100 Questions (and Answers) about IFRS: Prof Rachel Baskerville

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

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Nicolaas Smith

Copyright © 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Comment letter to the IASB Exposure Draft: Management Commentary

Submitter.............Organization..................Date

Nicolaas Smith........Real Value Accounting.........25th February, 2010

Ms Amy Schmidt
Project Manager: Management Commentary
International Accounting Standards Board
30 Cannon Street
London EC4M 6XH
United Kingdom

Attempted submission Via “Open to comment” page on www.iasb.org

This comment letter is published HERE on the IFRS Foundation website with ID CL32.


Dear Ms Schmidt

Request for comment on IASB Exposure Draft: Management Commentary

Thank you for the opportunity to comment on the IASB Exposure Draft: Management Commentary.

In my opinion the Board should develop an IFRS for the preparation and presentation of management commentary to make it binding.

I suggest changes in the content elements related to the analysis of the adequacy of the entity’s capital structure requiring details about real value unnecessarily being destroyed because of the implementation of the stable measuring unit assumption; real value to be gained by its rejection; related to plans to address this inadequacy and useful disclosure regarding the entity’s justification for choosing financial capital maintenance in nominal monetary units instead of in units of constant purchasing power during low inflation and deflation as authorized by the IASB.

I do not agree with the Board’s decision not to include detailed application guidance and illustrative examples in the final management commentary document. I suggest specific guidance regarding management’s obligation to supply details about real value unnecessarily destroyed as a result of their implementation of financial capital maintenance in nominal monetary units and real value to be gained when they change over to financial capital maintenance in units of constant purchasing power during low inflation.

My detailed answers to the questions in the Exposure Draft and my suggestions are contained in the attached appendix.

If you have any questions regarding this submission, please do not hesitate to contact me at realvalueaccounting@yahoo.com

Yours sincerely

Nicolaas Smith


Appendix – Response to the questions asked in the Exposure Draft: Management Commentary

Status of the Final Work Product

Question 1

Do you agree with the Board’s decision to develop a guidance document for the preparation and presentation of management commentary instead of an IFRS? If not, why?

No, I do not agree. It should be an IFRS to make it binding. Optional implementation has in the past meant “Keep the status quo” as far as IFRS are concerned. Financial capital maintenance in units of constant purchasing power is a good example: The IASB approved financial capital maintenance in units of constant purchasing power during low inflation and deflation in the Framework, Par 104 (a) twenty one years ago. Its implementation would stop the unnecessary destruction of hundreds of billions of Euros (probably much more) per annum in the world economy in the real value of entities´ capital and profits never maintained constant during low inflation. Its implementation would mean automatically maintaining instead of destroying hundreds of billions of Euros (probably much more) per annum in the real value of entities´ capital and profits in entities that at least break even whether they own revaluable fixed assets or not - without extra money or additional retained profits required to maintain existing capital - in the world economy during low inflation. No-one chooses it during low inflation or deflation because it is not a binding IFRS: it is an option. It is nullified as our Taiwanese friends so eloquently state. I would also point to the waste of IASB resources in producing a document simply to be nullified by making it optional as in the case of financial capital maintenance in units of constant purchasing power during low inflation and deflation over the last 21 years.


Content elements of a decision-useful management commentary

Question 2

Do you agree that the content elements described in paragraphs 24–39 are necessary for the preparation of a decision-useful management commentary? If not, how should those content elements be changed to provide decision-useful information to users of financial reports?

Yes, I agree, but, I suggest that the following (in italics) should be added to paragraphs 29 and 33:

Paragraph 29

Disclosure about resources depends on the nature of the entity and the industry in which the entity operates. Management commentary should set out the critical financial and non-financial resources available to the entity and how those resources are used in meeting management’s stated objectives for the entity. Analysis of the adequacy of the entity’s capital structure,


“with reference to the concept of capital maintenance: in particular

(1) supplying details of the real value destroyed in shareholders´ equity never maintained constant in real value as a result of insufficient revaluable fixed assets under Historical Cost Accounting when the entity has chosen financial capital maintenance in nominal monetary units as authorized by the IASB in the Framework, Par 104 (a) and

(2) supplying details of the gain to the entity if it should choose continuous financial capital maintenance in units of constant purchasing power during low inflation and deflation also authorized by the IASB in the Framework, Par 104 (a). ”

“Analysis of” financial arrangements (whether or not recognised in the statement of financial position), liquidity and cash flows, as well as plans to address any identified inadequacies

“- specifically the identified inadequacy of financial capital maintenance in nominal monetary units per se to maintain the real value of shareholders´ equity and other constant items constant during inflation and deflation taking into account the fact that its remedy, namely, continuous financial capital maintenance in units of constant purchasing power during low inflation and deflation has been authorized by the IASB 21 years ago” - or surplus resources, are examples of disclosures that can provide useful information.

Paragraph 33

Management commentary should include a clear description of the entity’s financial and non-financial performance, the extent to which
that performance may be indicative of future performance and management’s assessment of the entity’s prospects. Useful disclosure in
that area can help users to make their own assessments about the assumptions and judgements used by management in preparing the financial statements

“specifically management’s justification in entities implementing the HCA model for their choice to measure financial capital maintenance in nominal monetary units during low inflation and deflation instead of in units of constant purchasing power in terms of the IASB´s Framework, Par 104 (a).”


Application guidance and illustrative examples

Question 3

Do you agree with the Board’s decision not to include detailed application guidance and illustrative examples in the final management commentary guidance document? If not, what specific guidance would you include and why?

No, I do not agree. The Board should include detailed application guidance to cover the items detailed in paragraphs 24-39 in the Exposure Draft as to be amended as suggested above and specifically include the following:

Management have to:

(1) state in the Management Commentary that their choice of the traditional Historical Cost basis which includes the stable measuring unit assumption, destroys the real value of constant real value non-monetary items never maintained, at a rate equal to the annual rate of inflation;

(2) state that this includes the destruction of the real value of Shareholders´ Equity when the entity does not have sufficient fixed assets that are or can be revalued via the Revaluation Reserve equal to the updated original real value of all contributions to Shareholders’ Equity under the HC basis;

(3) state the percentage and amount of Shareholders´ Equity that are not being maintained; i.e., the percentage and amount of Shareholders´ Equity that are subject to real value destruction at a rate equal to the annual inflation rate because of management’s choice, in terms of the Framework, Par 104 (a), to maintain financial capital maintenance in nominal monetary units instead of in units of constant purchasing power – both practices being compliant with IFRS;

(4) state the amount of real value destroyed during the last and previous financial years in Shareholders´ Equity and all other constant items never maintained because of management’s choice to implement the Historical Cost Accounting model;

(5) state the updated total amount of real value destroyed from the entity’s inception to date in this manner in at least Shareholders´ Equity never maintained as described above;

(6) state the change in the updated real value of Shareholders´ Equity if management should decide – as they are freely allowed to do at any time - to measure financial capital maintenance in units of constant purchasing power instead of in nominal monetary units as authorized by the IASB in the Framework, Par 104 (a);

(7) state management’s estimate of the amount of real value to be destroyed by their implementation of the stable measuring unit assumption during the following accounting year under the HC basis;

(8) state that the real value calculated in (7) represents the amount of real value the entity would gain during the following accounting year and every year there after for an unlimited period of time – ceteris paribus – when management choose to measure financial capital maintenance in units of constant purchasing power – which is compliant with IFRS – as authorized by the IASB in the Framework, Par 104 (a) in 1989 which they are free to choose any time they decide;

(9) state management’s reason(s) for choosing financial capital maintenance in nominal monetary units instead of in units of constant purchasing power in terms of the IASB´s Framework, Par 104 (a).

Rationale for my answers and suggestions above:

It is relevant information for existing and potential capital providers that the real value of the capital they provided - or are about to provide - to an entity as well as their share of other items in shareholders´ equity, e.g. retained profits which are possible dividends to them, are unnecessarily being destroyed - or would unnecessarily, be destroyed - at a rate equal to the annual rate of inflation as a result of the implementation of the Historical Cost Accounting model during low inflation for the portion of the real value of shareholders´ equity which is not maintained constant as a result of insufficient revaluable fixed assets under HCA.

It is equally relevant information for existing and potential capital providers that continuous financial capital maintenance in units of constant purchasing power which has also been authorized by the IASB 21 years ago in the Framework, Par 104 (a) would maintain the real value of shareholders´ equity and all other constant real value non-monetary items constant at all levels of inflation and deflation for an unlimited period of time in all entities that at least break even – ceteris paribus - irrespective of whether an entity owns revaluable fixed assets or not. This would happen automatically as a result of a correct IASB-authorized basic accounting model approved in 1989 at all levels of inflation and deflation without requiring more money from capital providers for additional capital contributions or additional retained profits to simply maintain existing equity’s existing real value.

The Framework, Par 104 (a) states:

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

Constant items are one of the three fundamentally different basic economic items in the economy. The other two are monetary items and variable real value non-monetary items. Variable items are non-monetary items with variable real values over time. Examples are property, plant, equipment, inventory, finished goods, foreign exchange, etc. Constant items are non-monetary items with constant real values over time. Examples are all items in the income statement, all items in shareholders´ equity, trade debtors, trade creditors, taxes payable, taxes receivable, provisions, all non-monetary payables, all non-monetary receivables, etc. Constant items have to be continuously valued in units of constant purchasing power in order to maintain their real values constant during inflation and deflation.

The generally accepted view under the HC paradigm that economic items consist of only monetary and non-monetary items avoids the proper split of non-monetary items in variable and constant items because of the implementation of the stable measuring unit assumption. This results in variable items valued at HC (e.g. fixed assets, inventory, etc.) and constant items currently also valued at HC (e.g. shareholders´ equity and most items in the income statement – excluding salaries, wages, rentals and other items normally inflation-adjusted) being classified as simply non-monetary items under HCA.

The real value of shareholders´ equity currently being valued at HC is only 100% maintained constant in the rare cases where 100% of the updated original real values of all contributions to shareholders´ equity are invested in revaluable fixed assets. It is hardly ever the case that even 100% of the updated original real values of all contributions to shareholders´ equity excluding retained profits are invested in revaluable fixed assets. Retained profits in most entities are thus treated the same as monetary items (cash) and their real values are being destroyed at a rate equal to the annual rate of inflation when financial capital maintenance is measured in nominal monetary units in low inflationary economies.

The stable measuring unit assumption is based on the fallacy that changes in the purchasing power of money are not sufficiently important for entities to choose to continuously measure financial capital maintenance in units of constant purchasing power
during low inflation and deflation as authorized by the IASB in the Framework, Par 104(a). Hyperinflation is defined by the IASB as 100% cumulative inflation over three years, i.e. 26% annual inflation for 3 years in a row. Financial capital maintenance in units of
constant purchasing power is required by the IASB in IAS 29 during hyperinflation: it is thus required at 26% annual inflation for 3 years in a row. It is, however, left as an option at 20% or 15% or 6% or 2% for three years in a row or any number of years. Real value destruction in constant items never maintained constant by the implementation of the stable measuring unit assumption at continuous 20% inflation (which would wipe out 100% of the real value of shareholders´ equity never maintained constant in 4 years) is currently considered as not sufficiently important for the implementation of continuous financial capital maintenance in units of constant purchasing power. Financial capital maintenance in nominal monetary units per se currently unknowingly, unnecessarily and
unintentionally destroy 51% of the real value of shareholders´ equity and all other constant items never maintained constant over 35 years in all economies with continuous 2% annual inflation.

Financial capital maintenance in nominal monetary units per se as authorized by the IASB in the Framework, Par 104 (a) is a fallacy during low inflation and deflation. IFRS should not be based on fallacies as they currently are. It is impossible to maintain the real value of entities´ capital and profits constant with financial capital maintenance in nominal monetary units per se during inflation and deflation. The only way to maintain the real value of capital and profits constant for an unlimited period of time in entities that at least
break even during low inflation and deflation – all else being equal - is with continuous financial capital maintenance in units of constant purchasing power per se irrespective of whether those entities own fixed assets or not. There is no other way.

“The erosion of business profits and invested capital caused by inflation” is generally accepted.

“In Mr. Mosso's view, conventional accounting measurements fail to capture the erosion of business profits and invested capital caused by inflation.” FAS 33, 1979, P 24 (superseded by FAS 89)

There is absolutely no doubt in the accounting profession that real value is being destroyed in entities´ capital and profits and there is equally absolutely no doubt in the accounting profession that it is caused by inflation. In fact, “the erosion of business profits and invested capital caused by inflation” is a fallacy. Inflation is always and everywhere a monetary phenomenon as per the late American Nobel Laureate Milton Friedman. Inflation destroys the real value of money and other monetary items – nothing else. Inflation has no effect on the real value of non-monetary items. It is impossible for inflation per se to destroy 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.
http://www.mufad.org/index2.php?option=com_docman&task=doc_view&gid=9&Itemid=100

It is not inflation doing the destroying: it is unnecessary, unknowing and unintentional destruction by the implementation of the stable measuring unit assumption under financial capital maintenance in nominal monetary units (the HCA model) during low inflation - as authorized by the IASB in the Framework, Par 104 (a) - of the real value of constant items never maintained constant amounting to hundreds of billions of Euros (probably much more) in the world economy each and every year. It is relatively easy for individual entities to calculate the amount of real value unnecessarily, unknowingly and unintentionally being destroyed as indicated above during the current year in low inflationary economies. That would give an estimate of the annual value to be gained from changing over to continuous financial capital maintenance in units of constant purchasing power as authorized by the IASB twenty one years ago. Basically it is Retained Earnings times the average rate of annual inflation in most entities.

The real values of all constant items, e.g. shareholders´ equity, will knowingly be maintained constant for an unlimited period of time in all entities that at least break even with continuous financial capital maintenance in units of constant purchasing power – ceteris paribus – amounting to hundreds of billions of Euros (probably much more) in the world economy each and every year, no matter what the rate of inflation without requiring more money for additional capital or additional retained profits to maintain the existing real values of existing constant items constant - whether entities own revaluable fixed assets or not. It is simply a matter of maintaining existing real value as indicated above instead of currently unnecessarily, unknowingly and unintentionally destroying existing real value.

Continuous financial capital maintenance in units of constant purchasing power only results in zero destruction of real value in constant items for an unlimited period of time at any level of inflation or deflation in entities that at least break even – ceteris paribus. It has no direct effect on the rate of inflation or deflation.

The removal of the 5 words “either nominal monetary units or” from the IASB Framework, Par 104 (a) would make this comment letter and appendix superfluous.

No other issues noted.

_____________________________________________________________________________________

This comment letter is published HERE on the IFRS Foundation website with ID CL32.

Copyright © 2010 Nicolaas J Smith

SA accountants confused

SA accountants and accounting lecturers at SA universities do not understand that they can stop this unknowing destruction by SA accountants of about R200 billion per annum in the real value of SA companies´ constant items never maintained by simply rejecting the stable measuring unit assumption when they freely choose the IFRS compliant financial capital maintenance in units of constant purchasing power model at all levels of inflation and deflation.

IFRS do, however, already – 21 years ago – allow the rejection of the stable measuring unit assumption as an alternative to HCA at all levels of inflation and deflation. 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."

Par 104 (a) was authorized by the IASB predecessor body, the International Accounting Standards Committee Board in April, 1989 and adopted by the IASB in 2001.

The stable measuring unit assumption is also rejected in IAS 29 Financial Reporting in Hyperinflationary Economies.

The Standards already reject the stable measuring unit assumption under the above two circumstances.
Copyright © 2010 Nicolaas J Smith

HCA abdicates one of its main functions

1970-style Constant Purchasing Power (CPP) inflation accounting was a popular but failed attempt at inflation accounting at the time. It was a form of inflation accounting which tried unsuccessfully to make corporate accounts more informative when comparing current transactions with previous transactions by updating all non-monetary items (without distinguishing between variable and constant real value non-monetary items) equally by means of the Consumer Price Index during high and hyperinflation. 1970-style CPP inflation accounting was abandoned as a failed and discredited inflation accounting model for reasons explained below when general inflation decreased to low levels thereafter.


The function of financial accounting is not just “to convey value information about the economic resources of a business” as Harvey Kapnick stated in the 1976 Sax Lecture.

http://newman.baruch.cuny.edu/DIGITAL/saxe/saxe_1975/kapnick_76.htm

The objectives of general purpose financial reporting are:

1) Automatic maintenance of the constant purchasing power of capital in all entities that at least break even - ceteris paribus.


2) Provision of continuously updated decision-useful financial information about the reporting entity to capital providers and other users.

This can only be achieved by valuing constant items in units of constant purchasing power, i.e., by inflation-adjusting all constant items by means of the monthly CPI during low inflation and deflation, namely, by measuring financial capital maintenance in units of constant purchasing power as approved by the IASB in the Framework, Par 104 (a) twenty one years ago and by valuing both variable and constant items at the daily parallel rate in terms of IAS 29 during hyperinflation.

HCA has unknowingly abdicated the essential financial capital maintenance function of accounting to the fiction that money is stable in real value during inflation and deflation. In so doing, they have in the past unknowingly destroyed and currently unknowingly destroy real value on a massive scale (at least R200 billion per annum) in the SA real economy when they implement their very destructive stable measuring unit assumption as part of the IASB approved traditional Historical Cost Accounting model for an unlimited period of time during indefinite inflation.

Kindest regards,

Nicolaas Smith

Copyright © 2010 Nicolaas J Smith

Inflation: two definitions

Variable real value non-monetary items do not need to be and are not valued in units of constant purchasing power during low inflation because they are valued in terms of SA GAAP or IFRS at, for example, fair value, market value, present value, recoverable value, net realizable value, etc which always automatically take inflation - amongst many other things - into account. Variable items are only valued in units of constant purchasing power during hyperinflation as required by the IASB in IAS 29 since the board regards hyperinflation as an exceptional circumstance.

There is a school of thought that 2% inflation is completely unharmful and that it has no disadvantages compared to absolute price stability. That is not correct. 2% inflation will destroy, for example, 51% of the real value of all monetary items and all constant items never maintained, e.g. Retained Profits, over 35 years – all else being equal – when the stable measuring unit assumption is implemented for an indefinite period of time during indefinite inflation.

It is not necessary for accountants to inflation-adjust by means of the CPI, which is a general price index, variable real value non-monetary items (e.g. properties, shares, raw material, etc.) which are subject to product specific price increases for the purpose of valuing these variable items during the accounting period on a primary valuation basis during non-hyperinflationary periods. These variable items are generally subject to market based real value changes determined by supply and demand.

They incorporate product specific price changes or product specific inflation where the word inflation is, very unfortunately, also used to simply mean a product or product group price increase instead of the general use of the word in economics to mean the destruction of the real value of money over time, i.e. a destruction of the general purchasing power of money which is caused by/results in an increase in the general price level over time. The word inflation thus has two totally different but generally accepted meanings in economics: (1) inflation meaning the destruction of the real value of money and other monetary items over time and (2) inflation meaning any price increase.

Kindest regards,

Nicolaas Smith

Copyright © 2010 Nicolaas J Smith

The Rand is an unstable monetary unit of account

SA accountants unknowingly destroy or maintain (please note: not create) the real value of constant real value non-monetary items (please note: not variable real value non-monetary items) depending on whether they choose the IASB approved traditional HCA model under which they implement their very destructive stable measuring unit assumption for an unlimited period of time during indefinite inflation or the IASB approved real value maintaining financial capital maintenance in units of constant purchasing power model under which they select to reject the stable measuring unit assumption at all levels of inflation and deflation for an unlimited period of time.

Inflation is a uniquely monetary phenomenon and can only destroy the real value of money and other monetary items over time. It has no effect on the real value of non-monetary items. See GUCENME and ARSOY above. SA accountants unknowingly, unintentionally and unwittingly do the destroying of the real value of constant items never maintained over time, e.g. Retained Earnings, Issued Share capital, other items in Shareholder’s Equity, etc when they choose the traditional HCA model during low inflationary periods.

It is correct, essential and compliant with IFRS to inflation-adjust or update constant real value non-monetary items by means of the CPI which is a general price index at all levels of inflation and deflation. The reason for this is that constant items are expressed in terms of money, i.e. in terms of an unstable monetary unit of account which is the same as the unstable monetary medium of exchange. Inflation destroys the real value of the unstable monetary medium of exchange - which is also the unstable monetary unit of account in accounting and the economy in general.

Constant items thus have to be updated or inflation-adjusted at a rate equal to the rate of inflation or deflation, i.e. valued in units of constant purchasing power, in order to maintain their real values constant during inflation and deflation because the unit of measure in accounting is an unstable monetary unit of account and consequently hardly ever absolutely stable during periods of inflation and deflation. Months of zero annual inflation are very few and far between. Sustainable zero inflation has never been achieved before and it does not seem very likely that it will be achieved any time soon in the future.

Kindest regards,

Nicolaas Smith

Copyright © 2010 Nicolaas J Smith

Capital maintenance

Capital maintenance is the continuous maintenance of the real value of capital over time; i.e. the constant purchasing power of capital.

Financial capital maintenance in nominal monetary units per se is a fallacy: it is impossible to maintain the real value of capital constant over time in nominal monetary units per se during inflation and deflation.

There are two ways of looking at capital maintenance:

1. In terms of fact
2. In terms of IFRS

1. In terms of fact

The fact that capital maintenance is the continuous maintenance of the constant purchasing power of capital means that there are only two concepts of capital maintenance:

a) Physical capital maintenance as defined in the Framework
b) Continuous financial capital maintenance in units of constant purchasing power as defined in the Framework, Par 104 (a) which states:

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

2. In terms of IFRS

There are 3 concept of capital maintenance in terms of IFRS:

a) Physical capital maintenance as defined in the Framework.

b) Financial capital maintenance in nominal monetary units as authorized by the IASB in the Framework, Par 104 (a) which is a fallacy, but, is implemented by 99.99% of entities in the world economy and results in their accountants (not inflation as the FASB, IASB and most accountants believe) unknowingly, unnecessarily and unintentionally destroying the real value of their companies´ shareholder’s equity (never maintained by sufficient revaluable fixed assets) with the implementation of their very destructive stable measuring units assumption during low inflation at a rate equal to the annual rate of inflation in all countries with low inflation amounting to hundreds of billions of Euros in the world economy each and every year.

c) Continuous financial capital maintenance in units of constant purchasing power which the IASB authorized in the Framework, Par 104 (a) in 1989 for implementation during low inflation and deflation as an alternative to the globally implemented generally accepted traditional Historical Cost Accounting model, but, it is ignored by almost everyone. Financial capital maintenance in units of constant purchasing power during low inflation would stop the unknowing destruction by accountants of the real value of companies´ capital and profits never maintained amounting to hundreds of billions of Euros in the world economy per annum implementing their very destructive stable measuring unit assumption under HCA during low inflation.

Accountants would knowingly maintain hundreds of billions of Euros in the real value of companies´ capital and profits per annum without extra money in new capital contributions or extra retained profits when they measure financial capital maintenance in units of constant purchasing power during low inflation as authorized by the IASB in the Framework, Par 104 (a) in 1989. This is not understood by the IASB, FASB, other accounting authorities and most accountants and accounting lecturers and professors. If they understood it, they would have stopped the stable measuring unit assumption by now. Financial capital maintenance in units of constant purchasing power units is only required by the IASB in IAS 29 Financial Reporting in Hyperinflationary Economies.

The legal requirements for satisfying the liquidity and solvency tests do not constitute a fourth concept of capital maintenance, but, are simply the legal basis for either financial capital maintenance in nominal monetary units – when you assume the that the stable measuring unit assumption satisfies the requirement for “fairly valued” as 99.99% of entities currently incorrectly assume - as well as financial capital maintenance in units of constant purchasing power where under the very destructive stable measuring unit assumption is rejected in terms of the Framework, Par 104 (a). Unfortunately no-one chooses this option.

In most jurisdictions the legal requirements of “liquidity” and “solvency” have to be satisfied in the case of

• payment of dividends to shareholders
• reduction of a company’s share capital or reserves
• a company’s purchase of its own shares

A company is prohibited from making any payment in whatever form from shareholders´ equity if there are reasonable grounds for believing:

(a) that the company is or would after the payment be unable to pay its debts as they become due in the ordinary course of business (this is known as the “liquidity” test); or

(b) the consolidated assets of the company fairly valued would after the payment be less than the consolidated liabilities of the company (this is known as the “solvency” test) The Capital Maintenance Concept and Share Repurchases in South African Law - By F.H.I. Cassim and Rehana Cassim
Copyright © 2010 Nicolaas J Smith

Inflation Accounting

One of the inflation accounting models that was tried unsuccessfully in the 1970´s and 1980´s was Constant Purchasing Power Accounting (CPPA).

The Financial Accounting Standards Board issued an exposure draft in the United States in January, 1975, that required supplemental financial reports on a Constant Purchasing Power inflation accounting price-level basis. The Securities and Exchange Commission in the USA proposed in 1976 the disclosure of the current replacement cost of amortizable, depletable and depreciable assets used for production as well as most inventories at the financial year-end. It also proposed the disclosure of the approximate value of amortization, depletion and depreciation as well as the approximate value of cost of sales that would have been accounted in terms of the current replacement cost of productive capacity and inventories.

Both supplemental Constant Purchasing Power inflation accounting financial statements and value accounting were experimented with in Canada. Australia tried both replacement-cost inflation accounting and CPP price-level inflation accounting. Netherland companies experimented with value accounting. Replacement-cost disclosures for equity capital financed items were considered in Germany. CPP inflation accounting supplemental financial statements were tried in Argentina. Brazil successfully used various indexes to update constant and variable non-monetary items for the 30 years from 1964 to 1994. In the United Kingdom an original proposal of supplementary CPP financial accounting financial reports was replaced by the Sandilands Committee proposal for a value accounting approach for inventories, marketable securities and productive property. South Africa had published a discussion paper on value accounting at the time.

The FASB issued FAS 33 Financial Reporting and Changing Prices in 1979. It only applied to certain large, publicly held enterprises. No changes were to be made in the primary financial statements; the information required by FAS 33 was to be presented as supplementary information in published annual reports.

These companies were required to calculate and report:

a. Income from continuing operations reflecting the effects of general inflation
b. The purchasing power loss or gain on net monetary items.
c. Calculate income from continuing operations on a current cost basis
d. Calculate the current cost amounts of property, plant, equipment and inventory at the end of the fiscal year
e. Report increases or decreases in current cost amounts of property, plant, equipment and inventory, net of inflation.

FAS 89 Financial Reporting and Changing Prices superseded FASB Statement No. 33 in 1986 and made voluntary the supplementary disclosure of constant purchasing power/current cost information.

Presently, inflation accounting describes a complete price-level inflation accounting model, namely the Constant Purchasing Power inflation accounting model defined in IAS 29 Financial Reporting in Hyperinflationary Economies required to be implemented only during hyperinflation which is an exceptional circumstance according to the IASB. It serves to make HC and CC financial statements more useful at the period end by restating all non-monetary items – variable and constant real value non-monetary items - by inflation-adjusting them by applying the period-end CPI during hyperinflation.

“In a hyperinflationary economy, reporting of operating results and financial position in the local currency without restatement is not useful. Money loses value at such a rate that comparison of amounts from transactions and other events that have occurred at different times, even within the same accounting period, is misleading.” IAS 29 Par 2.

The fallacy that inflation destroys the real value of non-monetary items is currently still generally accepted. It is still mistakenly accepted as a fact that the erosion or destruction of companies´ capital and profits is caused by inflation.
It became very clear to me during 2008 that inflation has no effect on the real value of non-monetary items over time. The understanding of the real value destroying effect of the stable measuring unit assumption on constant items never maintained is an ongoing process. Not inflation, per se, but SA accountants´ implementation of the very destructive stable measuring unit assumption during low inflation as it forms part of the HCA model, destroys the real value of constant real value non-monetary items never maintained over time. There is no substance in the statement that inflation destroys the real value of non-monetary items which do not hold their real value over time. Inflation has no effect on the real value on 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.


Copyright © 2010 Nicolaas J Smith

The accusation that I suggest inflation-accounting in SA is not true.

The IASB approved financial capital maintenance in nominal monetary units fallacy led SA accountants to choose to implement the traditional Historical Cost Accounting model during non-hyperinflationary periods where under they select to maintain the stable measuring unit assumption for an unlimited period of time during indefinite inflation. They value both variable items stated at Historical Cost in terms of IFRS or SA GAAP, as well as constant items also stated at Historical Cost in terms of the Historical Cost Accounting model, in nominal monetary units during non-hyperinflationary periods. Both HC variable and HC constant real value non-monetary items are thus considered by SA accountants to be simply HC non-monetary items.

There is a fixation in accounting that constant purchasing power inflation-adjustment simply means adjusting company financial statements mainly to make current year statements more comparable with previous year statements. Inflation-adjustment is not automatically thought of as affecting the fundamental values of the underlying resources although that is what is done with world wide annual inflation-adjustment of salaries, wages, rentals, etc. The two processes are seen as different processes.


The high inflation 1970´s

During the period of high inflation in the 1970´s accountants and accounting authorities tried various inflation accounting models in an attempt to reflect in company financial reports the effect of high inflation on monetary and – mistakenly - non-monetary items too. Inflation has no effect on the real value of non-monetary items.

They did not realize that it was simply their choice of the stable measuring unit assumption that was destroying the real value of constant real value non-monetary items never maintained although the FASB did mention the stable measuring unit assumption in FAS 89. The IASB never mentioned it in either IAS 6 or IAS 15. “The erosion of business profits and invested capital caused by inflation” was clearly stated in FAS 33 and “the erosive impact of inflation on profits and capital” was stated in both FAS 33 and FAS 89. The FASB did, however, realize that “Relative to most changes in financial reporting, the changes required by Statement 33 were monumental.” Their implementation was eventually made voluntary.

During that period inflation accounting described a range of accounting models designed to reflect the effect of changing prices on financial reporting. Changing prices included changes in specific prices as well as changes in the general price level which resulted in the destruction of the purchasing power of money, i.e. inflation. It was and still is generally accepted that inflation affects the real value of non-monetary items. That is not true. Inflation has no effect on the real value of non-monetary items.

Inflation is a uniquely monetary phenomenon. It is not inflation, but, SA accountants´ selection of the HCA model and implementing the very destructive stable measuring unit assumption and financial capital maintenance in nominal monetary units (the first based on a fallacy and the second being a very popular accounting fallacy) which unknowingly destroy the real value of constant real value non-monetary items never maintained during low inflationary periods in the SA real economy.

Copyright © 2010 Nicolaas J Smith

What price stability?

“The South African Reserve Bank is the central bank of the Republic of South Africa. It regards its primary goal in the South African economic system as the achievement and maintenance of price stability.

The South African Reserve Bank conducts monetary policy within an inflation targeting framework. The current target is for CPI inflation to be within the target range of 3 to 6 per cent on a continuous basis.” SARB.

Absolute price stability is a year-on-year increase in the Consumer Price Index of zero percent. A year-on-year increase in the CPI of above zero but below 2% is a high degree of price stability – it is not absolute price stability.

“The ECB´s Governing Council has announced a quantitative definition of price stability:

Price stability is defined as a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%.

The Governing Council has also clarified that, in the pursuit of price stability, it aims to maintain inflation rates below, but close to, 2% over the medium term.” European Central Bank

http://www.ecb.int/mopo/strategy/pricestab/html/index.en.html

A below 2% year-on-year increase in the European Monetary Union’s harmonized CPI is the European Central Bank’s chosen definition of price stability. It is not the factual definition of absolute price stability. Theoretically, the SARB´s chosen definition of price stability is for “inflation to be within the target range of 3 to 6 per cent on a continuous basis”. In fact, the SARB´s chosen definition of price stability is for inflation to be 6% per annum on a continuous basis because when inflation targeting is implemented inflation generally trends to the upper limit.

SA accountants, on the other hand, simply assume that the Rand is perfectly stable in SA´s low inflationary economy, but, only for the purpose of valuing balance sheet constant real value non-monetary items which they account as Historical Cost items. In conformity with world practice they do not apply this assumption to the valuing of certain Income Statement constant items, namely salaries, wages, rentals, etc. They value other income statement items in nominal monetary units, i.e. at HC. SA accountants do not regard changes in the general purchasing power or real value of the Rand to be sufficiently important to measure financial capital maintenance in units of constant purchasing power as they have been authorized by the IASB in the Framework, Par 104 (a) in 1989.

They generally choose to implement financial capital maintenance in nominal monetary units, also authorized by the IASB in the Framework, Par 104 (a) in 1989. It is impossible to maintain the real value of capital stable by measuring financial capital maintenance in nominal monetary units per se during low inflation or deflation. Financial capital maintenance in nominal monetary units per se during inflation and deflation is a fallacy.

Kindest regards,

Nicolaas Smith

Copyright © 2010 Nicolaas J Smith

No fundamental constant

One of the basic principles in accounting is “The Measuring Unit principle:

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

Paul H. Walgenbach, Norman E. Dittrich and Ernest I. Hanson, (1973), Financial Accounting, New York: Harcourt Brace Javonovich, Inc. Page 429.

However, non-monetary items are not all fundamentally the same. Non-monetary items are, in fact, subdivided into variable real value non-monetary items and constant real value non-monetary items. The three fundamentally different basic economic items are monetary items, variable items and constant items although it is generally accepted under the HC paradigm that there are only two basic economic items, namely, monetary and non-monetary items.

HC accountants regard all non-monetary items stated at HC, whether they are variable real value non-monetary HC items or constant real value non-monetary HC items to be fundamentally the same, namely, simply non-monetary items when they implement their very destructive stable measuring unit assumption as part of the traditional HCA model during low inflationary periods.

This is the result of money illusion. People make the mistake of thinking that money is stable in real value in a low inflationary environment. Inflation always and everywhere destroys the real value of money over time. It is thus impossible for money to be stable in real value during inflation. On the other hand, inflation has no effect on the real value of non-monetary items over time.
The unit of measure in accounting is the base money unit of the most relevant currency. Money is not stable in real value during inflation.

This means that the monetary unit of measure in accounting is not a stable monetary unit of measure during inflation and deflation. Accountants´ unstable monetary unit of measure or unstable monetary unit of account is the only generally accepted unit of measurement that is not an absolute value. It does not contain a fundamental constant. All other generally accepted units of measurement of time, distance, velocity, mass, momentum, energy, weight, etc are absolute values, e.g. second, minute, hour, metre, yard, litre, kilogram, pound, mile, kilometre, inch, centimetre, gallon, ounce, etc.

Kindest regards,

Nicolaas Smith

Copyright © 2010 Nicolaas J Smith

Capital maintenance without more money or profits

Capital maintenance logically means maintaining the real value of existing capital. Any other definition is obviously wrong. The IASB´s financial capital maintenance in nominal monetary units is a joke besides being a fallacy. Unfortunately the world economy is based on that statement. Capital is a constant real value non-monetary item: thus, it is a constant item from the moment it is contributed and logically should remain a constant real value non-monetary item forever - all else being equal - providing the company breaks even: a loss is a loss.

Financial capital can be measured in nominal monetary units for historical purposes only during inflation and deflation. The IASB´s statement in the Framework, Par 104 (a) that "Financial capital maintenance can be measured in nominal monetary units" is a fallacy during inflation and deflation - that means always: we have never had zero inflation and we are not likely to have zero inflation any time soon.

Capital is saved up real value used to create more real value. In the case of human capital it is accumulated experience and knowledge used to create more real value via a company structure.

In general most companies start off with a capital base more or less sufficient for the purpose the company was created for. Under the traditional Historical Cost Accounting model fixed assets used to be accounted only at historical cost. Obviously land and buildings bought many years ago and accounted at their original cost do not appear at their current values in the financial statements. There are thus hidden or unreported holding gains often assumed sufficient to maintain the real value of capital.

Capital maintenance used to imply not paying dividends from capital. A company´s nominal capital was seen as a guarantee for creditors for amounts owed to them.

Today a SA company can pay dividends from capital as long as it is still solvent and liquid after the payment.

It can not pay dividends from capital if there are reasonable grounds for believing:

(a) that the company is or would after the payment be unable to pay its debts as they become due in the ordinary course of business (this is known as the “liquidity” test); or
(b) the consolidated assets of the company fairly valued would after the payment be less than the consolidated liabilities of the company (this is known as the “solvency” test).

When a company has no revaluable fixed assets its capital is simply a monetary item: the same as cash and its real value is simply destroyed at the annual rate of inflation.

Most companies do not have revaluable fixed assets equal to the original real value of all contributions to shareholders´ equity. The real value of their retained profits and capital are thus being destroyed at the annual rate of inflation in proportion of the original real value not backed by revaluable fixed assets to the total original real value of all contributions to equity.

SA companies thus ended up with insufficient equity. They continuously attempt to fix this problem by retaining more and more profits in the company instead of paying them out as dividends. This is very evident in many quite old and large companies and groups. They have small amounts of capital and share premium but huge amounts of retained profits. They try to maintain their capital base with always more additions to retained profits because their accountants are unknowingly destroying the real value of their existing equity with their very destructive stable measuring unit assumption. Their accountants are very efficient and relentlessly unknowingly also destroy the real value of the retained profits and the vicious never ending annual cycle of unknowing real value destruction by SA accountants applying their very destructive stable measuring unit assumption just carries on and on.

When SA companies change over to financial capital maintenance in units of constant purchasing power they will maintain the real value of their equity with financial capital maintenance in units of constant purchasing power forever: no extra money or retained profits required. All they have to do is break even and implement financial capital maintenance in unit of constant purchasing power instead of their current financial capital maintenance in nominal monetary units which is a fallacy: financial capital maintenance in nominal monetary units per se during low inflation and deflation is impossible even though the IASB authorized it 21 years ago.

The IASB´s International Financial Reporting Standards are thus based on popular accounting fallacies. They should not be. In the case of South Africa, it costs us about R200 billion per annum in real value unnecessarily, unknowingly and unintentionally destroyed by our accountants implementing their very destructive stable measuring units assumption - as approved by the IASB in 1989. World wide that costs the world economy hundreds of billions of Euros per annum.

SA accountants do not understand what financial capital maintenance in units of constant purchasing power during low inflation means. If they did, they would have done something to stop the stable measuring unit assumption by now. SA accountants implement the stable measuring unit assumption.
Copyright © 2010 Nicolaas J Smith

The Mandela factor

Hi,

I was still in South Africa when Nelson Mandela walked free. Not being very interested in politics, I was not very much aware of his release and its implications for South Africa at the time. Today I realize it was because of National Party disinformation. I also did not know at that time that most of Steve Biko´s friends hanged themselves all by their lonesome selves in their cells.

Today I am very much aware of the Mandela factor, after watching the Mugabe factor in Zimbabwe on a day to day basis over the last two years. South Africa has Mandela, Zimbabwe has Mugabe: see the difference.

Milton Friedman stated that inflation is always and everywhere a monetary phenomenon. It is a statement with very important implications which are not easily grasped.

I state that the value of fiat money depends on all the underlying value systems in an economy. It seems to be correct: the Mugabe factor resulted in there being no Zimbabwe Dollar today in Zimbabwe. The Mandela factor is one of the many reasons why the Rand has a relatively strong foreign exchange value with an internal real value subject to 6% inflation or 6% annual real value destruction in the Rand. SA suffers from 3% inertial or built-in unnecessary inflation. In my opinion inflation should be lowered to 3% with a equal 3% drop in all interest rates in SA.

Long live Nelson Mandela!

Kindest regards,

Nicolaas Smith

Copyright © 2010 Nicolaas J Smith

Accounting for non-accountants: stable measuring unit assumption

For accountants

Accountants today still apply their stable measuring unit assumption to the valuation of companies´ capital and profits.

Under the current global Historical Cost Accounting model you can keep your capital and profits at nominal value if you always buy fixed property or land for the exact original real value of the capital and profits you keep in your company. The real value of your capital and profits - stated at nominal value - would generally be maintained by sufficient unrecorded or hidden holding gains in the revaluable fixed property assets. Only maybe hotel companies and perhaps also property companies buying properties and making money from the rent can generally maintain the real value of their capital and profits (I don’t really think so) by stating them in nominal values in their books. Most other companies do not do that.

For non-accountants

The three basic economic items in the economy are valued as follows:

1. Monetary items

Examples: Rands, bank loans, car loans, housing loans, student loans, any money loan or savings in Rand.

You can only value and account or state them at their original nominal values during the current financial period. No other way because you cannot update money.

2. Variable real value non-monetary items

Examples: property, plant, equipment, stock, shares, foreign exchange, etc.

They are valued by accountants in terms of International Financial Reporting Standards or SA Generally Accepted Accounting Practice.

3. Constant real value non-monetary items

Examples: capital, retained profits, capital reserves, trade debtors, trade creditors, taxes payable, taxes receivable, etc.

They have constant real values, but, accountants value them at historical cost: i.e. they treat them the same as money.

Now, we all know inflation destroys the real value of money.

Accountants think that inflation also destroys the real value of capital, retained profits, debtor, creditors, etc.

Obviously it is not inflation destroying these items´ real values: it is their choice of valuing these items in nominal monetary units. They can also value them in units of constant purchasing power; i.e. they can inflation-adjust them during low inflation. The IASB authorized them 21 years ago to do that.

Accountants do not do this because they are not taught to do that and because they and all accounting authorities think it is inflation doing the destroying. It is not inflation. Inflation can only destroy the real value of money. Nothing else. Inflation can not destroy the real value of non-monetary items. When accountants inflation-adjust these items, they never lose their real values, no matter what the rate of inflation.

All accountants and accounting authorities believe absolutely that the erosion of capital and profits is caused by inflation. They have absolutely no doubt about it. They are wrong. Inflation cannot destroy the real value of non-monetary items. When they inflation adjust these items, they maintain their real values forever in companies that at least break even.

What is so good about financial capital maintenance in units of constant purchasing power is that it has been authorized by the IASB 21 years ago and that it does not require any more new money or new capital to maintain companies´ capital and profits. Accountants unknowingly destroy companies´ capital and profits by treating capital and profits like money when they implement their stable measuring unit assumption.

So, they can maintain capital and profits´ real values by not destroying these existing real values. As simple as that.

How is this done? By inflation-adjusting all constant items in a company and by accounting the loss of real value in money caused by inflation. No extra new money needed.

This has been authorized by the IASB in 1989 and is compliant with International Financial Reporting Standards. So, there is nothing to worry about: it is all legal and IASB-approved.
Copyright © 2010 Nicolaas J Smith

Accounting for Non-CA´s: Monetary items

For CA´s

“Monetary items have to be stated at their original nominal values because money cannot be updated. Inflation destroys the real value of money, but accountants ignore this real value destruction during low inflation, but, account it during hyperinflation. Obviously, if you account it under hyperinflation, you also have to account it under low inflation.”

For Non-CA´s

There are three fundamentally different basic economic items in the economy:

1. Monetary items
2. Variable real value non-monetary items
3. Constant real value non-monetary items

Monetary items

The R100 notes in your pocket do not magically change to R94 notes after a year of 6% inflation. They keep their nominal value of R100, but, they are only worth R94 in real value.

So, in your business, if you have R100 000 in your company bank account on 1st January and you keep the money in the bank for the whole year, then your accountant will state that R100 000 as R100 000 in your year end accounts. It is only worth R94 000 in real value, but, because the R100 note in your pocket cannot change, your accountant has to state the money as R100 000 in your accounts.

Compare this to stock: if you had R100 000 stock for resale in your company on 1st January and you have the same stock on 31st December and the stock´s net realizable value was only R94 000 your accountant will account it at R94 000 with R6 000 written off as a loss in your profit and loss account. But, he is not allowed to do that with the real value loss in money - not under low inflation. Under hyperinflation, yes, but not under low inflation. Crazy, isn´t it? This gets fixed under financial capital maintenance in units of constant purchasing power during low inflation which was authorized by the IASB in 1989 and which I promote for SA accountants. I am actually an unofficial agent for the IASB - doing what they should have been doing for the last 21 years - but, they don´t like me either because I state that accountants unknowingly destroy real value doing traditional historical cost accounting and they base International Financial Reporting Standards on fallacies - which is true.

Inflation, in very simple terms, means there are too many Rands in the economy in relation to the actual real value in the economy. Zero inflation would mean, for example, that there are R100 billion of real value in the economy and R100 billion of Rands in the economy and it stays like that over a year. What does actually happen is that there are R100 billion real value in the economy and R106 billion of Rands in the economy. Now there are too many Rands and every Rand, after a year, is only worth 100/106 = R0.94 in real value. So, the simple fact of having too many Rands in the economy destroyed the real value of each and every Rand by 6%: each and every Rand is now only worth 94 cents. This is inflation in simple terms. So, it is thus a fact that inflation always and everywhere destroys the real value of money and monetary items like bank loans over time.

The International Accounting Standards Board, the highest accounting authority in the world, forces companies do show this loss or cost of inflation as an actual business cost, but, only during hyperinflation. The IASB defines hyperinflation as 100% cumulative inflation over 3 years. 26% annual inflation for 3 years in a row will equal 100% cumulative inflation. So, the IASB forces companies to account the cost of inflation as a business cost being deducted from profits before tax, but, only during hyperinflation and not during low inflation. This is obviously wrong. If companies have to do it at 26% annual inflation for 3 years in a row they obviously have to do it at 20% annual inflation for 3 years in a row too and at 6% annual inflation and 2% annual inflation and 1% annual inflation, etc. A cost is a cost under all circumstances. But, not according to the IASB. That is obviously a mistake.

When SA accountants stop Historical Cost Accounting during low inflation, as I am promoting, they will change to financial capital maintenance in units of constant purchasing power and they will account the cost of inflation during low inflation as they are required by the IASB to do under hyperinflation. Financial capital maintenance in units of constant purchasing power has also been authorized by the IASB twenty-one years ago. So, it is fine for SA accountants to change over and do that.

Kindest regards,

Nicolaas Smith

Copyright © 2010 Nicolaas J Smith

Historical Cost Accounting erodes companies´ equity

Boerseun, Thank you for your visits. You know I appreciate your comments.

Today you stated:

"I always come to read your posts and then get even more confused. I try my best and the little bit that I do grasp does at least show me something is seriously wrong."

It is really easy to understand.

People think money keeps its real value. That is not true, as you know and as we all know.

A long time ago, let´s say 200 years ago, accountants did all accounting at the original historical values of all items.

They assumed money was perfectly stable in real value; i.e. they assumed there was no inflation and there never will be inflation. They applied their stable measuring unit assumption. We all know there is inflation and money loses its real value.

Over the last 100 years they have realized that you cannot value everything at its original historical cost. You cannot value shares you bought at R1 per share in 1951 which are selling on the JSE today at R1000 per share at the original R1 per share, for example. You have to show them in your accounts at their current value.

So, accountants have rules (International Financial Reporting Standards) to value variable real value non-monetary items.

Monetary items have to be stated at their original nominal values because money cannot be updated. Inflation destroys the real value of money, but accountants ignore this real value destruction during low inflation, but, account it during hyperinflation. Obviously, if you account it under hyperinflation, you also have to account it under low inflation.

Accountants today still apply their stable measuring unit assumption to the valuation of companies´ capital and profits.

Under the current global Historical Cost Accounting model you can keep your capital and profits at nominal value if you always buy fixed property or land for the exact original real value of the capital and profits you keep in your company. The real value of your capital and profits - stated at nominal value - would generally be maintained by sufficient unrecorded or hidden holding gains in the revaluable fixed property assets. Only maybe hotel companies and perhaps also property companies buying properties and making money from the rent can generally maintain the real value of their capital and profits (I don’t really think so) by stating them in nominal values in their books. Most other companies do not do that.

Because they do not update their capital and profits, their accountants are unknowingly destroying capital and profits´ real values at the rate of inflation. When they do not update the constant real value non-monetary items capital and retained profits, then they are the same as monetary items and we all know money and monetary items lose their real values because of inflation. The same happens to capital and profits not updated. They all think for a very long time that it is inflation doing this destroying. Capital and profits are constant real value non-monetary items. They are not monetary items. If they value capital and profits in units of constant purchasing power (inflation-adjust them) then they will always maintain their real values, no matter what the inflation rate is. So, it is not inflation doing the destroying, it is their choice of the stable measuring unit assumption which they can stop any time they want to.

However, under hyperinflation they update capital and profits, but, not under low inflation. So, they admit and agree that capital and profits must be updated under hyperinflation, but, they refuse to do it under low inflation. They admit that capital and profits´ real values are destroyed under hyperinflation, i.e. 26% inflation for 3 years in a row equalling 100% cumulative inflation (the IASB´s definition of hyperinflation) but they do not consider that, say, 20% inflation forever will require them to update capital and profits. They claim that there is no destruction of the real value of capital and profits at 20% inflation – or if there is, then it is inflation´s fault: it has nothing to do with their decision to choose the stable measuring unit assumption and to implement it. A decision they can change to financial capital maintenance in units of constant purchasing power today, if they want to: but, no, it is inflation doing the destroying – according to the IASB, the US FASB and all accountants.

They thus unknowingly destroy the real value of capital and profits under low inflation.

That is all I am stating. Very easy to understand. They are all very upset with me because I say they do this unknowingly, unnecessarily and unintentionally.
The International Accounting Standards Board authorized them to update capital and profits during low inflation in the Framework, Par 104 (a) in 1989. It states:

“Financial capital maintenance can be measured either in nominal monetary units OR IN UNITS OF CONSTANT PURCHASING POWER.”

So, accountants can stop this destruction any time they want to. I am just promoting that idea. That´s all. It is not my idea. It is the IASB´s idea.

Because accounting is double entry, it means that they can maintain the real value of capital and profits in all companies that at least break even FOREVER, by just updating all constant items equally and correctly. There is no extra money required to do this. They must just stop destroying existing real value. It is a matter of maintaining existing real value. No extra money required at all. Just stop destroying real value that already exists.

The IASB forces them to do this under hyperinflation, but, under low inflation it gives them a choice. Because all accountants have been applying the stable measuring unit assumption for the last 700 years and all the accountants in the world are doing it today, except in hyperinflationary economies, no-one wants to change.

The truth is that they do not realize it is happening. They all think it is inflation doing the destroying and that they as accountants can do nothing about it. It is not true. The IASB forces them to do it correctly under hyperinflation.

Accountants and all accounting authorities state very firmly and very, very confidently that the erosion (destruction) of companies´ capital and profits is caused by inflation. The IASB, the US FASB, everybody agree with that statement. So they all agree that companies´ capital and profits are being destroyed. There is no problem with that. They all admit it. There is destruction of real value. But, they all blame inflation.

However, it is impossible for inflation to destroy companies´ capital and profits because inflation is always and everywhere a monetary phenomenon, as Milton Friedman stated. Inflation has no effect on the real value on 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.

So, Boerseun, it is not so difficult to understand. Quite easy actually.

My estimate of the real value unknowingly destroyed by SA acountants in constant items never maintained is about R200 billion per annum. That is quite a lot of real value that is destroyed each and every year in the SA real economy. All SA accountants have to do to stop that and to boost the SA real economy with about R200 billion each and every year forever is freely choose financial capital maintenance in units of constant purchasing power; i.e. they must choose to update capital and profits instead of unkowingly destroy their real values year in year out.


Copyright © 2010 Nicolaas J Smith

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