The world only goes round by misunderstanding

The world only goes round by misunderstanding. Charles Baudelaire

It is generally accepted under the current Historical Cost paradigm that the economy is divided in only two parts: the monetary economy and the non-monetary or real economy. It is also generally accepted that there are only two basic economic items in the economy: monetary items and non-monetary items. Monetary items are money held and items with an underlying monetary nature. Non-monetary items are all items that are not monetary items.

No distinction is generally made between the valuation of variable real value non-monetary items, e.g. property, plant, equipment, inventory, etc valued at Historical Cost under the Historical Cost Accounting model and constant real value non-monetary items, e.g. Issued Share capital, retained Earnings, other items in Shareholders´ Equity and most items in the income statement (excluding items like salaries, wages, rentals, etc. valued in units of constant purchasing power) also valued at Historical Cost under the HCA model.

This is the result of the fact that the economy is based on the Historical Cost paradigm. Historical Cost is the traditional measurement basis in accounting. It is thus generally accepted for accountants to choose to implement the very destructive stable measuring unit assumption (based on a fallacy) and measure financial capital maintenance in nominal monetary units (another complete fallacy) as authorized by the IASB in the Framework, Par 104 (a) during low inflationary periods.

Kindest regards,

Nicolaas Smith

Copyright © 2010 Nicolaas J Smith

Value date December 2009

South African Consumer Price Index 109.2 December 2009

Base year 2008 = 100 Table A – All Urban Areas

All items in financial reports dated December 2009 have to be updated or restated or inflation-adjusted in terms of the December 2009 CPI in order to reflect their correct and valid nominal or updated or inflation-adjusted values at the date they are read. Unadjusted December 2009 financial reports are out of date or wrong as from the date the January 2010 CPI is published - if it is different from the December 2009 CPI value. All financial reports not updated or restated or inflation-adjusted every time the CPI changes are - in principle - wrong. They certainly are out of date. Since most financial reports are not published during the period of the CPI for their period-end date, most financial reports are always published, in principle, with wrong values at first publication.

All SA financial reports of SA companies with December year ends published after the January 2010 CPI (with a different value from the 109.2 December 2009 value) is published and these financial reports are not inflation adjusted or restated or updated in terms of the January 2010 CPI value, will be published with wrong values on first publication.

Values in electronic copies will be updated automatically with Real Value Enabler™ - US Patent Applied For - when the necessary technology becomes available.

Example

Assumption: Inflation assumed to remain at 6% per annum in SA for an indefinite period of time.

..............................................Nominal Value........Real Value
.....................................................................at Dec 2009
CPI as at Dec 2009..............109.2.........R100.00.............R100.00

Assumed values for the CPI

Dec 2010........................115.8.........R106.00.............R100.00
Dec 2011........................122.7.........R112.36.............R100.00
Dec 2012........................130.1.........R119.10.............R100.00
Dec 2013........................137.9.........R126.25.............R100.00
Dec 2014........................146.1.........R133.82.............R100.00
Dec 2015........................154.9.........R141.85.............R100.00
Dec 2020........................207.3.........R189.83.............R100.00
Dec 2030........................371.2.........R339.96.............R100.00
Dec 2080......................6 838.2.......R6 262.05.............R100.00


All financial reports, e.g. income statements and balance sheets, dated December 2009 have to be restated as above to be able to be read correctly at the above future dates.

The restated values will not be the assumed real values of the items at the above future dates, but, the real values of the items at December 2009 restated at the assumed future CPI values.

All items in historical financial reports have to be restated every time the CPI changes, not to value them correctly, but, to reflect their real values correctly at the original date of the financial report.

Kindest regards,

Nicolaas Smith

Copyright © 2010 Nicolaas J Smith

Price-level accounting does not prevail for balance sheet constant items

Price-level accounting as Harvey Kapnick hoped for in 1976 clearly does not prevail for balance sheet constant items and most income statement items, except during rare instances of hyperinflation (e.g., Turkey’s latest period of hyperinflation) when companies are required to implement IAS 29 which is the IASB´s Constant Purchasing Power inflation accounting model and the tax authorities accept the restated amounts as the new real values of those items as happened in the case of Turkey.

Price-level accounting generally did prevail in the Brazilian economy during the 30 years from 1964 to 1994 when they indexed many variable and constant items in their non-monetary or real economy with daily indexation with a daily index value supplied by their government. They stopped that with the full implementation of the traditional HCA model, financial capital maintenance in nominal monetary units and the stable measuring unit assumption when they changed the Unidade Real de Valor into their latest currency, the Real, in 1994. They stopped daily indexation which is, in principle, the same as continuous financial capital maintenance in units of constant purchasing power.

Price-level accounting does prevail in the valuation of certain income statement items, e.g. salaries, wages, rentals, etc. which are inflation-adjusted annually by means of the CPI in most economies.

If SA accountants understood that the implementation of the stable measuring unit assumption during low inflation results in the unknowing, unnecessary and unintentional destruction by SA accountants of massive amounts of real value in constant items never maintained in the SA economy, they would have called for its rejection by now.


Copyright © 2010 Nicolaas J Smith

IASB clueless about destruction by stable measuring unit assumption

The International Accounting Standards Board confirms the fact that the Historical Cost paradigm is firmly in place when it states in IAS 29 Financial Reporting in Hyperinflationary Economies and in the Framework that companies´ primary financial reports are prepared in most economies based on the traditional Historical Cost Accounting model without taking changes in the general level of prices (here it is clear that the IASB blames inflation and not the stable measuring unit assumption) or specific price changes of assets into account, with the exception that investments, equipment, plant and properties can be revalued. The IASB does not mention the destruction of the real value of balance sheet constant items never maintained when accountants implement the stable measuring unit assumption during low inflationary periods because it is not generally understood: the IASB, like the US Financial Accounting Standards Board and most accountants mistakenly believe that the destruction (erosion) of companies´ capital and profits is caused by inflation.

They all support the stable measuring unit assumption (based on a fallacy) and the actual fallacy of financial capital maintenance in nominal monetary units during low inflation and deflation. The destruction of real value in constant items by implementing the stable measuring unit assumption is very well understood - and compensated for by inflation-adjusting them by applying the annual CPI - in the case of the income statement constant items salaries, wages, rentals, etc.

Neither is the real value maintaining effect on balance sheet constant items understood of freely choosing to measure financial capital maintenance in units of constant purchasing power instead of in nominal monetary units – both models being approved by the IASB in the Framework, Par 104 (a).

The International Accounting Standards Committee (the IASB predecessor body) blamed changing prices in IAS 15 Information Reflecting the Effects of Changing Prices for affecting an enterprise’s results of operation and financial position. They defined changing prices as (1) specific price changes and (2) changes in the general price level which changed the general purchasing power of money, i.e. they blamed specific price changes and inflation for affecting companies´ results and financial position. Whereas the FASB mentioned the stable measuring unit assumption in FAS 33 and FAS 89, the IASB never mentioned it in either IAS 6 Accounting Response to Changing Prices or IAS 15. IAS 15 completely superseded IAS 6. IAS 15 was eventually withdrawn.

Because most accountants and users of financial statements have been inculcated with a model of financial reporting that assumes stability of the monetary unit, accepting a change of this consequence would take a lengthy period of time under the best of circumstances. FAS 89, Par 4, 1986

The integrity of the historical cost/nominal dollar system relies on a stable monetary system. FAS 33, 1979.
Copyright © 2010 Nicolaas J Smith

Accounting can not and does not create real value out of thin air

It must be clearly understood, however, that accounting per se can not and does not create real value out of thin air – out of nothing.

Accountants can not and do not create real value or wealth by simply passing some update accounting entries when no real value already exists.

Constant real value non-monetary items, e.g. Issued Share Capital, Share Premium, Retained Profits, Capital Reserves, other items in Shareholders´ Equity, Trade Debtors, Trade Creditors, Taxes Payable, Taxes Receivable, etc first have to exist for accountants to be able to maintain the real values of those existing constant real value non-monetary items stable by continuously measuring financial capital maintenance in units of constant purchasing power as approved by the IASB and by continuously valuing income statement constant items in terms of units of constant purchasing power in order to determine profit or loss in units of constant purchasing power during low inflation and deflation.

Accountants can maintain the existing real values of existing balance sheet constant items, e.g. Issued Share capital, Retained Earnings, etc stable in companies at least breaking even for an unlimited period of time, ceteris paribus, when they choose to measure financial capital maintenance in units of constant purchasing power during low inflation and deflation as approved by the IASCB in the Framework, Par 104 (a) in 1989 and adopted by the IASB in 2001.

The Framework, Par 104 (a) states:

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

Financial capital maintenance in nominal monetary units per se during inflation and deflation is a fallacy. It is impossible to maintain the real value of capital stable in nominal monetary units per se during inflation and deflation. The only way to maintain the real value of capital constant during inflation and deflation per se in companies that at least break even - all else being even - is with financial capital maintenance in units of constant purchasing power.

The IASB has thus, amazingly, authorized the fallacy of financial capital maintenance in nominal monetary units per se during inflation and deflation as well as its only and perfect antidote during inflation and deflation in one and the same statement in 1989. The antidote is perfect during inflation and deflation; the values may not be perfect as a result of the way the CPI is calculated.

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

Kindest regards,

Nicolaas Smith

Copyright © 2010 Nicolaas J Smith

Capital deficiency during sub-prime crisis

The world economy would be more robust today if only financial capital maintenance in units of constant purchasing power had been authorized in the Framework, Par 104 (a) in 1989. Accountants would today maintain the real values of all companies´ and banks´ Issued Share Capital, Retained Earnings and all other items in Shareholders´ Equity since then in companies and banks that at least break even, instead of unknowingly destroying their real values never maintained at a rate equal to the rate of inflation year in year out during low inflationary periods when they implement their very destructive stable measuring unit assumption based on a fallacy, but, approved by the IASB – for an unlimited period of time during indefinite inflation. They unknowingly do this because they are authorized to choose to measure financial capital maintenance in nominal monetary units – another complete fallacy also approved by the IASB – implementing the traditional HCA model authorized by the IASB in the exact same Framework, Par 104 (a) 21 years ago.

Had only real value maintaining financial capital maintenance in units of constant purchasing power been approved in 1989 it would have made a significant difference over this period as verified by the huge capital injections required as a result of the capital deficiency problems caused by the continuous unknowing, unnecessary and unintentional destruction by accountants´ implementation of the stable measuring unit assumption in the valuation of banks´ and companies´ Shareholders´ Equity values never maintained under the HCA model as evidenced during the recent sub-prime financial crisis.

Kindest regards,

Nicolaas Smith

Copyright © 2010 Nicolaas J Smith

Financial capital maintenance in units of constant purchasing power

Financial capital maintenance in units of constant purchasing power, i.e. the inflation-adjustment by means of the CPI of only constant items - not inflation accounting complete price-level adjustment of all (variable and constant) non-monetary items - during low inflation and deflation has also been authorized by the IASC Board thirteen years after Harvey Kapnick´s 1976 prediction. The IASC Board approved the Framework, Par 104 (a) in 1989 stating that

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

However, the enormous real value destroying function of the very destructive stable measuring unit assumption when accountants choose, also in terms of Par 104 (a), the IASB approved very popular accounting fallacy of financial capital maintenance in nominal monetary units and apply it in the valuing of constant items never maintained, e.g. reported retained earnings, in low inflationary economies when the stable measuring unit assumption is maintained for an unlimited period of time during indefinite inflation, is not generally understood by the IASB and SA accountants, at all. This is clearly verified by the fact that both financial capital maintenance in nominal monetary units as well as real value maintaining financial capital maintenance in units of constant purchasing power during inflation and deflation were approved by the IASB in the Framework, Par 104 (a) in 1989. Accountants can choose the one or the other and state that they have prepared primary financial statements in terms of IFRS.

However, when they choose the traditional HCA model they unknowingly destroy real value on a massive scale in the real or non-monetary economy during low inflation when the very destructive stable measuring unit assumption is maintained for an unlimited period of time during indefinite inflation. When they choose IASB approved financial capital maintenance in units of constant purchasing power they would maintain the real values of all constant items during inflation and deflation in companies which at least break even, empowering and enriching those companies, their shareholders and the economy in general with the accompanying benefits to workers and employment for an unlimited period of time – all else being equal.

As the Deutsche Bundesbank stated:

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

Deutsche Bundesbank, 1996 Annual Report, P 83.

Financial capital maintenance in units of constant purchasing power during inflation and deflation would result in absolute price stability only in constant items for an unlimited period of time in companies that at least break even – all else being equal. The IASB predecessor body, the IASC Board, approved absolute price stability in income statement and balance sheet constant items when they authorized the Framework, Par 104 (a) in 1989 approving the option of measuring financial capital maintenance in units of constant purchasing power during low inflation and deflation.

HCA is very destructive during inflation

Also approving the traditional HCA model in the Framework, Par 104 (a), on the other hand, has been very costly for the world economy as amply illustrated by the deficiency in bank and company capital during the recent sub-prime financial crisis. This clearly illustrates the lack of understanding the very destructive effect of the stable measuring unit assumption on balance sheet constant items during low inflationary periods.
Copyright © 2010 Nicolaas J Smith

Historical Cost Accounting is based on popular IASB-approved accounting fallacies

Price-level accounting

SA accountants generally choose to measure financial capital maintenance in nominal monetary units (one of the three very popular accounting fallacies not yet extinct) and thus apply their very destructive stable measuring unit assumption (another of the three accounting fallacies) as part of the traditional HCA model based on these fallacies. They generally value balance sheet constant items as well as most income statement items – which are all constant items - at Historical Cost because they value them in nominal monetary units as a result of the fact that they assume the Rand is perfectly stable for this purpose. They only value certain income statement items, e.g. salaries, wages, rentals, etc in real value maintaining units of constant purchasing power and inflation-adjust them by means of the annual CPI during low inflation.

Complete price-level accounting

Complete price-level accounting also called Constant Purchasing Power Accounting (CPPA) was developed as an inflation accounting model whereby all non-monetary items – variable and constant items – are inflation-adjusted by means of the period-end CPI in order to make financial statements more comparable with previous year statements during periods of high and hyperinflation. The non-monetary or real economy of a hyperinflationary economy can only be maintained stable by applying the daily parallel US Dollar exchange rate to the valuation of all non-monetary items instead of the period-end CPI as required by IAS 29.

The Framework is applicable

The implementation of the concepts of capital, the capital maintenance concepts and the profit/loss determination concepts during non-hyperinflationary periods are not covered in IAS, IFRS or Interpretations. These concepts are covered in the Framework, Par 102 to 110. There are no specific IAS or IFRS relating to these concepts. The Framework is thus applicable as per IAS8.11. The valuation of the constant items Issued Share capital, reported retained earnings, other items in Shareholders´ Equity and other constant items is thus covered in the IASB´s Framework, Par 104 (a) which states “Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power” authorized in 1989.

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

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

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

Kindest regards,

Nicolaas Smith

© Copyright 2010 Nicolaas J Smith

Value accounting prevails for monetary and variable items

The accounting model SA accountants choose determines whether they unknowingly destroy massive amounts annually in the real value of reported constant items never maintained or knowingly would maintain massive amounts of real value every year in reported constant items in the constant item economy depending on whether they choose the IASB-approved traditional HCA model when they apply the very destructive stable measuring unit assumption for an unlimited period of time during indefinite inflation or IASB-approved financial capital maintenance in units of constant purchasing power during inflationary and deflationary periods – both models amazingly approved in the Framework, Par 104 (a) in 1989. It is not inflation doing the destroying in reported constant real value non-monetary items never maintained, e.g. in companies´ capital and profits, as the IASB, the FASB and most accountants believe. SA accountants are unnecessarily, unknowingly and unintentionally doing the destroying when they implement the stable measuring unit assumption during indefinite inflation. Inflation has no effect on the real value of non-monetary items.

Value accounting

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

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

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

Most SA accountants agree that accounting should be value based. By value based they mean that variable real value non-monetary items can not always be valued at Historical Cost and are to be valued in terms of specific standards formulated in IFRS or SA GAAP at, for example, market value, net realizable value, fair value, present value or recoverable value, etc.

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

Value accounting also prevails as far as the accounting and valuing of monetary items during the current accounting period are concerned. Monetary items are measured in nominal monetary units no matter which accounting model is used. The real values of monetary items are kept always current by inflation and deflation since the nominal values of monetary items are normally not updated or inflation-adjusted during the current accounting period in any inflationary or deflationary economy. The real value of money and other monetary items generally changes monthly during inflation and deflation. It is destroyed during inflation and increased during deflation.

The nominal values of monetary items stay the same during the current financial period under any accounting model, but, their real values are automatically adjusted by inflation and deflation. The real value of money and other monetary items can be halved every 24.7 hours as has happened recently during hyperinflation in Zimbabwe. According to Prof Steve Hanke from John Hopkins University prices halved every 15.6 hours during hyperinflation in Hungary in 1946.

The net monetary loss or net monetary gain resulting from holding an excess of either monetary item assets or monetary item liabilities is currently only calculated and accounted during the implementation of Constant Purchasing Power inflation accounting as defined in IAS 29 in hyperinflationary economies. Net monetary gains and losses would also be calculated and accounted during low inflation and deflation when companies start measuring financial capital maintenance in units of constant purchasing power in terms of the Framework, Par 104 (a). They are not calculated and accounted under the traditional Historical Cost Accounting model, although it can be done according to Harvey Kapnick. See Saxe Lecture, 1976.

Copyright (c) 2005-2010 Nicolaas J Smith

SA accountants clueless about destruction by stable measuring unit assumption

The real values of many reported constant real value non-monetary items, for example, reported retained earnings never maintained, in the SA economy are currently not being maintained stable during low inflation. To the contrary: they are unnecessarily, unknowingly and unintentionally being destroyed at a rate equal to the annual rate of inflation by SA accountants implementing their very destructive stable measuring unit assumption when they measure financial capital maintenance in nominal monetary units – the accounting fallacy as authorized by the IASB in the Framework, Par 104 (a) in 1989 - for an unlimited period of time during indefinite inflation.

Many accountants see themselves as simply providing historic economic information. They do not understand the fact that continuously maintaining the constant purchasing power of capital which requires continuously maintaining the real values of all constant items stable during inflation and deflation is a basic objective of accounting. This is the result of:

(1) the three popular accounting fallacies; namely,

(a) the stable measuring unit assumption (authorized by the IASB) ,
(b) financial capital maintenance in nominal monetary units (authorized by the IASB) and
(c) the erosion of companies´ profits and capital by inflation (fully accepted by the IASB, the FASB);

(2) the fact that most accountants and accounting authorities do not understand the real value destroying effect of the very destructive stable measuring unit assumption on reported constant items never maintained during low inflationary periods when the stable measuring unit assumption/financial capital maintenance in nominal monetary units is applied for an unlimited period of time during indefinite inflation and

(3) the fact that most accountants and accounting authorities do not understand the real value maintaining effect on constant items of continuously measuring financial capital maintenance in units of constant purchasing power during low inflation as approved by the IASB in the Framework, Par 104 (a).

If they had understood the above, they would have stopped the stable measuring unit assumption / financial capital maintenance in nominal monetary units by now.


This is what the International Accounting Standards Committee Board authorized 21 years ago in the Framework for the Preparation and Presentation of Financial Statements, Par 104 (a):

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

It was adopted by the IASB in 2001.

Amazingly the very popular accounting fallacy of financial capital maintenance in nominal monetary units and its perfect antidote are both authorized in the exact same IASB statement in 1989.

There are no specific IFRS relating to the concepts of capital or the concepts of capital maintenance. The Framework thus applies.

“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 December 2009

Copyright © 2005 - 2010 Nicolaas J Smith

It is not inflation doing the destroying

The understanding of the difference between the generally accepted accounting practice whereby SA accountants unnecessarily, unknowingly and unintentionally destroy the real values of only existing reported constant items never maintained only in the SA constant item economy with their free choice of implementing their very destructive stable measuring unit assumption during low inflation as authorized by the IASB when it approved the very popular accounting fallacy of financial capital maintenance in nominal monetary units during low inflation in the Framework, Par 104 (a) in 1989 and the destruction by the economic process of inflation of the real value of only money and other monetary items only in the monetary economy is an ongoing process. It has become clear to me, since September 2008, that inflation and hyperinflation only destroy the real value of money and other monetary items. Inflation and hyperinflation only have one – a monetary – component. It is clear to me now that it is not inflation that is causing (or hyperinflation that could cause) the destruction of the SA real economy or the real value of reported constant items never maintained in the SA real economy. It is clear to me now that inflation does not have a non-monetary component.

Copyright © 2005 - 2010 Nicolaas J Smith

Economic fallacies not yet extinct

Economic history is replete with fallacies which became extinct with the developement of economic understanding.

The three economic fallacies not yet extinct are:

1. The stable measuring unit assumption.

2. Financial capital maintenance in nominal monetary units.

3. The erosion of companies´ profits and capital caused by inflation.

We all know that money is not perfectly stable and that it is impossible to maintain the real value of capital with financial capital maintenance in nominal monetary units per se during inflation and deflation.

SA accountants unknowingly destroy the real value of companies´ profits and capital never maintained with their free choice of implementing the stable measuring unit assumption during inflation. Inflation can only destroy the real value of money and other monetary items. Inflation has no effect on the real value of non-monetary items.

The erosion of companies´ capital and profits by inflation is a very popular accounting fallacy stated by, for example, the US Financial Accounting Standards Board:

The basic proposition underlying Statement 33 — that inflation causes historical cost financial statements to show illusory profits and mask erosion of capital — is virtually undisputed. Financial Accounting Standard FAS 89 (voluntary disclosure), Par 4, P 5, 1986

and

Mr. Mosso dissents because he believes that the Statement does not bring the basic problem it addresses — measuring the effect of inflation on business operations — into focus. Because of that he doubts that it will effectively communicate the erosive impact of inflation on profits and capital and the significance of that erosion on all who have an investment stake in business enterprises. FAS 33 (superseded by FAS 89), Par 67, P 22, 1979.

The FASB blamed inflation for the erosion – which is the same as destruction – of companies´ capital and profits, but, in the same paragraph carried on to admit that the traditional Historical Cost Accounting model or, specifically, the stable measuring unit assumption does the destroying:

Because most accountants and users of financial statements have been inculcated with a model of financial reporting that assumes stability of the monetary unit, accepting a change of this consequence would take a lengthy period of time under the best of circumstances. FAS 89, Par 4, P6, 1986.

The International Accounting Standards Board also blamed inflation in IAS 15 Information Reflecting the Effects of Changing Prices (withdrawn):

The information required by this standard is designed to make users of an enterprise’s financial statements aware of the effects of changing prices on the results of its operations. IAS 15, Par 7, 1983.

Both shareholders´ equity being a company’s capital as well as retained profits are 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.

© 2005-2010 by Nicolaas J Smith. All rights reserved

No reproduction without permission.

Hegemony of Historical Cost Accounting

Monetary items

SA accountants value and account monetary items during the current accounting period at their original nominal monetary values under all accounting models during low inflation, hyperinflation and deflation. Inflation determines the always current real value of the Rand and other monetary items in the SA monetary economy. This is the result of the fact that the real value of money and other monetary items cannot be updated or inflation-adjusted or valued in units of constant purchasing power during the current accounting period.

The real value of the Rand and other monetary items in the SA monetary economy changes equally normally every month with the publication of the new CPI value. Currently, the applicable CPI value can become available up to a month and a half after the date of a transaction in SA´s low inflationary economy. The daily parallel rate is generally constantly available in a hyperinflationary economy. The CPI is the internal exchange rate between the value of the Rand and real value in the SA economy. The parallel rate fulfils this role in a hyperinflationary economy.

Variable items

Variable items in SA are continuously valued and accounted in terms of IFRS or SA GAAP at, for example, fair value, market value, net realizable value, recoverable value, present value, etc.

Constant items

Real values of constant real value non-monetary items in the SA constant item economy have to be continuously maintained stable during low inflation by means of continuous financial capital maintenance in units of constant purchasing power, i.e. inflation-adjusting them monthly during low inflation by means of the CPI as authorized in the IASB´s Framework, Par 104 (a) in 1989. Annual inflation-adjustment is only currently being done in the case of certain income statement items, e.g., salaries, wages, rentals, etc. in South Africa as well as in most other non-hyperinflationary economies.

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


Meanwhile the standards, twenty years ago, already provided the option to reject the stable measuring unit assumption in the Framework, Par 104 (a) which states:

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

I want the International Accounting Standards Board to remove the accounting fallacy "financial capital maintenance can be measured in nominal monetary units" from the Framework, Par 104 (a). International Financial Reporting Standards should not be based on very popular accounting fallacies.
Hyperinflation

Valuation in units of constant purchasing power is required for all non-monetary items (variable and constant items) by the IASB during hyperinflation as per the Constant Purchasing Power inflation accounting model defined in IAS 29 Financial Reporting in Hyperinflationary Economies. The only way a country can maintain its non-monetary or real economy stable during hyperinflation is by measuring all non-monetary items in units of constant purchasing power; however, not by restating HC or current cost financial statements at the end of the reporting period in terms of the period-end CPI to make them more useful as required by IAS 29, but, by applying the daily parallel US Dollar exchange rate, or - as was done, in principle, in Brazil - with indexation during the 30 years from 1964 to 1994.

IAS 29 was implemented by Zimbabwean companies listed on their stock exchange by applying the CPI at year-end as required by the IASB. Zimbabwean accountants unnecessarily, unknowingly and unintentionally destroyed their country’s real economy by implementing Historical Cost Accounting during the financial year, as supported by the IASB in IAS 29, and then restated their year-end Historical Cost financial statements in terms of the year-end CPI to make them more useful. That did not stop them from unknowingly destroying their real economy with HCA during hyperinflation.

PricewaterhouseCoopers state:

"Inflation-adjusted financial statements are an extension to, not a departure from, historical cost accounting."

Financial Reporting in Hyperinflationary Economies – Understanding IAS 29, PricewaterhouseCoopers, May 2006.

© 2005-2010 by Nicolaas J Smith. All rights reserved

No reproduction without permission.

Monumental: The most critical set of issues this century

Here is some related information which highlights the problem:

The US Financial Accounting Standards Board tried to address the problem of accountants unknowingly destroying companies´ capital and profits by applying the stable measuring unit assumption (which is fallaciously believed by everyone to be caused by inflation: inflation can only destroy the real value of money and other monetary items – nothing else.) in their Financial Accounting Standard FAS 33 Financial Reporting and Changing Prices which was completely superseded by FAS 89 with the same title.

FAS 89

This Statement supersedes FASB Statement No. 33, Financial Reporting and Changing Prices, and its subsequent amendments, and makes voluntary the supplementary disclosure of current cost/constant purchasing power information. The Statement is effective for financial reports issued after December 2, 1986.

This Statement was adopted by the affirmative vote of four members of the Financial

Accounting Standards Board. Messrs. Lauver, Mosso, and Swieringa dissented.

Mr. Mosso dissented to the issuance of Statement 33 and he dissents to its rescission, both for the same reason. He believes that accounting for the interrelated effects of general and specific price changes is the most critical set of issues that the Board will face in this century.

It is too important either to be dealt with inconclusively as in the original Statement 33 or to be written off as a lost cause as in this Statement. The basic proposition underlying Statement 33—that inflation causes historical cost financial statements to show illusory profits and mask erosion of capital — is virtually undisputed.

(My note: Erosion is the same as destruction of capital.)

Specific price changes are inextricably linked to general inflation, and the combination of general and specific price changes seriously reduces the relevance, the representational faithfulness, and the comparability of historical cost financial statements.

Although the current inflation rate in the United States is relatively low in the context of recent history, its compound effect through time is still highly significant.

Mr. Lauver:

Relative to most changes in financial reporting, the changes required by Statement 33 were monumental.

Because most accountants and users of financial statements have been inculcated with a model of financial reporting that assumes stability of the monetary unit, accepting a change of this consequence would take a lengthy period of time under the best of circumstances.

The measures set out in FAS 33 were the start of the process – definitely not the final solution. I do not agree with the specifics of FAS 33. I do agree with the broad principle that accountants unnecessarily destroy companies´ capital and profits when they choose to implement the stable measuring unit assumption - which is virtually undisputed as stated by the FASB.

The International Accounting Standards Board also attempted a similar standard: IAS 15 Information Reflection the Effect of Changing Prices. It was also withdrawn.

“At its meeting in October 1989, the Board of IASC approved the following statement to be added to IAS 15:

“The international consensus on the disclosure of information reflecting the effects of changing prices that was anticipated when IAS 15 was issued has not been reached. As a result, the Board of IASC has decided that enterprises need not disclose the information required by IAS 15 in order that their financial statements conform with International Accounting Standards.

However, the Board encourages enterprises to present such information and urges those that do to disclose the items required by IAS 15.”

Copyright © 2005 - 2010 Nicolaas J Smith

93.3% of internal financing unknowingly destroyed by SA accountants in banks and companies

It is generally the case that SA companies and banks do not invest 100% of the updated original real values of all contributions to their shareholders´ equity in fixed assets, e.g. land and buildings or other fixed property which are or can be revalued via the Revaluation Reserve to compensate for the real value shortfall in shareholders´ equity under Historical Cost Accounting rules during low inflation.

SA accountants thus generally unnecessarily, unknowingly and unintentionally destroy the real value of SA banks´ and companies´ reported retained earnings and other constant items never maintained at a rate equal to the annual rate of inflation (conservatively estimated at about R200 billion per annum) – all else being equal – when they choose to measure financial capital maintenance in nominal monetary units and implement their very destructive stable measuring unit assumption as part of the real value destroying traditional HCA model for an unlimited period of time during indefinite inflation.

SA accountants unnecessarily, unknowingly and unintentionally in this manner generally destroyed 93.3% of the real value of reported retained earnings that remained in SA banks and companies from January 1981 to Nov 2009 when they maintain their very destructive stable measuring unit assumption for an unlimited period of time during indefinite inflation.
Valuing the three economic items

Economic items are economic values. They are made up of monetary items, variable items and constant items. SA accountants value, record, classify, summarize and report transactions and events involving economic items in terms of the depreciating Rand.

(1) The real value of the Rand and all other monetary items in the SA monetary economy generally changes every month during low inflation. Months of zero annual inflation are rare and generally not sustained over a significant period of time.

(2) The real value of variable items may change all the time, e.g. the price of foreign exchange, precious metals, quoted shares, commodities, properties, goods, services, etc.

(3) The real values of constant items stay the same (or are suppose to stay the same) all the time – all else being equal; e.g. salaries, wages, rentals, issued share capital, reported retained profits, shareholders equity, trade debtors, trade creditors, taxes payable, taxes receivable, etc.

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

Kindest regards,

Nicolaas Smith

Accountants value everything they account

Accountants value everything they account


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

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

"Accounting is a measurement instrument."

David Mosso, Ex Member of the US Financial Accounting Standards Board

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

Many accountants still think that accounting is just a recording exercise during which they merely record past economic activity. That is not correct. Accountants value economic items when they account them. Accounting is the continuous maintenance of the constant purchasing power of capital and the provision of continuously updated decision-useful financial information about the reporting entity to capital providers and other users. It involves the valuing, recording, classifying, summarizing and reporting of an entity’s economic activity.

Accounting for inflation

In response to a letter to the editor of the Financial Mail, Accounting for Inflation published on 9th May, 2008 in which I stated:

“SA accountants freely destroy real value in the real economy with their assumption that the rand is perfectly stable only for the purpose of accounting constant value items, and have absolutely no concern about the negative impact this has on sustainable economic growth.”

The IASB is dead right that financial capital maintenance can be measured in units of constant purchasing power during low inflation, hyperinflation and deflation. The IASB has my vote.
The statements that HC financial reporting does not destroy wealth and that there is no substance in my suggestion that value destruction would end if SA accountants abandon the stable measuring unit assumption have no substance as can be unequivocally proven in the case of SA banks´ and companies´ shareholders equity values never maintained in SA´s low inflationary economy.

The real values of SA banks´ and companies´ shareholders´ equity are unnecessarily, unknowingly and unintentionally being destroyed by their accountants at a rate equal to the annual rate of inflation when their boards of directors choose to apply the stable measuring unit assumption (one of the two very popular accounting fallacies authorized by the IASB) for an unlimited period of time during indefinite inflation when these entities do not own sufficient fixed assets that are or can be revalued via the Revaluation Reserve to compensate for the real value shortfall in these items under the HCA model.

Copyright © 2005 - 2010 Nicolaas J Smith

To be or not to be a constant item, that is the question

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 Par 104 (a), 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. Date: 15 th January, 2010 http://www.iasplus.com/standard/framewk.htm

IAS 8 Par 11 states that managers, in exercising their judgement, have to first apply the rules and regulations in IFRS and interpretations by the International Financial Reporting Interpretations Committee which deal with similar and related items and, only secondly the measurement concepts, criteria for recognition and definitions for expenses, income, liabilities and assets as stated in the Framework.

There are no applicable IFRS or Interpretations regarding the valuation of the constant real value non-monetary items issued share capital, reported retained earnings, capital reserves, share premium account, share discount account, the concepts of capital, the capital maintenance concepts, the determination of profit/loss concept, etc. The measurement concepts and direct and indirect definitions in the Framework are thus applicable. There are Standards related to the constant items 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 IAS 8.11 the Standards take precedence over the Framework in the case of these items.



Conflict

There is a conflict with the capital maintenance concept in the Framework where IFRS treat constant real value non-monetary items like monetary items or variable items. The only way the financial capital concept of continuously measuring financial capital maintenance in units of constant purchasing power in terms of the provisions in the Framework, Par 104 (a) can be correctly implemented, is with the correct treatment of all constant real value non-monetary items as constant items and not as monetary or variable items. The incorrect treatment of constant items as monetary or variable items may lead to the incorrect calculation of the Net Monetary Loss or Gain from holding monetary items as required when measuring financial capital maintenance in units of constant purchasing power in terms of the Framework, Par 104 (a) and as required in IAS 29.

Examples

Examples of constant real value non-monetary items in today’s economy are income statement constant items, e.g. salaries, wages, rentals, all other items in the income statement as well as balance sheet constant items, e.g. reported 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, all other non-monetary payables and receivables, etc.

Kindest regards,

Nicolaas Smith

IFRS authorize both destruction and maintenance of real value in SA

Maintaining the real values of all constant items in the SA economy where our accountants use the double entry accounting model to account economic activity is only possible with the real value maintaining Constant ITEM Purchasing Power Accounting (CIPPA) model as authorized by the IASB twenty years ago in the Framework, Par 104 (a) (which is applicable in the absence of specific IFRS) during non-hyperinflationary periods.

Maintaining the real values of all constant items stable in the SA economy is not possible, at present, while SA accountants implement the real value destroying traditional HCA model under which they apply the very destructive stable measuring unit assumption as authorized by the IASB in the Framework, Par 104 (a) in 1989. SA accountants unnecessarily, unknowingly and unintentionally destroy real value on a massive scale in the SA real economy when they measure financial capital maintenance in nominal monetary units as part of traditional HCA.

This unnecessary, unknowing and unintentional destruction by SA accountants in the real value of constant items not fully or never maintained amounts to about R200 billion per annum for as long as they choose to implement the very destructive stable measuring unit assumption for an unlimited period of time during indefinite inflation. When they freely choose to measure financial capital maintenance in units of constant purchasing power, amazingly also authorized by the IASB in the Framework, Par 104 (a) in 1989 they will knowingly maintain that plus/minus R200 billion in real value per annum by not destroying existing reported constant item real value of, for example, reported retained profits, with their very destructive stable measuring unit assumption during low inflation.

The real value of reported retained profits can be maintained constant during low inflation and deflation under IFRS but not under HCA although the HC model is also authorized under IFRS. Both the destruction and the maintenance of the real value of reported retained profits and all other reported constant items never maintained during low inflation are, paradoxically, authorized under IFRS. Accountants are free to choose the one or the other. Both are compliant with IFRS.

Kindest regards,

Nicolaas Smith

SA accounting based on two popular accounting fallacies.

Today South African accountants unknowingly destroy the real value of existing reported constant items never maintained when they implement their very destructive stable measuring unit assumption during low inflation because they generally measure financial capital maintenance in SA banks and companies in nominal monetary units implementing the HCA model based on those two very popular IASB approved and authorized accounting fallacies.

Accountants at Johannesburg Stock Exchange listed companies as well as accountants at unlisted SA companies who prepare their financial statements in terms of International Financial Reporting Standards generally choose to measure financial capital maintenance in nominal monetary units, the accounting fallacy as approved by the International Accounting Standards Board in the Framework for the Preparation and Presentation of Financial Statements, Par 104 (a) which they apply in the absence of specific IFRS relating to the concept of capital, the concept of capital maintenance, the concept of profit /loss determination and in the absence of specific IFRS for the valuation of specific constants items, e.g. Shareholders´ Equity items, etc.

The Framework, Par 104 (a) states:

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

Astonishingly, the IASB approved and authorized both real value destroying HCA stated in terms of the very popular accounting fallacies as well as its only perfect antidote (the antidote is perfect, not the resulting values) during inflation, hyperinflation and deflation, in one and the same statement in 1989. It is impossible to maintain the real value of capital stable by measuring it in nominal monetary units per se during inflation, hyperinflation or deflation. The IFRS statement that financial capital maintenance can be measured in nominal monetary units is only true at sustainable zero inflation – a monetary mode never achieved in the past and maybe never to be achieved in the future. The IASB statement is a fallacy under the three general monetary modes: inflation, hyperinflation and deflation.

Accountants at JSE listed companies have to prepare financial reports in terms of IFRS and thus have to make the choice presented to them in the Framework, Par 104 (a) while accountants at unlisted SA companies can prepare financial statements either in terms of IFRS or South African Generally Accepted Accounting Practice. The boards of directors of SA companies listed on the JSE - which are all implementing IFRS - actually have to make the choice; their accountants being the accounting experts, obviously, advise them about the appropriate choice to make. Financial capital maintenance in nominal monetary units is a popular accounting fallacy authorized by the IASB in the Framework, Par 104 (a) in 1989. It is, however, not an appropriate accounting policy for SA companies during inflation, hyperinflation and deflation.

Unfortunately most, if not all, SA boards of directors choose financial capital maintenance in nominal monetary units as part of the real value destroying HCA model which includes the very destructive stable measuring unit assumption – another popular accounting fallacy authorized by the IASB in 1989 – in SA´s low inflationary economy. This results in their accountants unnecessarily, unknowingly and unintentionally destroying about R200 billion in the real value of existing reported constant items never or not fully maintained in the SA constant item economy each and every year.

Accountants preparing financial reports of unlisted SA companies in terms of SA GAAP generally also choose to measure financial capital maintenance in nominal monetary units and implement the very destructive HCA model since it is the generally accepted traditional accounting model.

© 2005-2010 by Nicolaas J Smith. All rights reserved

No reproduction without permission.

IASB should not authorize IFRS based on massively destructive fallacies

There was only one systemic process of real value destruction operating only in the monetary economy before the invention of the Historical Cost Accounting model. The economic process of inflation only destroyed the real value of depreciating money and other depreciating monetary items equally throughout the monetary economy at that time as it does today in economies subject to inflation and hyperinflation.

There was no simultaneous second systemic process, as we experience it today, whereby Historical Cost accountants unknowingly, unnecessarily and unintentionally destroy massive amounts of real value of existing reported constant items never or not fully maintained, e.g. reported retained profits, only in the constant item economy because they implement their very destructive stable measuring unit assumption (one of the two IASB approved very popular accounting fallacies) during low inflation and hyperinflation.

This includes the unknowing destruction by HC accountants of the real values of issued share capital, share premium account and non-distributable reserves in companies without sufficient fixed assets that are or can be revalued via the Revaluation Reserve to maintain these items´ real values under HCA during low inflation. The reason was that the real value destroying traditional Historical Cost Accounting model which includes the very destructive stable measuring unit assumption and financial capital maintenance in nominal monetary units (the very popular accounting fallacies authorized by the IASB in the Framework, Par 104 a in 1989) was not yet invented at that time.

The International Accounting Standards Board is a private, independent accounting standards board. The mission of the IASB is to develop a single set of global accounting standards. The IASB cooperates with national accounting standard boards for international convergence of accounting standards. IASB should not authorize IFRS based on massively destructive accounting fallacies, e.g. financial capital maintenance in nominal monetary units per se and the stable measuring unit assumption during low inflation which cost the SA economy about R200 billion in real value unknowingly destroyed in constant items never maintained by SA accountants implementing HCA in the SA economy each and every year. Currently the IASB is doing that in the Framework, Par 104 (a) which states that financial capital maintenance can be measured in nominal monetary units.

Kindest regards,

Nicolaas Smith