, however, the main concern of users is with the operating capability of the entity, a physical concept of capital should be used. The concept chosen indicates the goal to be attained in determining profit, even though there may be some measurement difficulties in making the concept operational.
Concepts of Capital Maintenance and the Determination of Profit
The concepts of capital give rise to the following concepts of capital maintenance:
Par. 104
(a) Financial capital maintenance. Under this concept a profit is earned only if the financial (or money) amount of the net assets at the end of the period exceeds the financial (or money) amount of net assets at the beginning of the period, after excluding any distributions to, and contributions from, owners during the period. Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power.
(b) Physical capital maintenance. Under this concept a profit is earned only if the physical productive capacity (or operating capability) of the entity (or the resources or funds needed to achieve that capacity) at the end of the period exceeds the physical productive capacity at the beginning of the period, after excluding any distributions to, and contributions from, owners during the period.
Par. 105
The concept of capital maintenance is concerned with how an entity defines the capital that it seeks to maintain. It provides the linkage between the concepts of capital and the concepts of profit because it provides the point of reference by which profit is measured; it is a prerequisite for distinguishing between an entity’s return on capital and its return of capital; only inflows of assets in excess of amounts needed to maintain capital may be regarded as profit and therefore as a return on capital. Hence, profit is the residual amount that remains after expenses (including capital maintenance adjustments, where appropriate) have been deducted from income. If expenses exceed income the residual amount is a loss.
Par. 106
The physical capital maintenance concept requires the adoption of the current cost basis of measurement. The financial capital maintenance concept, however, does not require the use of a particular basis of measurement. Selection of the basis under this concept is dependent on the type of financial capital that the entity is seeking to maintain.
Par. 107
The principal difference between the two concepts of capital maintenance is the treatment of the effects of changes in the prices of assets and liabilities of the entity. In general terms, an entity has maintained its capital if it has as much capital at the end of the period as it had at the beginning of the period. Any amount over and above that required to maintain the capital at the beginning of the period is profit.
Par. 108
Under the concept of financial capital maintenance where capital is defined in terms of nominal monetary units, profit represents the increase in nominal money capital over the period. Thus, increases in the prices of assets held over the period, conventionally referred to as holding gains, are, conceptually, profits. They may not be recognised as such, however, until the assets are disposed of in an exchange transaction. When the concept of financial capital maintenance is defined in terms of constant purchasing power units, profit represents the increase in invested purchasing power over the period. Thus, only that part of the increase in the prices of assets that exceeds the increase in the general level of prices is regarded as profit. The rest of the increase is treated as a capital maintenance adjustment and, hence, as part of equity.
Par. 109
Under the concept of physical capital maintenance when capital is defined in terms of the physical productive capacity, profit represents the increase in that capital over the period. All price changes affecting the assets and liabilities of the entity are viewed as changes in the measurement of the physical productive capacity of the entity; hence, they are treated as capital maintenance adjustments that are part of equity and not as profit.
Par. 110
The selection of the measurement bases and concept of capital maintenance will determine the accounting model used in the preparation of the financial statements. Different accounting models exhibit different degrees of relevance and reliability and, as in other areas, management must seek a balance between relevance and reliability. The Framework is applicable to a range of accounting models and provides guidance on preparing and presenting the financial statements constructed under the chosen model. At the present time, it is not the intention of the Board of IASC to prescribe a particular model other than in exceptional circumstances, such as for those entities reporting in the currency of a hyperinflationary economy. This intention will, however, be reviewed in the light of world developments.
The IASB Framework was approved by the IASC Board in April 1989 for publication in July 1989, and adopted by the IASB in April 2001.
CPPA inflation accounting is required by the IASB during hyperinflation
The IASB authorized the CIPPA model during low inflation in the Framework, Par. 104 (a) as an alternative to the Historical Cost Accounting model. The IASB, however, specifically requires the implementation of the CPPA inflation accounting model during hyperinflation as per IAS 29 Financial Reporting in Hyperinflationary Economies which is based on the CPPA model. [http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=CELEX:32003R1725:EN:NOT]
© 2005-2010 by Nicolaas J Smith. All rights reserved
No reproduction without permission.
Constant Item Purchasing Power Accounting is an International Accounting Standards Board approved basic accounting model alternative to traditional Historical cost accounting during low inflation. IAS 29 requires the updating of all non-monetary items (both variable and constant real value non-monetary items) by means of the Consumer Price Index during hyperinflation. Constant Item Purchasing Power Accounting as approved by the IASB in the Framework, Par. 104 (a) only requires the updating of constant real value non-monetary items during non-hyperinflationary periods. In terms of the Framework, Par. 104 (a), accountants can choose CIPPA to implement a financial capital concept of invested purchasing power instead of the traditional Historical Cost concept of invested money. They will thus implement a constant purchasing power financial capital maintenance concept by measuring financial capital maintenance in units of constant purchasing power instead of the traditional Historical Cost nominal monetary units and they will implement a constant purchasing power profit/loss determination concept. It simply means inflation-adjusting only constant real value non-monetary items, e.g. issued share capital, retained income, shareholders´ equity, trade debtors, trade creditors, deferred tax assets and liabilities, salaries, wages, rentals, etc, by means of the Consumer Price Index while valuing variable real value non-monetary items, e.g. property, plant, equipment, shares, inventory, etc in terms of International Financial Reporting Standards or Generally accepted accounting practice during non-hyperinflationary periods. Monetary items are valued at their original nominal values during the accounting period under all accounting models.
Monetary items, variable items and constant items are the three fundamentally different basic economic items in the economy.
Constant Item Purchasing Power Accounting will automatically maintain instead of continually erode - as the Historical Cost Accounting model is currently doing - the real value of all constant items never or not fully updated, including banks´ and companies´ capital base, for an unlimited period of time - all else being equal. Constant Item Purhcasing Power Accounting was authorized by the IASB in 1989 as an alternative to the traditional historical cost accounting model at all levels of inflation and deflation in the Framework for the Preparation and Presentation of Financial Statements and forms part of International Financial Reporting Standards. [http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=CELEX:32003R1725:EN:NOT]
The Framework, Par. 104 (a)
"Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power."
Discredited 1970-style CPPA was a form of inflation accounting which tried unsuccessfully - by updating all non-monetary items (variable as well as constant real value non-monetary items) equally by means of the Consumer Price Index during high inflation - to allow for the effect of inflation in an attempt to make corporate accounts more informative when comparing current transactions with previous transactions.
Nevertheless, almost all accountants and accounting authorities - excluding the IASB - still regard Constant item purchasing power accounting as a discredited and failed 1970-style CPPA inflation accounting model. They ignore the Constant Item Purchasing Power Accounting model´s substantial benefits, for example, automatically maintaining banks´ and companies´ capital base, when accountants choose to inflation-adjust only constant items by means of the CPI thus maintaining their real values while they value variable items in terms of IFRS. Monetary items cannot be inflation-adjusted or updated and accountants value them at their original nominal values during the accounting period.
Certain income statement constant real value non-monetary items, most notably salaries, wages and rentals, are inflation-adjusted by means of the CPI, that is, valued or measured in units of constant purchasing power, in most economies.
The IASB specifically requires the CPPA inflation accounting model to be used during hyperinflation as per International Accounting Standard IAS 29 Financial Reporting in Hyperinflationary Economies. [http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=CELEX:32003R1725:EN:NOT][http://www.pwc.com/gx/eng/about/svcs/corporatereporting/IAS29Publication06.pdf]PricewaterhouseCoopers, Financial Reporting in Hyperinflationary Economies, Understanding IAS 29
1970-style CPPA was a failed inflation accounting model
International Accounting Standard 29, Par. 6:
"In most countries, primary financial statements are prepared on the historical cost basis of accounting without regard either to changes in the general level of prices or to increases in specific prices of assets held, except to the extent that property, plant and equipment and investments may be revalued. Some entities, however, present financial statements that are based on a current cost approach that reflects the effects of changes in the specific prices of assets held.
The following quote from Geoffrey Whittington's book Inflation Accounting - An Introduction to the Debate, published in 1983, reflects the above position:
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.
Inflation Accounting: An Introduction to the Debate, Geoffrey Whittington, Cambridge University Press, 1983, ISBN 0521270553, ISBN 9780521270557, P. 73.[http://books.google.com/books?hl=en&id=-5Dz0JtXM9sC&dq=inflation+accounting+by+geoffrey+whittington&printsec=frontcover&source=web&ots=vrKex7Mpzp&sig=b6JGICF8YHoHzzAXESioFwOieBc&sa=X&oi=book_result&resnum=1&ct=result#PPA73,M1]
Constant Item Purchasing Power Accounting as a financial capital maintenance concept
The specific choice of measuring financial capital maintenance in units of constant purchasing power (the CIPPA model) at all levels of inflation and deflation as contained in the Framework, was approved by the International Accounting Standards Board’s predecessor body, the International Accounting Standards Committee Board, in April 1989 for publication in July 1989 and adopted by the IASB in April 2001.
“In the absence of a Standard or an Interpretation that specifically applies to a transaction, management must use its judgement in developing and applying an accounting policy that results in information that is relevant and reliable. In making that judgement, IAS 8.11 requires management to consider the definitions, recognition criteria, and measurement concepts for assets, liabilities, income, and expenses in the Framework. This elevation of the importance of the Framework was added in the 2003 revisions to IAS 8."
IAS Plus, Deloitte [http://www.iasplus.com/standard/framewk.htm]
IAS8. 11:
“In making the judgement, management shall refer to, and consider the applicability of, the following sources in descending order:
(a) the requirements and guidance in Standards and Interpretations dealing with similar and related issues; and
(b) the definitions, recognition criteria and measurement concepts for assets, liabilities, income and expenses in the Framework.”
[http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=CELEX:32003R1725:EN:NOT]
There is no applicable International Financial Reporting Standard or Interpretation regarding the valuation of constant real value non-monetary items, e.g. issued share capital, retained earnings, capital reserves, all other items in Shareholders Equity, trade debtors, trade creditors, deferred tax assets and liabilities, taxes payable and receivable, all other non-monetary receivables and payables, Profit and Loss account items such as salaries, wages, rents, etc. The Framework is thus applicable.
Despite being part of IFRS Constant Item Purchasing Power Accounting is almost completely ignored by accountants in non-hyperinflationary economies even though it would maintain instead of diminish the real values of not only all income statement constant items but also all balance sheet constant real value non-monetary items for an unlimited period of time. This is because the CIPPA model is generally viewed by almost all accountants and accounting authorities, excluding the IASB, as a 1970-style failed CPPA inflation accounting model that requires all non-monetary items - variable real value non-monetary items and constant real value non-monetary items - to be inflation-adjusted by means of the Consumer Price Index. They - including the IASB - fail to introduce the substantial real value maintaining benefits, which last for an unlimited period of time (all else being equal), of measuring financial capital maintenance in units of constant purchasing power in companies and the economy in general.
The IASB did not approve Constant Item Purchasing Power Accounting in 1989 as an inflation accounting model. CIPPA by measuring financial capital maintenance in units of constant purchasing power incorporates an alternative capital concept, financial capital maintenance concept and profit determination concept to the Historical Cost capital concept, financial capital maintenance concept and profit determination concept. CIPPA only requires all constant real value non-monetary items, e.g. issued share capital, retained income, all other items in Shareholders Equity, trade debtors, trade creditors, deferred tax assets and liabilities, taxes payable and receivable, all items in the profit and loss account, etc to be valued in units of constant purchasing power. Variable real value non-monetary items, e.g. property, plant, equipment, listed and unlisted shares, inventory, etc are valued in terms of IFRS and are not required in terms of the Framework, Par. 104 (a) to be valued in units of constant purchasing power.
CIPPA is authorized by the IASB during low inflation
The statement "Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power," in the IASB´s Framework, Paragraph 104 (a), means that Constant Item Purchasing Power Accounting has been authorized by the International Accounting Standards Board since 1989 as an alternative to the traditional Historical Cost Accounting model, including during periods of low inflation. This means that the international accounting profession has been in agreement regarding the use of Constant Purchase Power Accounting for financial capital maintenance in units of constant purchasing power during low inflation since 1989. It also means that Constant Item Purchasing Power Accounting and the inflation-adjustment of constant real value non-monetary items to maintain their real values in a low inflationary environment are authorized by International Financial Reporting Standards since the Framework is part of IFRS.
Constant real value non-monetary items like salaries, wages, rents, pensions, utilities, transport fees, etc are normally valued by accountants in terms of Constant Purchasing Power units during low inflation in most economies. Payments in money for these items are normally inflation-adjusted by means of the Consumer Price Index to compensate for the erosion of the real value of the monetary medium of exchange by inflation. Inflation is always and everywhere a monetary phenomenon and can only erode the real value of money (the functional currency inside an economy) and other monetary items. Inflation can not erode the real value of non-monetary items. Constant real value non-monetary items´ real values can be maintained by accountants choosing the Constant Item Purchasing Power Accounting model as per the Framework during low inflation as authorized in IFRS since 1989 instead of currently being eroded by the implementation by accountants of the traditional Historical Cost Model when they apply the stable measuring unit assumption. It is thus accountants´ choice of accounting model and not inflation that maintains or erodes the real value of constant real value non-monetary items like retained earnings, issued share capital (banks´ and companies´ capital base), capital reserves, other shareholder equity items, trade debtors, trade creditors, deferred tax assets and liabilities, other taxes payable and receivable, etc.
Implementing the CIPPA model means accountants choose to reject the stable measuring unit assumption which they implement when they choose to measure financial capital maintenance in nominal monetary units. Accountants world wide currently choose the traditional Historical Cost Accounting model except during hyperinflation when they are required by IFRS to implement IAS 29 which is based on the CPPA model.
Net monetary gain or loss
Accountants have to calculate the net monetary loss or gain from holding monetary items when they choose the CIPPA model and measure financial capital maintenance in units of constant purchasing power.
CIPPA as per the IASB's Framework
Framework for the Preparation and Presentation of Financial Statements
Concepts of Capital and Capital Maintenance
Concepts of Capital
Par. 102
A financial concept of capital is adopted by most entities in preparing their financial statements. Under a financial concept of capital, such as invested money or invested purchasing power, capital is synonymous with the net assets or equity of the entity. Under a physical concept of capital, such as operating capability, capital is regarded as the productive capacity of the entity based on, for example, units of output per day.
Par. 103
The selection of the appropriate concept of capital by an entity should be based on the needs of the users of its financial statements. Thus, a financial concept of capital should be adopted if the users of financial statements are primarily concerned with the maintenance of nominal invested capital '''or the purchasing power of invested capital'''. If, however, the main concern of users is with the operating capability of the entity, a physical concept of capital should be used. The concept chosen indicates the goal to be attained in determining profit, even though there may be some measurement difficulties in making the concept operational.
Concepts of Capital Maintenance and the Determination of Profit
The concepts of capital give rise to the following concepts of capital maintenance:
Par. 104
(a) Financial capital maintenance. Under this concept a profit is earned only if the financial (or money) amount of the net assets at the end of the period exceeds the financial (or money) amount of net assets at the beginning of the period, after excluding any distributions to, and contributions from, owners during the period. Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power.
(b) Physical capital maintenance. Under this concept a profit is earned only if the physical productive capacity (or operating capability) of the entity (or the resources or funds needed to achieve that capacity) at the end of the period exceeds the physical productive capacity at the beginning of the period, after excluding any distributions to, and contributions from, owners during the period.
Par. 105
The concept of capital maintenance is concerned with how an entity defines the capital that it seeks to maintain. It provides the linkage between the concepts of capital and the concepts of profit because it provides the point of reference by which profit is measured; it is a prerequisite for distinguishing between an entity’s return on capital and its return of capital; only inflows of assets in excess of amounts needed to maintain capital may be regarded as profit and therefore as a return on capital. Hence, profit is the residual amount that remains after expenses (including capital maintenance adjustments, where appropriate) have been deducted from income. If expenses exceed income the residual amount is a loss.
Par. 106
The physical capital maintenance concept requires the adoption of the current cost basis of measurement. The financial capital maintenance concept, however, does not require the use of a particular basis of measurement. Selection of the basis under this concept is dependent on the type of financial capital that the entity is seeking to maintain.
Par. 107
The principal difference between the two concepts of capital maintenance is the treatment of the effects of changes in the prices of assets and liabilities of the entity. In general terms, an entity has maintained its capital if it has as much capital at the end of the period as it had at the beginning of the period. Any amount over and above that required to maintain the capital at the beginning of the period is profit.
Par. 108
Under the concept of financial capital maintenance where capital is defined in terms of nominal monetary units, profit represents the increase in nominal money capital over the period. Thus, increases in the prices of assets held over the period, conventionally referred to as holding gains, are, conceptually, profits. They may not be recognised as such, however, until the assets are disposed of in an exchange transaction. When the concept of financial capital maintenance is defined in terms of constant purchasing power units, profit represents the increase in invested purchasing power over the period. Thus, only that part of the increase in the prices of assets that exceeds the increase in the general level of prices is regarded as profit. The rest of the increase is treated as a capital maintenance adjustment and, hence, as part of equity.
Par. 109
Under the concept of physical capital maintenance when capital is defined in terms of the physical productive capacity, profit represents the increase in that capital over the period. All price changes affecting the assets and liabilities of the entity are viewed as changes in the measurement of the physical productive capacity of the entity; hence, they are treated as capital maintenance adjustments that are part of equity and not as profit.
Par. 110
The selection of the measurement bases and concept of capital maintenance will determine the accounting model used in the preparation of the financial statements. Different accounting models exhibit different degrees of relevance and reliability and, as in other areas, management must seek a balance between relevance and reliability. The Framework is applicable to a range of accounting models and provides guidance on preparing and presenting the financial statements constructed under the chosen model. At the present time, it is not the intention of the Board of IASC to prescribe a particular model other than in exceptional circumstances, such as for those entities reporting in the currency of a hyperinflationary economy. This intention will, however, be reviewed in the light of world developments.
The IASB Framework was approved by the IASC Board in April 1989 for publication in July 1989, and adopted by the IASB in April 2001.
CPPA inflation accounting is required by the IASB during hyperinflation
The IASB authorized the CIPPA model during low inflation in the Framework, Par. 104 (a) as an alternative to the Historical Cost Accounting model. The IASB, however, specifically requires the implementation of the CPPA inflation accounting model during hyperinflation as per IAS 29 Financial Reporting in Hyperinflationary Economies which is based on the CPPA model. [http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=CELEX:32003R1725:EN:NOT]
© 2005-2010 by Nicolaas J Smith. All rights reserved
No reproduction without permission.
Saturday, 7 March 2009
Accountants value economic activity
The debate of how to account for value has been around for decades.
Robert Kemp, CPA Professor, University of Virginia – CC http://www.glgroup.com/News/Fair-Value-Accounting---The-Good-And-Bad-Of-It-In-The-Real-World-27848.html
The three distinct economic items in the economy
1. variable items
2. monetary items and
3. constant items
are economic values. Each economic item is an economic value expressed in terms of money. SA accountants account economic transactions involving these three economic items in an organized manner when they implement a double entry accounting model: journal entries, general ledger accounts, trial balances, cash flow statements, items in the Profit and Loss Account, assets and liabilities in the Balance Sheet plus other financial, management and costing reports.
SA accountants value economic items when they account economic activity in the accounting records and prepare financial reports of SA economic entities based on the double entry accounting model. Accounting entries are valuations of the economic items (the debit items and the credit items) being accounted.
SA accountants do not simply record economic activity. Accounting is not just a scorekeeping or recordkeeping of economic events. Accountants value economic items when they account them. Subsequent accounting entries are part of continuous generally accepted accounting practice of valuation of the economic items originally valued and accounted over time as required by SA Generally Accepted Accounting Practice and IFRS implemented in conjunction with the IASB´s Framework.
The measurement basis SA accountants choose to value constant real value non-monetary items determines whether they maintain or destroy their real values. Inflation being a monetary phenomenon cannot destroy the real value of constant real value non-monetary items. When accountants value constant items at their HC nominal monetary values they unknowingly destroy their constant real non-monetary values at a rate equal to the rate of inflation because the depreciating monetary unit of account is the same as the depreciating monetary medium of exchange and inflation destroys the real value of the depreciating monetary medium of exchange. Only when they choose to measure financial capital maintenance in real value maintaining units of constant purchasing power – as they can freely do in terms of the IASB´s Framework, Par. 104 (a) - do they maintain their real values over time.
Variable Items
SA accountants value variable real value non-monetary items in terms of IFRS or SA GAAP. “Listed companies use IFRS and the unlisted companies could use either IFRS or Statements of GAAP.”
Monetary items
SA accountants value monetary items at their original nominal monetary values; that is, at their original HC values since monetary items can not be updated or indexed during the current financial period for the purpose of
1. accounting their values during the reporting period,
2. determining the profit or loss for the reporting period, and
3. measuring financial capital maintenance in either nominal monetary units or constant purchasing power units
during inflation or deflation.
Inflation – not SA accountants - destroys the real value of SA monetary items over time. The internal real value of the Rand is automatically adjusted downwards as it is being destroyed by the economic process of inflation in SA´s inflationary economy as indicated by the rate of change in the CPI. Inflation destroys the real value of monetary items under any accounting model and also when no accounting model is implemented; that is, when a business does not account its economic activities; for example, street vendors. The accounting model has no affect on the real value of monetary items during the reporting period.
Double entry accounting cannot maintain the real value of monetary items during the reporting period. It is not an attribute of double entry accounting to maintain the real value of monetary items during the reporting period. Inflation destroys the real value of monetary items no matter which accounting model is used. That is why low inflation is so critical for long term sustainable economic growth.
Low inflation is what long term sustainable economic growth is built on. Alan Greenspan.
Constant items
SA accountants can choose to measure financial capital maintenance in either nominal monetary units or in real value maintaining units of constant purchasing power as authorized by the IASB in the Framework, Par. 104 (a).
It is very obvious that how SA accountants choose to measure financial capital maintenance does make a big difference to the real value of constant items. There is no substance in the statement that economic resources´ values – per se - are independent of the way in which we value them – no matter how well respected and how important that person is in the SA accounting and academic circles. The accounting model SA accountants choose in terms of the Framework, Par. 104 (a) is of critical importance. When they choose to measure financial capital maintenance in real value maintaining units of constant purchasing power they will maintain the real values of, for example, all SA banks´ and companies´ retained income values constant over time, all else being equal, instead of unknowingly destroying them as the currently do. The only way they can maintain the real value of constant real value non-monetary items during inflation and deflation is by choosing a Constant Purchasing Power Accounting model as per the IASB´s Framework, Par. 104 (a).
Not a single SA accountant in SA chooses to measure financial capital maintenance in real value maintaining units of constant purchasing power as authorized by the IASB in the Framework, Par. 104 (a). SA accountants, unfortunately, choose to measure financial capital maintenance in nominal monetary units and thereby, unknowingly, destroy the real values of constant items at a rate equal to the rate of inflation when they are never or not fully updated over time when they implement the very destructive stable measuring unit assumption as part of the HCA model. SA accountants are unknowingly killing the real economy at the rate of about R200 billion per annum – each and every year - as long as they carry on implementing the very destructive stable measuring unit assumption.
© 2005-2010 by Nicolaas J Smith. All rights reserved
No reproduction without permission.
Robert Kemp, CPA Professor, University of Virginia – CC http://www.glgroup.com/News/Fair-Value-Accounting---The-Good-And-Bad-Of-It-In-The-Real-World-27848.html
The three distinct economic items in the economy
1. variable items
2. monetary items and
3. constant items
are economic values. Each economic item is an economic value expressed in terms of money. SA accountants account economic transactions involving these three economic items in an organized manner when they implement a double entry accounting model: journal entries, general ledger accounts, trial balances, cash flow statements, items in the Profit and Loss Account, assets and liabilities in the Balance Sheet plus other financial, management and costing reports.
SA accountants value economic items when they account economic activity in the accounting records and prepare financial reports of SA economic entities based on the double entry accounting model. Accounting entries are valuations of the economic items (the debit items and the credit items) being accounted.
SA accountants do not simply record economic activity. Accounting is not just a scorekeeping or recordkeeping of economic events. Accountants value economic items when they account them. Subsequent accounting entries are part of continuous generally accepted accounting practice of valuation of the economic items originally valued and accounted over time as required by SA Generally Accepted Accounting Practice and IFRS implemented in conjunction with the IASB´s Framework.
The measurement basis SA accountants choose to value constant real value non-monetary items determines whether they maintain or destroy their real values. Inflation being a monetary phenomenon cannot destroy the real value of constant real value non-monetary items. When accountants value constant items at their HC nominal monetary values they unknowingly destroy their constant real non-monetary values at a rate equal to the rate of inflation because the depreciating monetary unit of account is the same as the depreciating monetary medium of exchange and inflation destroys the real value of the depreciating monetary medium of exchange. Only when they choose to measure financial capital maintenance in real value maintaining units of constant purchasing power – as they can freely do in terms of the IASB´s Framework, Par. 104 (a) - do they maintain their real values over time.
Variable Items
SA accountants value variable real value non-monetary items in terms of IFRS or SA GAAP. “Listed companies use IFRS and the unlisted companies could use either IFRS or Statements of GAAP.”
Monetary items
SA accountants value monetary items at their original nominal monetary values; that is, at their original HC values since monetary items can not be updated or indexed during the current financial period for the purpose of
1. accounting their values during the reporting period,
2. determining the profit or loss for the reporting period, and
3. measuring financial capital maintenance in either nominal monetary units or constant purchasing power units
during inflation or deflation.
Inflation – not SA accountants - destroys the real value of SA monetary items over time. The internal real value of the Rand is automatically adjusted downwards as it is being destroyed by the economic process of inflation in SA´s inflationary economy as indicated by the rate of change in the CPI. Inflation destroys the real value of monetary items under any accounting model and also when no accounting model is implemented; that is, when a business does not account its economic activities; for example, street vendors. The accounting model has no affect on the real value of monetary items during the reporting period.
Double entry accounting cannot maintain the real value of monetary items during the reporting period. It is not an attribute of double entry accounting to maintain the real value of monetary items during the reporting period. Inflation destroys the real value of monetary items no matter which accounting model is used. That is why low inflation is so critical for long term sustainable economic growth.
Low inflation is what long term sustainable economic growth is built on. Alan Greenspan.
Constant items
SA accountants can choose to measure financial capital maintenance in either nominal monetary units or in real value maintaining units of constant purchasing power as authorized by the IASB in the Framework, Par. 104 (a).
It is very obvious that how SA accountants choose to measure financial capital maintenance does make a big difference to the real value of constant items. There is no substance in the statement that economic resources´ values – per se - are independent of the way in which we value them – no matter how well respected and how important that person is in the SA accounting and academic circles. The accounting model SA accountants choose in terms of the Framework, Par. 104 (a) is of critical importance. When they choose to measure financial capital maintenance in real value maintaining units of constant purchasing power they will maintain the real values of, for example, all SA banks´ and companies´ retained income values constant over time, all else being equal, instead of unknowingly destroying them as the currently do. The only way they can maintain the real value of constant real value non-monetary items during inflation and deflation is by choosing a Constant Purchasing Power Accounting model as per the IASB´s Framework, Par. 104 (a).
Not a single SA accountant in SA chooses to measure financial capital maintenance in real value maintaining units of constant purchasing power as authorized by the IASB in the Framework, Par. 104 (a). SA accountants, unfortunately, choose to measure financial capital maintenance in nominal monetary units and thereby, unknowingly, destroy the real values of constant items at a rate equal to the rate of inflation when they are never or not fully updated over time when they implement the very destructive stable measuring unit assumption as part of the HCA model. SA accountants are unknowingly killing the real economy at the rate of about R200 billion per annum – each and every year - as long as they carry on implementing the very destructive stable measuring unit assumption.
© 2005-2010 by Nicolaas J Smith. All rights reserved
No reproduction without permission.
Three fundamentally different basic economic items
The economy is divided in the monetary and non-monetary or real economy. Economic items consist of monetary and non-monetary items. Non-monetary items are sub-divided in variable real value non-monetary items and constant real value non-monetary items. There are thus three fundamentally different basic economic items in the economy: monetary items, variable items and constant items.
Variable real value non-monetary items
The first economic items were variable real value items. Their real values were determined by supply and demand. Their values were not yet expressed in terms of money because money was not yet invented at that time.
The first economies were barter economies. People bartered economic items they possessed or produced in excess of their own personal needs for other products they desired from other people who had an excess of the products they in turn possessed or produced.
There was no inflation because there was no money. There was no monetary medium of exchange. There was no monetary unit of account. There was no monetary store of wealth. There was no money illusion.
There was no double entry accounting model at that time.
There were thus no Historical Cost Accounting model, no stable measuring unit assumption, no historical cost items and no nominal monetary units.
There was also no Consumer Price Index at that time and consequently there were no units of constant purchasing power and no real value maintaining Constant Purchasing Power Accounting model.
There were no financial reports: e.g. no profit and loss accounts and no balance sheets.
There were no monetary items and no constant items. There were only variable real value items not yet expressed in monetary terms.
Examples of variable real value non-monetary items in today’s economy are property, plant, equipment, inventory, shares, raw materials, merchandise, patents, trademarks, etc.
Monetary items
Money was then invented over a long period of time as a response to the limitations imposed by the barter economy. Eventually money came to fulfil the following three functions:
a. Medium of exchange
b. Store of value
c. Unit of account
Non-monetary items were only defined in monetary terms after the invention of money when it came to be used as the basic monetary unit of account in the economy. The economy came to be divided in the monetary economy and the non-monetary or real economy. There were monetary items and non-monetary items.
Monetary items
Monetary items are money held and items with an underlying monetary nature.
Examples of monetary items in today’s economy are bank notes and coins, bank 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.
Non-monetary items
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
There were still no units of constant purchasing power because there was still no CPI at that time. There was still no Historical Cost Accounting model and still no stable measuring unit assumption. There was still no Constant Purchasing Power Accounting model. There were still no double entry financial reports: still no profit and loss accounts and still no balance sheets.
Inflation
Inflation is always and everywhere a monetary phenomenon: Milton Friedman.
Inflation destroys the real value of money. Deflation creates real value in money.
Inflation reared its ugly head soon after the invention of money. It only destroyed the real value of money and other monetary items at that time as it does today. Inflation did not and can not destroy the real value of variable and constant items. Inflation has no effect on the real value of non-monetary items.
There was only one systemic economy-wide process of real value destruction at that time. The economic process of inflation destroyed the real value of money and other monetary items equally throughout the monetary economy at that time as it does today in economies subject to inflation.
There was no second systemic economy-wide accounting practice destroying the real value of constant real value non-monetary items never or not fully updated as we experience today because the real value destroying Historical Cost Accounting model, which includes the very destructive stable measuring unit assumption, was not yet invented at that time. Today South African accountants unknowingly destroy the real values of constant real value non-monetary items never or not fully updated because they choose to measure financial capital maintenance in SA banks and companies in nominal monetary units when they implement the very destructive stable measuring unit assumption as part of the real value destroying traditional Historical Cost Accounting model.
Constant items
Finally the double entry accounting model was invented. It was first comprehensively codified by the Italian Franciscan monk, Luca Pacioli in his book Summa de arithmetica, geometria, proportioni et proportionalita, published in Venice in 1494.
The invention of the double entry accounting model enables accountants to maintain the real values of both income statement as well as balance sheet constant real value non-monetary items – the third distinct category of economic items. Maintaining the real value of constant items in the SA economy where accountants use the double entry accounting model to account all economic activity is, however, only possible with the real value maintaining Constant Purchasing Power Accounting model during inflation. It is not possible, at present, while SA accountants implement the real value destroying traditional Historical Cost Accounting model because of their application of the very destructive stable measuring unit assumption during inflation. SA accountants unknowingly destroy real value on a massive scale in the real economy when they implement the traditional Historical Cost model.
The specific choice of measuring financial capital maintenance in units of constant purchasing power (the CPPA model) at all levels of inflation and deflation as contained in the Framework for the Preparation and Presentation of Financial Statements, was approved by the International Accounting Standards Board’s predecessor body, the International Accounting Standards Committee Board, in April 1989 for publication in July 1989 and adopted by the IASB in April 2001.
“In the absence of a Standard or an Interpretation that specifically applies to a transaction, management must use its judgement in developing and applying an accounting policy that results in information that is relevant and reliable. In making that judgement, IAS 8.11 requires management to consider the definitions, recognition criteria, and measurement concepts for assets, liabilities, income, and expenses in the Framework. This elevation of the importance of the Framework was added in the 2003 revisions to IAS 8." IAS Plus, Deloitte.
IAS8, 11: “In making the judgement, management shall refer to, and consider the applicability of, the following sources in descending order:
(a) the requirements and guidance in Standards and Interpretations dealing with similar and related issues; and
(b) the definitions, recognition criteria and measurement concepts for assets, liabilities, income and expenses in the Framework.”
There is no applicable International Financial Reporting Standard or Interpretation regarding the valuation of constant real value non-monetary items, e.g. issued share capital, retained earnings, capital reserves, all other items in Shareholders Equity, trade debtors, trade creditors, deferred tax assets and liabilities, taxes payable and receivable, all other non-monetary receivables and payables, Profit and Loss account items such as salaries, wages, rents, etc. The Framework is thus applicable.
The scope of the Framework includes dealing with defining, recognizing and measuring the items in financial statements and dealing with the concepts of capital and capital maintenance.
Framework, Par. 104 (a)
Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power.
The Framework, Par. 110 states that the choice of the measurement bases and the concept of capital maintenance will decide the accounting model applied in the preparation of the financial reports. The Framework applies to different accounting models and is a guide to the preparation and presentation of the financial reports under the chosen accounting model.
The Framework is the IASB approved basis for accountants to choose, in terms of Par. 104 (a), to measure financial capital maintenance in units of constant purchasing power – the CPPA model - instead of in nominal monetary units – the traditional HCA model. They can, in terms of Par. 110, choose the Constant Purchasing Power Accounting model implementing the constant purchasing power financial capital concept, capital maintenance concept and the determination of profit/loss in terms of units of constant purchasing power instead of the Historical Cost capital concept, capital maintenance concept and the determination of profit/loss in terms of nominal monetary units.
The Framework, Par. 102 states that most companies choose a financial concept of capital. Capital is the same as the shareholders´ equity of a company or its net assets when a financial concept of capital is adopted, for example, invested purchasing power or invested money.
The maintenance of capital is as important as its recognition and definition. Capital maintenance is an accounting practice implementing a concept of capital.
The Framework states that the needs of the users of financial reports should be the basis for choosing the correct concept of capital by a company. When the users of financial reports are mainly concerned with the preservation of the purchasing power of the invested capital or its nominal value, then a financial concept of capital should be used.
According to the Framework, the choice of the measurement bases and the concept of capital maintenance will decide the accounting model applied in the preparation of the financial reports. A profit is made under the financial capital maintenance concept only when the period-end financial (or money) net asset value is greater than at the start of the period, after subtracting distributions and contributions to and from shareholders during the accounting period. Financial capital maintenance can be calculated in either units of constant purchasing power or in nominal monetary units.
The real value maintaining Constant Purchasing Power Accounting model is thus an IASB approved alternative to the real value destroying traditional Historical Cost Accounting model.
The Framework states that the capital maintenance concept deals with how companies define the capital they want to preserve. It is the connection between the concepts of capital and the concepts of profit/loss since it gives the point of reference for calculating profit/loss.
Examples of constant real value non-monetary items in today’s economy are Profit and Loss Account items like salaries, wages, rentals, pensions, taxes, duties, fixed interest payments, etc as well as balance sheet items like retained earnings, issued share capital, capital reserves, share issue premiums, share issue discounts, provisions, capital reserves, all other shareholder’s equity items, trade debtors, trade creditors, other non-monetary debtors and creditors, taxes payable and receivable, deferred tax assets and liabilities, dividends payable and receivable, royalties payable and receivable, etc.
Variable real value non-monetary items
The first economic items were variable real value items. Their real values were determined by supply and demand. Their values were not yet expressed in terms of money because money was not yet invented at that time.
The first economies were barter economies. People bartered economic items they possessed or produced in excess of their own personal needs for other products they desired from other people who had an excess of the products they in turn possessed or produced.
There was no inflation because there was no money. There was no monetary medium of exchange. There was no monetary unit of account. There was no monetary store of wealth. There was no money illusion.
There was no double entry accounting model at that time.
There were thus no Historical Cost Accounting model, no stable measuring unit assumption, no historical cost items and no nominal monetary units.
There was also no Consumer Price Index at that time and consequently there were no units of constant purchasing power and no real value maintaining Constant Purchasing Power Accounting model.
There were no financial reports: e.g. no profit and loss accounts and no balance sheets.
There were no monetary items and no constant items. There were only variable real value items not yet expressed in monetary terms.
Examples of variable real value non-monetary items in today’s economy are property, plant, equipment, inventory, shares, raw materials, merchandise, patents, trademarks, etc.
Monetary items
Money was then invented over a long period of time as a response to the limitations imposed by the barter economy. Eventually money came to fulfil the following three functions:
a. Medium of exchange
b. Store of value
c. Unit of account
Non-monetary items were only defined in monetary terms after the invention of money when it came to be used as the basic monetary unit of account in the economy. The economy came to be divided in the monetary economy and the non-monetary or real economy. There were monetary items and non-monetary items.
Monetary items
Monetary items are money held and items with an underlying monetary nature.
Examples of monetary items in today’s economy are bank notes and coins, bank 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.
Non-monetary items
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
There were still no units of constant purchasing power because there was still no CPI at that time. There was still no Historical Cost Accounting model and still no stable measuring unit assumption. There was still no Constant Purchasing Power Accounting model. There were still no double entry financial reports: still no profit and loss accounts and still no balance sheets.
Inflation
Inflation is always and everywhere a monetary phenomenon: Milton Friedman.
Inflation destroys the real value of money. Deflation creates real value in money.
Inflation reared its ugly head soon after the invention of money. It only destroyed the real value of money and other monetary items at that time as it does today. Inflation did not and can not destroy the real value of variable and constant items. Inflation has no effect on the real value of non-monetary items.
There was only one systemic economy-wide process of real value destruction at that time. The economic process of inflation destroyed the real value of money and other monetary items equally throughout the monetary economy at that time as it does today in economies subject to inflation.
There was no second systemic economy-wide accounting practice destroying the real value of constant real value non-monetary items never or not fully updated as we experience today because the real value destroying Historical Cost Accounting model, which includes the very destructive stable measuring unit assumption, was not yet invented at that time. Today South African accountants unknowingly destroy the real values of constant real value non-monetary items never or not fully updated because they choose to measure financial capital maintenance in SA banks and companies in nominal monetary units when they implement the very destructive stable measuring unit assumption as part of the real value destroying traditional Historical Cost Accounting model.
Constant items
Finally the double entry accounting model was invented. It was first comprehensively codified by the Italian Franciscan monk, Luca Pacioli in his book Summa de arithmetica, geometria, proportioni et proportionalita, published in Venice in 1494.
The invention of the double entry accounting model enables accountants to maintain the real values of both income statement as well as balance sheet constant real value non-monetary items – the third distinct category of economic items. Maintaining the real value of constant items in the SA economy where accountants use the double entry accounting model to account all economic activity is, however, only possible with the real value maintaining Constant Purchasing Power Accounting model during inflation. It is not possible, at present, while SA accountants implement the real value destroying traditional Historical Cost Accounting model because of their application of the very destructive stable measuring unit assumption during inflation. SA accountants unknowingly destroy real value on a massive scale in the real economy when they implement the traditional Historical Cost model.
The specific choice of measuring financial capital maintenance in units of constant purchasing power (the CPPA model) at all levels of inflation and deflation as contained in the Framework for the Preparation and Presentation of Financial Statements, was approved by the International Accounting Standards Board’s predecessor body, the International Accounting Standards Committee Board, in April 1989 for publication in July 1989 and adopted by the IASB in April 2001.
“In the absence of a Standard or an Interpretation that specifically applies to a transaction, management must use its judgement in developing and applying an accounting policy that results in information that is relevant and reliable. In making that judgement, IAS 8.11 requires management to consider the definitions, recognition criteria, and measurement concepts for assets, liabilities, income, and expenses in the Framework. This elevation of the importance of the Framework was added in the 2003 revisions to IAS 8." IAS Plus, Deloitte.
IAS8, 11: “In making the judgement, management shall refer to, and consider the applicability of, the following sources in descending order:
(a) the requirements and guidance in Standards and Interpretations dealing with similar and related issues; and
(b) the definitions, recognition criteria and measurement concepts for assets, liabilities, income and expenses in the Framework.”
There is no applicable International Financial Reporting Standard or Interpretation regarding the valuation of constant real value non-monetary items, e.g. issued share capital, retained earnings, capital reserves, all other items in Shareholders Equity, trade debtors, trade creditors, deferred tax assets and liabilities, taxes payable and receivable, all other non-monetary receivables and payables, Profit and Loss account items such as salaries, wages, rents, etc. The Framework is thus applicable.
The scope of the Framework includes dealing with defining, recognizing and measuring the items in financial statements and dealing with the concepts of capital and capital maintenance.
Framework, Par. 104 (a)
Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power.
The Framework, Par. 110 states that the choice of the measurement bases and the concept of capital maintenance will decide the accounting model applied in the preparation of the financial reports. The Framework applies to different accounting models and is a guide to the preparation and presentation of the financial reports under the chosen accounting model.
The Framework is the IASB approved basis for accountants to choose, in terms of Par. 104 (a), to measure financial capital maintenance in units of constant purchasing power – the CPPA model - instead of in nominal monetary units – the traditional HCA model. They can, in terms of Par. 110, choose the Constant Purchasing Power Accounting model implementing the constant purchasing power financial capital concept, capital maintenance concept and the determination of profit/loss in terms of units of constant purchasing power instead of the Historical Cost capital concept, capital maintenance concept and the determination of profit/loss in terms of nominal monetary units.
The Framework, Par. 102 states that most companies choose a financial concept of capital. Capital is the same as the shareholders´ equity of a company or its net assets when a financial concept of capital is adopted, for example, invested purchasing power or invested money.
The maintenance of capital is as important as its recognition and definition. Capital maintenance is an accounting practice implementing a concept of capital.
The Framework states that the needs of the users of financial reports should be the basis for choosing the correct concept of capital by a company. When the users of financial reports are mainly concerned with the preservation of the purchasing power of the invested capital or its nominal value, then a financial concept of capital should be used.
According to the Framework, the choice of the measurement bases and the concept of capital maintenance will decide the accounting model applied in the preparation of the financial reports. A profit is made under the financial capital maintenance concept only when the period-end financial (or money) net asset value is greater than at the start of the period, after subtracting distributions and contributions to and from shareholders during the accounting period. Financial capital maintenance can be calculated in either units of constant purchasing power or in nominal monetary units.
The real value maintaining Constant Purchasing Power Accounting model is thus an IASB approved alternative to the real value destroying traditional Historical Cost Accounting model.
The Framework states that the capital maintenance concept deals with how companies define the capital they want to preserve. It is the connection between the concepts of capital and the concepts of profit/loss since it gives the point of reference for calculating profit/loss.
Examples of constant real value non-monetary items in today’s economy are Profit and Loss Account items like salaries, wages, rentals, pensions, taxes, duties, fixed interest payments, etc as well as balance sheet items like retained earnings, issued share capital, capital reserves, share issue premiums, share issue discounts, provisions, capital reserves, all other shareholder’s equity items, trade debtors, trade creditors, other non-monetary debtors and creditors, taxes payable and receivable, deferred tax assets and liabilities, dividends payable and receivable, royalties payable and receivable, etc.
Saturday, 28 February 2009
CIPPA is an IASB approved alternative to Historical Cost Accounting
The International Accounting Standards Board´s Framework introduced the real value maintaining Constant ITEM Purchasing Power Accounting model as an alternative to the real value destroying traditional Historical Cost Accounting model in 1989 in Par. 104 (a) where it states that financial capital maintenace - not variable real value non-monetary items, e.g. property, plant, equipment, inventory, intangible assets, etc, - can be meansured in either nominal monetary units - the very destructive traditional HCA model - or in units of constant purchasing power: the CIPPA model. [10] The Framework is part of International Financial Reporting Standards.
Buy the ebook for $2.99 or £1.53 or €2.68
The CIPPA model is chosen by hardly any accountant in non-hyperinflationary economies even though it would maintain the real values of constant real value non-monetary items - e.g. issued share capital, retained income, other shareholder equity items, trade debtors, trade creditors, etc for an unlimited period of time. This is because the CIPPA model is generally viewed by accoutants as a 1970´s failed inflation-accounting model that requires all non-monetary items - variable real value non-monetary items and constant real value non-monetary items - to be inflation-adjusted by means of the Consumer Price Index.
The IASB did not approve CIPPA in 1989 as an inflation accounting model. CIPPA by measuring financial capital maintenance in units of constant purchasing power incorporates an alternative capital concept, financial capital maintenance concept and profit determination concept to the Historical Cost capital concept, financial capital maintenance concept and profit determination concept. CIPPA only requires all constant real value non-monetary items, e.g. issued share capital, retained income, all other items in Shareholders Equity, trade debtors, trade creditors, deferred tax assets and liabilities, taxes payable and receivable, all items in the profit and loss account, etc to be valued in units of constant purchasing power. Variable real value non-monetary items, e.g. property, plant, equipment, listed and unlisted shares, inventory, etc are valued in terms of IFRS and are not required in terms of the Framework, Par. 104 (a) to be valued in units of constant purchasing power.
Buy the ebook for $2.99 or £1.53 or €2.68
The IASB requires entities to implement IAS 29 which is a CPP inflation accounting model during hyperinflation.
Buy the ebook for $2.99 or £1.53 or €2.68
The CIPPA model is chosen by hardly any accountant in non-hyperinflationary economies even though it would maintain the real values of constant real value non-monetary items - e.g. issued share capital, retained income, other shareholder equity items, trade debtors, trade creditors, etc for an unlimited period of time. This is because the CIPPA model is generally viewed by accoutants as a 1970´s failed inflation-accounting model that requires all non-monetary items - variable real value non-monetary items and constant real value non-monetary items - to be inflation-adjusted by means of the Consumer Price Index.
The IASB did not approve CIPPA in 1989 as an inflation accounting model. CIPPA by measuring financial capital maintenance in units of constant purchasing power incorporates an alternative capital concept, financial capital maintenance concept and profit determination concept to the Historical Cost capital concept, financial capital maintenance concept and profit determination concept. CIPPA only requires all constant real value non-monetary items, e.g. issued share capital, retained income, all other items in Shareholders Equity, trade debtors, trade creditors, deferred tax assets and liabilities, taxes payable and receivable, all items in the profit and loss account, etc to be valued in units of constant purchasing power. Variable real value non-monetary items, e.g. property, plant, equipment, listed and unlisted shares, inventory, etc are valued in terms of IFRS and are not required in terms of the Framework, Par. 104 (a) to be valued in units of constant purchasing power.
Buy the ebook for $2.99 or £1.53 or €2.68
The IASB requires entities to implement IAS 29 which is a CPP inflation accounting model during hyperinflation.
Sunday, 22 February 2009
Accountants can choose Constant Item Purchasing Power Accounting
The IASB´s Framework, Par. 104 (a) states: "Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power."
The word can means it is a choice open to all accountants since 1989 to measure financial capital maintenance (not variable real value non-monetary items) in units of constant purchasing power.
Several IFRS statements correctly prevent the use of price-level accounting methods of measurement for the valuation of variable real value non-monetary items, e.g. IAS16 Property, Plant and Equipment, intangible assets( IAS38) and inventories (IAS2) during the accounting period including at the financial report date - in non-hyperinflationary economies. IAS29 requires restatement of all non-monetary items in units of constant purchasing power during hyperinflation.
I agree that IAS16, IAS38 and IAS2 take precedence over the Framework - since these Standards relate to variable real value non-monetary items.
The Scope of the Framework includes:
Par. 5. The Framework deals with:
.........
(c) the definition, recognition and measurement of the elements from which financial statements are constructed; and
(d) concepts of capital and capital maintenance.
Capital is not a variable real value non-monetary item. Capital is a constant real value non-monetary item - like e.g. all the items in Shareholders Equity, etc.
The Framework, Par. 110 states: "The selection of the measurement bases and concept of capital maintenance will determine the accounting model used in the preparation of the financial statements."
When accountants choose to measure financial capital maintenance in units of constant purchasing power, they choose to implement the real value maintaining Constant Item Purhasing Power Accounting model instead of the real value destroying traditional Historical Cost Accounting model. This choice is open to all accountants since April 1989 as stated in the Framework, Par. 104 (a).
There is no applicable IFRS statement regarding the valuation of constant real value non-monetary items, e.g. all elements in Shareholders Equity, etc. Par. 104 (a) of the Framework is thus valid as an IFRS basis for accountants to choose to measure financial capital maintenance in units of constant purchasing power thus implementing the constant purchasing power financial capital concept and capital maintenance concept instead of the Historical Cost capital concept and capital maintenance concept.
The IASB approved option of measuring financial capital maintenance in units of constant purchasing power has nothing to do with the valuation of variable real value non-monetary items. It is all about "concepts of capital and capital maintenance" [par. 5 (d)] which " will determine the accounting model used in the preparation of the financial statements" [par. 110]. Nothing at all about the valuation of variable real value non-monetary items like PPE, intangible assets and inventory. It is stated under the section: Concepts of Capital and Capital Maintenance in the Framework.
As a result of the Framework, Par. 104 (a) all accountants in the world (who implement IFRS) choose - knowingly or unknowingly - either the Historical Cost or the Constant Item Purchasing Power accounting model. They all choose the very destructive HCA model because
(1) it is the traditional accounting model,
(2) they and accounting authorities do not undestand the real value destroying effect of the stable measuring unit assumption during low inflation and
(3) they and accounting authorities do not understand the real value maintaining effect of choosing financial capital maintenance in constant purchasing power units in terms of the IASB´s Framework, Par. 104 (a) which states that "Financial capital maintenance can be measured in nominal monetay units or in units of constant purchasing power."
The IASB requires them to implement IAS 29 which is based on the inflation accounting CPPA model - during hyperinflation.
The Framework, Par. 104 (a) empowers accountants to implement the real value maintaining Constant Item Purchasing Power Accounting model during non-hyperinflationary periods which requires only constant items to be inflation-adjusted by means of the CPI during non-hyperinflationary periods.
The word can means it is a choice open to all accountants since 1989 to measure financial capital maintenance (not variable real value non-monetary items) in units of constant purchasing power.
Several IFRS statements correctly prevent the use of price-level accounting methods of measurement for the valuation of variable real value non-monetary items, e.g. IAS16 Property, Plant and Equipment, intangible assets( IAS38) and inventories (IAS2) during the accounting period including at the financial report date - in non-hyperinflationary economies. IAS29 requires restatement of all non-monetary items in units of constant purchasing power during hyperinflation.
I agree that IAS16, IAS38 and IAS2 take precedence over the Framework - since these Standards relate to variable real value non-monetary items.
The Scope of the Framework includes:
Par. 5. The Framework deals with:
.........
(c) the definition, recognition and measurement of the elements from which financial statements are constructed; and
(d) concepts of capital and capital maintenance.
Capital is not a variable real value non-monetary item. Capital is a constant real value non-monetary item - like e.g. all the items in Shareholders Equity, etc.
The Framework, Par. 110 states: "The selection of the measurement bases and concept of capital maintenance will determine the accounting model used in the preparation of the financial statements."
When accountants choose to measure financial capital maintenance in units of constant purchasing power, they choose to implement the real value maintaining Constant Item Purhasing Power Accounting model instead of the real value destroying traditional Historical Cost Accounting model. This choice is open to all accountants since April 1989 as stated in the Framework, Par. 104 (a).
There is no applicable IFRS statement regarding the valuation of constant real value non-monetary items, e.g. all elements in Shareholders Equity, etc. Par. 104 (a) of the Framework is thus valid as an IFRS basis for accountants to choose to measure financial capital maintenance in units of constant purchasing power thus implementing the constant purchasing power financial capital concept and capital maintenance concept instead of the Historical Cost capital concept and capital maintenance concept.
The IASB approved option of measuring financial capital maintenance in units of constant purchasing power has nothing to do with the valuation of variable real value non-monetary items. It is all about "concepts of capital and capital maintenance" [par. 5 (d)] which " will determine the accounting model used in the preparation of the financial statements" [par. 110]. Nothing at all about the valuation of variable real value non-monetary items like PPE, intangible assets and inventory. It is stated under the section: Concepts of Capital and Capital Maintenance in the Framework.
As a result of the Framework, Par. 104 (a) all accountants in the world (who implement IFRS) choose - knowingly or unknowingly - either the Historical Cost or the Constant Item Purchasing Power accounting model. They all choose the very destructive HCA model because
(1) it is the traditional accounting model,
(2) they and accounting authorities do not undestand the real value destroying effect of the stable measuring unit assumption during low inflation and
(3) they and accounting authorities do not understand the real value maintaining effect of choosing financial capital maintenance in constant purchasing power units in terms of the IASB´s Framework, Par. 104 (a) which states that "Financial capital maintenance can be measured in nominal monetay units or in units of constant purchasing power."
The IASB requires them to implement IAS 29 which is based on the inflation accounting CPPA model - during hyperinflation.
The Framework, Par. 104 (a) empowers accountants to implement the real value maintaining Constant Item Purchasing Power Accounting model during non-hyperinflationary periods which requires only constant items to be inflation-adjusted by means of the CPI during non-hyperinflationary periods.
Sunday, 28 December 2008
Difference between deflation and disinflation
Updated on 23 July 2013
Deflation is a sustained decrease in the general price level resulting in a sustained increase in the real value of money and other monetary items not deflation-adjusted daily as well as constant real value non-monetary items treated as monetary items (e.g. trade debtors, trade creditors, all other non-monetary receivables, all other non-monetary payables, etc.), i.e., not measured in units of constant purchasing power in terms of a daily index, under Historical Cost Accounting. These items are worth more in real value all the time during deflation as opposed to being worth less in real value all the time during inflation. Deflation is negative inflation. The above only applies to monetary items not deflation-adjusted daily under Capital Maintenance in Units of Constant Purchasing Power. Constant items are always and everywhere measured in units of constant purchasing power in terms of a daily index under CMUCPP.
Disinflation is lower inflation. Prices are still rising during disinflation, but at a lower rate. The general price level still rises, but, at a slower rate resulting in a continued, but, lower rate of real value destruction in money and other monetary items as well as constant real value non-monetary items treated as monetary items. A lowering of inflation is not deflation but disinflation.
Under Economic Capital Maintenance in Units of Constant Purchasing Power under which
(1) all constant real value non-monetary items are always and everywhere measured in units of constant purchasing power in terms of a daily index and
(2) all monetary items (except local currency bank notes and coins outside the banking system) are inflation-adjusted or deflation-adjusted daily
only local currency bank notes and coins outside the banking system lose real value all the time during inflation and disinflation and gain in real value all the time during deflation.
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Deflation means the general price level is not increasing at all, but, actually decreasing continuously and the internal functional currency – money - and other monetary items as well as constant items treated as monetary items under HCA not deflation-adjusted daily in terms of a daily index are worth more all the time. Deflation causes an increase in the real value of money and other monetary items as well as constant items treated as monetary items under HCA not deflation-adjusted daily in terms of a daily index.
Inflation destroys real value in money and monetary items not inflation-adjusted daily as well as constant items treated as monetary items under HCA, i.e., not measured in units of constant purchasing power in terms of daily index. Disinflation destroys real value in money, etc. more slowly. Deflation creates real value in money, etc.
Inflation is a sustained increase in the general price level. Disinflation is a slower sustained increase in the general price level. Deflation is a sustained decrease in the general price level.
Disinflation happens after a period of higher inflation in what are normally considered low inflation economies and is sometimes initially popularly confused with deflation. During disinflation many prominent prices, for example, oil, fuel, commodity, property and food prices are falling, but, the general price level is still actually rising, albeit at a much slower rate than during normal low inflation. When the slowing annual inflation rate moves lower and lower it eventually gets to a zero percent annual rate for maybe a month or two. When the general price level then continues to decline even further - below zero percent per annum - the economy flips over (a very big change) from inflation to deflation: not just a slower increase in the general increasing price level as during disinflation but actually a sustained decrease in the general price level below zero percent per annum which causes an increase in the real value of money, etc.: the opposite of inflation or negative inflation.
Countries (excluding Japan) have little recent experience of deflation. Deflation is generally regarded as a very serious economic problem that everyone is trying to avoid at all costs especially after what happened during the Great Depression.
Copyright © 2008 Nicolaas Smith
Thursday, 4 December 2008
Inflation has no effect on the real value of non-monetary items
Geoffrey Whittington, one of the world’s leading experts in inflation accounting and International Financial Reporting Standards stated:
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“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.” Inflation Accounting, Geoffrey Whittington. P. 73.
It is clear from Whittington’s benchmark book that CPPA can be applied in periods of high and hyperinflation to index or inflation-adjust non-monetary accounts by means of a general index, normally the CPI, which reflects changes in the purchasing power of the functional currency. Accountants in this manner determine the values of non-monetary items when
(1) they account them during the reporting period
(2) calculate the period-end profit or loss and
(3) measure financial capital maintenance in units of constant purchasing power
during high and hyperinflation.
Whittington signed off the preface to his book in 1983. The IASB´s Framework was authorized in 1989.
This book, contrary to Whittington’s book, is not about SA accountants implementing 1970-style inflation accounting in the SA economy during low inflation.
This book is about SA accountants maintaining the real values of constant real value non-monetary items during low inflation in the SA economy by implementing the Constant Purchasing Power Accounting model as authorized in the IASB´s Framework, Par. 104 (a) which forms part of International Financial Reporting Standards.This book is about SA accountants indexing or inflation-adjusting constant items never or not fully updated in the low inflationary SA economy by means of the CPI which reflects changes in the purchasing power of the Rand, as authorized in the IASB´s Framework which forms part of IFRS.
This book is about SA accountants choosing to measure financial capital maintenance in SA companies in units of constant purchasing power during low inflation as authorized in the IASB´s Framework which forms part of IFRS.
This book is about SA accountants rejecting the stable measuring unit assumption during low inflation as authorized in the IASB´s Framework which forms part of IFRS.
This book is about stopping SA accountants unknowingly destroying about R200 billion of real value in the SA real economy each and every year when they choose to implement the traditional Historical Cost Accounting model instead of the CPPA model as authorized in the IASB´s Framework which forms part of IFRS: because they unknowingly make the Historical Cost Mistake.
This book is about SA accountants being able to maintain about R200 billion of real value in the SA real economy for an unlimited period of time instead of unknowingly destroying it year in year out as they do at the moment.
This book is about SA accountants abandoning the Historical Cost Accounting model and adopting the Constant Purchasing Power Accounting model in SA´s low inflationary economy – as authorized in the IASB´s Framework which forms part of IFRS.
Current reporting period monetary item accounts cannot be indexed or inflation-adjusted under any circumstance because the real value of money cannot be maintained during inflation or deflation under any circumstance.
This book does not propose that the historical costs of variable real value non-monetary items, e.g. property, plant, equipment, shares, stock, raw materials, patents, trademarks, etc, are to be consistently indexed or inflation-adjusted by SA accountants by means of the CPI for the purpose of valuation during the current accounting period, for calculating the period-end profit or loss and for financial capital maintenance during low inflation. Variable items are valued by SA accountants in terms of IFRS or SA Generally Accepted Accounting Practice excluding during hyperinflation when the implementation of International Accounting Standard IAS 29 Financial Reporting in Hyperinflationary Economies is specifically required by the IASB. SA has never experienced hyperinflation which may explain a possible lack of profound analysis of value accounting in SA.
This book is about SA accountants rejecting the stable measuring unit assumption in the SA economy at all levels of inflation and deflation as authorized in the IASB´s Framework which forms part of IFRS.
It is very clear from the IASB´s Framework, Par. 104 (a) that measuring financial capital maintenance in units of constant purchasing power is authorized by the IASB as the basis for a CPPA model at any level of inflation and deflation. The IASB does not state that financial capital maintenance can be measured in nominal monetary units (the traditional HC model) only during low inflation and that it can be measured in units of constant purchasing power (the CPP model) only during high and hyperinflation. It states simply that either the one or the other can be used. That means at all levels of inflation and deflation. It does, however, specifically require IAS 29 during hyperinflation.
In the Framework, Par. 101 the IASB states that companies most commonly use the traditional HC measurement basis to prepare their financial reports and that other measurement bases are used in combination with HC. The IASB does, however, specifically require entities only in hyperinflationary economies – being exceptional circumstances - to implement IAS 29. IAS 29 is based on CPPA. No-where is it stated by the IASB that the basic CPPA model can only be used during high inflation and hyperinflation or that it can not be used during low inflation.
The IASB - as far as measurement bases are concerned - specifically mentions historical cost, current cost, realizable (settlement) value, present value, market value, recoverable value and fair value which SA accountants, in fact, use to value variable items like property, plant, equipment, stock, shares, raw materials, patents, trademarks, etc in terms of IFRS or SA GAAP.
In Par. 104 (a) the IASB authorizes SA accountants to measure financial capital maintenance in units of constant purchasing power which would determine that they use the CPPA model instead of the traditional HC that they use at the moment. Although SA accountants choose to measure financial capital maintenance in nominal monetary units, that is, they choose the HC model, they do, however, use units of constant purchasing power to index or inflation-adjust constant items like salaries, wages, rentals, etc. SA accountants can also use units of constant purchasing power, in terms of Par. 104 (a), to value constant items like retained earnings, issued share capital, other shareholder equity items, trade debtors and creditors, etc to implement a CPP concept of capital maintenance. The IASB notes that entities use various different measurement bases in varying combinations and to different degrees in their financial reports.
We commonly find that SA companies state in their opening notes to their balance sheet that their financial reports have been prepared based on the traditional HC model. We normally find that they use different measurement bases to different degrees and in different combinations including items that are indexed or inflation-adjusted by means of the CPI in SA´s low inflationary economy; e.g. salaries, wages, rentals, utility prices, transport fees, etc. CPP indexing or inflation-adjustment is thus currently a generally accepted accounting practice in SA´s low inflationary economy only for the above-mentioned items.
In the case of salaries and wages the annual CPP indexation or inflation-adjustment normally involves labour union negotiations with employer bodies. To maintain the constant purchasing power of salaries and wages – which are expressed in nominal Rand monetary terms - they normally agree on an annual increase in the nominal Rand payment values of salaries and wages that covers – or compensates for or inflation-adjusts for - at least the expected rate of destruction in the real value of the Rand – which is the monetary medium of exchange in SA for the payment of constant purchasing power salaries and wages - for the period in question – normally the year ahead - plus an additional percentage increase for increases in productivity or for political or social reasons by government employment-contract negotiators.
CPP indexation or inflation-adjustment is thus part of IFRS and it is also a SA generally accepted accounting practice and well understood in SA´s low inflationary economy for constant real value non-monetary items like salaries, wages, rents, etc.
Despite the fact that CPPA is authorized in the IASB´s Framework, Par. 104 (a) as it forms part of IFRS since April 1989 as an alternative choice to the traditional HC model at any level of inflation and deflation, it is, unfortunately, not chosen by a single SA accountant in SA to measure financial capital maintenance in units of constant purchasing power and to value constant items in the balance sheet like retained earnings, issued share capital, other shareholder equity items, taxes payable and receivable, trade debtors and trade creditors, etc. SA accountants value these items at HC. Where CPPA is not applied and these constant items are never or not fully updated SA accountants unknowingly destroy their real values at the rate of inflation because they choose to measure financial capital maintenance in nominal monetary units; that is, they choose the traditional HC model which includes the stable measuring unit assumption.
The real values of these constant real value non-monetary items are not being destroyed by inflation since inflation is a monetary phenomenon and can only destroy the real value of money and other monetary items; namely, in SA, the real value of the monetary medium of exchange, the Rand; that is, the SA functional currency. Milton Friedman, the American economist and Noble Laureate, correctly stated that: Inflation is always and everywhere a monetary phenomenon. Inflation has no effect on the real value of non-monetary items. Inflation cannot erode or destroy the real value of non-monetary items. Erode is, in fact, the same as destroy – there is no difference. SA accountants´ choice of implementing the stable measuring unit assumption as part of the HC model – instead of the CPP option - means that they unknowingly destroy the real values of constant items never or not fully updated in the SA real economy on a massive scale. The erosion or destruction stops the moment they choose to implement the CPPA model no matter what the level of inflation or deflation. The choice is theirs as authorized in the IASB´s Framework which is part of IFRS. It is thus SA accountants´ choice of accounting model and not inflation that is doing the destroying. The real values of these constant items are unknowingly being destroyed by SA accountants because they, unfortunately, implement the stable measuring unit assumption only for the purpose of valuing the above specified constant items. When they value and account constant items like retained earnings, issued share capital, capital reserves, provisions, other shareholder equity items, trade debtors and creditors, taxes payable and receivable, deferred tax assets and liabilities, etc, they assume that changes in the Rand´s general purchasing power are not sufficiently important to require adjustments to the nominal values of these constant items in order to maintain their real values constant over time. They value and account them at their historical costs and unknowingly destroy their real values at the rate of inflation each and every year – as long as they carry on implementing the HC model and the stable measuring unit assumption.
In the same breath, they do exactly the opposite: they now suddenly acknowledge that inflation is destroying the real value of the Rand as a monetary medium of exchange and they index or inflation adjust by means of the CPI constant real value non-monetary items like salaries, wages, rents, pensions, etc by increasing their nominal values at the rate of inflation thus keeping their real values constant over the time period in question.
SA accountants of listed JSE companies comply with IFRS. If SA should enter into hyperinflation they would implement IAS 29. They would then apply the CPPA model and index or inflation-adjust items like retained earnings, issued share capital, capital reserves, provisions, other shareholder equity items, trade debtors and creditors, taxes payable and receivable, deferred tax assets and liabilities, etc by means of the CPI. They would update issued share capital for all JSE listed companies from the date it was contributed, etc and maintain their real values constant under hyperinflation.
When SA is not in a hyperinflationary economy any more they would stop the CPPA model and go back to the real-value-destroying HC model and again destroy all these items´ real values at the rate of inflation or they can choose to carry on with the CPPA model and maintain their real values constant or they can choose to change now to the CPPA model in terms of Par. 104 (a). The choice is theirs since CPPA has already been authorized in the IASB´s Framework since 1989.
Inflation accounting is generally only used in periods of very high inflation, for example in the 1970´s and during hyperinflation, e.g. in the current hyperinflationary economy in Zimbabwe. The IASB´s IAS 29 is only required during hyperinflation. Hyperinflation is defined by the IASB as a cumulative inflation rate of 100% over three years; that is, 26% per annum inflation for three years in a row.
The principal objective of this book is to demonstrate with actual values that SA accountants unknowingly destroy the real value of constant items never or not fully updated in the SA real economy on a massive scale because they choose to measure financial capital maintenance in nominal monetary units in terms of Par. 104 (a); that is, they choose to implement the stable measuring unit assumption as it forms part of the traditional Historical Cost Accounting model only for this purpose.
It is an objective of this book to show that measuring financial capital maintenance in units of constant purchasing power - as authorized in the IASB´s Framework, Par. 104 (a) - is the only way to maintain the real values of constant real value non-monetary items at all levels of inflation and deflation in the SA economy; namely, with a Constant Purchasing Power Accounting model. It is the only way to stop SA accountants unknowingly destroying the real value of constant items on a massive scale in the SA real economy during inflation.
Another objective is to show that there are three distinct economic items in the economy, namely, variable real value non-monetary items, monetary items and constant real value non-monetary items and that they are valued in distinctly different ways during the reporting period when SA accountants choose to measure financial capital maintenance in units of constant purchasing power in terms of Par. 104 (a).
It is an objective of this book to start a process to stop SA accountants unknowingly destroying the real values of constant items at the rate of inflation where they are never or not fully updated in the real economy because they choose to measure financial capital maintenance in nominal monetary units. The objective is thus to get SA accountant to choose the other official option in Par. 104 (a); namely, to measure financial capital maintenance in units of constant purchasing power during low inflation as authorized in IFRS.
Measuring financial capital maintenance in units of constant purchasing power means rejecting the stable measuring unit assumption and with it the traditional Historical Cost Accounting model; that is, it means indexing all constant real value non-monetary items by means of the CPI at all levels of inflation and deflation in the SA economy, except during hyperinflation when indexing of not only constant items but all non-monetary items are to be done, not at the CPI, but, at the parallel rate. See Hyperinflation. Indexing by means of the CPI during hyperinflation as required in IAS 29 is one of the main reasons for its failure as an accounting standard.
The IASB does not state anything in Par 104 (a) about measuring financial capital maintenance in units of constant purchasing power being an option only or specifically for the purpose of inflation accounting in high inflationary and hyperinflationary economies. It is an IASB authorized alternative to the traditional HC model at any level of inflation or deflation as clearly evident from the wording of Par. 104 (a). This book is mainly about that. Obviously, CPPA is also applicable in high inflationary and hyperinflationary periods when inflation accounting per se is normally used. This book is, however, mainly about measuring financial capital maintenance in units of constant purchasing power as an alternative to HCA during low inflation in the SA economy in order to stop SA accountants unknowingly destroying massive amounts of real value in the real economy.
Any accounting practice that adjusts monetary values to compensate for or to correct the effect of the destruction of the monetary medium of exchange’s real value can be seen as inflation accounting since inflation destroys the real value of the monetary unit of account which is used as the monetary medium of exchange in the internal economy. All updating of salaries, minimum wages, rentals, utility prices, etc is currently maintaining the real values of those items in units of constant purchasing power – where it is exactly the same as the inflation rate during the relevant period - even when the main accounting model is stated to be the traditional HCA model.
Framework, Par. 110:
The selection of the measurement bases and concept of capital maintenance will determine the accounting model used in the preparation of the financial statements.
The IASB authorizes two concepts of capital maintenance in Par. 104 (a): in nominal monetary units; i.e. the HCA model - and in units of constant purchasing power; i.e. the CPPA model. The IASB does not exclude the CPPA model during low inflation. It authorizes it as an alternative to the traditional HCA model at all levels of inflation and deflation. It only mandates that it specifically requires IAS 29, which is based on CPPA, during hyperinflation.
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Copyright © 2008 Nicolaas Smith
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