Why is inventory inflation-adjusted under CIPPA? Is this not against IAS 2?

IAS 2 (Technical Summary) states:
Inventories shall be measured at the lower of cost and net realisable value.

The Historical Cost of inventories is inflation-adjusted during low inflation because there is no stable measuring unit assumption under Constant ITEM Purchasing Power Accounting. Implementing CIPPA means an entity is applying financial capital maintenance in units of constant purchasing power during low inflation and deflation.

That means

Firstly that all constant real value non-monetary items (all items in the income statement, equity, trade debtors, trade creditors, etc.) are measured in units of constant purchasing power (inflation-adjusted every time the CPI changes);

Secondly that variable real value non-monetary items (property, plant, equipment, inventories, foreign exchange, etc.) are valued in terms of IFRS or GAAP on a primary basis and

Thirdly that monetary items are measured in nominal monetary units during the current financial period which includes the calculation and accounting of the net monetary gain or loss for the financial period.

Variable items, e.g. inventories, that are valued on a primary basis at HC in terms of IFRS are inflation-adjusted every time the CPI changes because there is no stable measuring unit assumption.

Measurement at HC does not mean or imply that the stable measuring unit assumption is applied. The stable measuring unit assumption is rejected under CIPPA. HC valuation is simply the measurement of an item at its original nominal historical cost in terms of IFRS or GAAP which is then inflation-adjusted every time the CPI changes: i.e. monthly.

Kindest regards

Nicolaas Smith
realvalueaccounting@yahoo.com

Copyright © 2010 Nicolaas J Smith

Two methods to calculate the net monetary loss or gain

Accountants have to calculate the net monetary loss or gain from holding monetary items when they choose the Constant Purchasing Power Accounting (CIPPA) model where under they measure financial capital maintenance in units of constant purchasing power in the same way as the IASB requires its calculation and accounting during hyperinflation. There are net monetary losses and net monetary gains during low inflation too, but they are not required to be calculated when accountants choose the traditional HCA model.


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Nicolaas Smith
realvalueaccounting@yahoo.com

Copyright © 2010 Nicolaas J Smith

Value does not exist independently of how we measure it.

Hi,

CA007 stated in our mother of all debates:

"I state: Value DOES exist independently of how we ACCOUNTING measure it."

My reply was:

I spent a lot of time and I have prepared an excellent concise response to your statement that "value exist independently of how we accounting measure it".

I then realized that we first have to agree what the concept of a unit of constant purchasing power is, what the effect of applying it is, whether it is part of IFRS, whether it is generally accepted, does it work, does it not work, is there something like it, is it just a theoretical concept and no-one ever uses it, or is it used every day by billions of people - or not, is it never ever used, does no-one use it ever, has it ever been used in the past, does it appear in IFRS, how many times is it applied in IFRS - if at all, is it junk, is it real, does it affect the economy, does it have any effect, yes or no, what exactly is it, is there such a thing, or is it just my imagination, who supports it, etc, etc.

I will prepare a stament - with references to reliable third party source - although I am a bit worried that you may not accept them since you wish to regard what happened in Brazil during 30 years as "irrelevant".

We will have to agree that Brazil did exist during those 30 years from 1964 to 1994 and that 185 million people did measure all their non-monetary items DAILY in units of constant purchasing power and we will have to agree that it kept their internal non-monetary real market more or less stable while hyperinflation destroyed ONLY the real value of their money - not the real value of their non-monetary items. We also will have to agree that the reason why hyperinflation did not destroy the real value of all their non-monetary items was because they remeasured them DAILY in units of constant purchasing power. We will have to agree that it is impossible for hyperinflation to destroy any non-monetary item. We will have to agree that hyperinflation like inflation can only destroy the real value of money and other monetary items - nothing esle. We will have to agree that it was because they implemented measurement in units of constant purchasing power. We will have to agree that the Brazilian economy was not a barter economy during those 30 years as you claim. There may have been barter here and there on a miniscule scale, but the economy was not a barter economy. The whole economy remeasured all non-monetary items DAILY in units of constant purchasing power.

We will have to agree that this is not irrelevant as you say.

We did the same in Auto-Sueco (Angola) in 1996 where I worked in Luanda, Angola. I implemented it. It is not theory to me.

I know that various other South-American countries also used indexation during about the same period as Brazil - and even later.

If you are not prepared to agree that Brazil used the measurement of all non-monetary items during 30 years by means of units of constant purchasing power and that it had a real effect on their economy - totally different from the stable measuring unit assumption that you apply in your accounting - then I am prepared to research other cases of indexation - especially in South American countries.

This is all about units of constant purchasing power.

We will have to agree that it was because they rejected the stable measuring unit assumption - the basis of your accounting model, namely, HCA. We will have to agree that they did not apply HCA. We will have to agree that they rejected the stable measuring unit assumption - the fundamental basis of Historical Cost Accounting. We will have to agree that they maintained their NON-MONETARY OR REAL economy more or less stable BECAUSE they applied measurement in units of constant purchasing power. We will have to agree that they applied inflation-accounting and that it worked - that measurement in units of constant purchasing power did and does make a difference to the economy.

This is all about measurement in units of constant purchasing power and whether it makes a difference to the eonomy or not (for those who do not accept historical facts from the recent economic history of Brazil).

CA007, I wish to ask you: do you accept that there is a concept of units of constant purchasing power?

Yes or no?

Or do you regard the whole concept of units of contant purchasing power as authorized in IFRS in the Framework, Par 104 (a) twenty one years ago (how long have you been an accountant?) as irrelevant as you regard 30 years of economic history in Brazil?

Par 104 (a) states: "Financial capital maintenance can be measured either in nominal monetary units OR UNITS OF CONSTANT PURCHASING POWER". (my capitals)

Par 104 (a) does not state "during hyperinflation". That is stated in IAS 29. Par 104 (a) thus applies under all levels of inflation and deflation - LOW inflation too.

CA007, do you accept measurement in units constant purchasing power during LOW inflation as authorized in IFRS?

Or, do you regard it as irrelevant?

During low inflation ONLY constant real value non-monetary items (NOT variable real value non-monetary items) are measured in units of constant purchasing power.

During hyperinflation ALL non-monetary items - both constant and variable items - are measured in units of constant purchasing power.

I do not wish to implement inflation-accounting in SA.

I wish SA accountants to measure ONLY constant items during LOW inflation as authorized in IFRS.

CA007, do you accept measurement in units constant purchasing power during LOW inflation as authorized in IFRS?

Or, do you regard it as irrelevant?

After I have your view about measurement in units of constant purchasing power, then I will be able to respond fully to your statement that value exist independently of how we accounting measure it. I am not running away from your statement. I will answer it in detail. You know already that I disagree with you. I intend to prove my point with historical facts and other facts.

You see, stating that what happened in Brazil during 30 years when an important country like Brazil as a whole maintained its whole non-monetary or real economy more or less stable - they even GREW economically - they had positive GDP growth - DURING hyperinflation of 2000 % per annum - by means of measuring all non-monetary items (variable and constant items - variable items too because they were in hyperinflation - this is not necessary during low inflation) by the accounting practice (authorized in IFRS) of measuring all non-monetary items in units of constant purchasing power which affected their economy in a massive way - they kept their non-monetary economy more or less stable during hyperinflation - by you stating that is irrelevant makes it very difficult to agree anything with you.

You can similarly state any fundamental fact is "irrelevant." It is difficult to agree on anything when one participant in the debate assumes the right to state proven historical facts are irrelevant.

What happened in Brazil during those 30 years is relevant to our discussion.

They did maintain the real value of all non-monetary items - variable and constant items - by measuring them in units of constant purchasing power - for 30 years: something they could not have done if they had implemented HCA, i.e. the stable measuring unit assumption during those 30 years. Value existed, yes, and they maintained those real values by means of measurement in units of constant purchasing power. If they had chosen HCA during those 30 years they would not have been able to maintain their real values: their choice of accounting model, not inflation, would have destroyed the real value.

Value thus does not simply exist irrespective of the ACCOUNTING measure we choose to implement over a period of time: during the financial year. When we choose HCA, we destroy the real value of constant items NEVER MAINTAINED during low inflation and hyperinflation - over the period of time of the financial year.

Measuring an item in units of constant purchasing power does maintain its real value - over time: the accounting period. As such it does affect the economy. The real value first has to exist. Measuring it in units of constant purchasing power (inflation-adjusting it) does maintain its existing real value during the accounting period during inflation. It is the choice of the accounting method, the choice of the measuring unit, namely, actually choosing measurement in units of constant purchasing power during inflation (rejecting the 3000 year old stable measuring unit assumption) that maintains the real value of the item - over time. By maintaining the real value - over time - by choosing the accounting method or measuring unit namely units of constant purchasing power, the existing real value is not destroyed - over time: the accounting period. It is not inflation doing the destroying in the non-monetary item. The real value of the non-monetary item is destroyed when the accountant chooses to measure its value in nominal monetary units during inflation - over a period of time: the accounting period. So, it is the choice of the accounting model or accounting method or measuring unit that is doing the destroying because when the accountant chooses measurement in units of constant purchasing power, the non-monetary item´s real value is maintained irrespective of the rate of inflation - always over time.

It is not inflation doing the destroying: it is the choice of applying the stable measuring unit assumption - over time during inflation. Measurement in units of constant purchasing power does affect the economy when it is applied over time. Measurement in units of constant purchasing power does not create real value over time where it NEVER existed. It simply MAINTAINS EXISTING real value in constant real value non-monetary items during low inflation - applied over time.

CA007,

Brazil was in high and hyperinflation for 30 years. Brazil was not a barter economy - as you believe - during those 30 years.

Venezuela is in hyperinflation now. Venezuela is not a barter economy now.

Zimbabwe was in hyperinflation for 18 or 19 years - Zimbabwe was not a barter economy.

The issue here is: does measuring a constant real value non-monetary item in units of constant purchasing power during low inflation affect the economy?

The answer is: yes.

It maintains the real value of the constant real value non-monetary item. It does not create new real value. It maintains it. It is the choice of measurement unit that maintains the real value: when the accountants chooses measurement in units of constant purchasing power during low inflation as authorized in IFRS in the Framework, Par 104 (a) DURING LOW INFLATION, then the real value of the non-monetary item is maintained, i.e. it is not destroyed. It is not inflation doing the destroying.

When the accountant chooses to measure the value of a constant real value non-monetary item in nominal monetary units, i.e. the accountant chooses to apply the stable measuring unit assumption during low inflation, i.e. the accountant chooses to assume there is no inflation DURING LOW INFLATION, then the implementation of that choice of measurement destroys the real value of the constant real value non-monetary item DURING INFLATION.

It is able to prove that measurement in units of constant purchasing power during low inflation maintains the real value of constant items in many ways.

It is able to prove that the accountant´s choice to implement the stable measuring unit assumption and not inflation is doing the destroying in many ways.

CA007´s reply was:

"You certainly know what you are talking about and I will need time to think it over.

I will concede: the Brazil example is not irrelevant to our debate.

Your question:

“ CA007, do you accept measurement in units constant purchasing power during LOW inflation as authorized in IFRS? “

My answer: Yes. I accept for both economic and financial reporting purposes

Kindest regards

Nicolaas Smith
realvalueaccounting@yahoo.com

Copyright © 2010 Nicolaas J Smith

"Is the process of financial reporting the same as a process of wealth creation?"

That was the question asked by CA007 after he came to accept financial capital maintenance in units of constant purchasing power during LOW inflation as authorized in IFRS in the Framework, Par 104 (a) in 1989 on our Mother of all Debates

This was my answer:

This one is easy to answer immediately:

The answer is NO.

I emphatically always state that accountants do not and can not create wealth or real value out of nothing: out of thin air: by simply passing some update or inflation-adjustment accounting entries. They never do.

Accountants can only MAINTAIN EXISTING real value, BUT, ONLY with measurement in units of constant purchasing power during low inflation and hyperinflation.

(OR - ONLY in the case of the real value of SHAREHOLDERS´ EQUITY - not the real value of any other constant real value non-monetary item under HCA - under HCA during low inflation - when 100% of all contributions to the equity balance is continuously invested in revaluable fixed assets with an equivalent updated real value (revalued or not) - something that is only generally the case with property, hospital and hotel companies. This is where the unknowing destruction of real value by accountants choosing to implement the stable measuring unit assumption, i.e. assuming that inflation is zero percent during actual low inflation of up to 25% during three years in a row - enters the picture: they unknowingly destroy real value in that portion of equity that is never backed or maintained by investment in revaluable fixed assets with an equivalent updated real value under HCA during low inflation.)

How do accountants maintain EXISTING constant real non-monetary value during low inflation?

By NOT DESTROYING IT: i.e by measuring it in units of constant purchasing power: i.e. the OPPOSITE of what they do under HCA when they assume that there is no inflation even if inflation is 25% per annum forever. They destroy the real value by measuring the constant real value non-monetary items in nominal montary units: exactly the same as monetary units: treating constant real value non-monetary items the same as cash.

The constant real non-monetary value must first legally exist, then, accountants can MAINTAIN (instead of destroy with applying the stable measuring unit assumption; i.e ASSUMING there is no inflation and measuring it in nominal monetary units during low inflation) its real value ONLY with measurement in units of constant purchasing power during low inflation and hyperinflation.

We must remember that accounting has that little-understood magic: it is double entry: for every debit there is an equivalent credit.

The existing constant real non-monetary value of all constant real value non-monetary items is only maintained constant in all entities that at least break even when all constant real value non-monetary items are measured in units of constant purchasing power, all variable items are correctly valued in terms of IFRS and the net monetary gain or loss from holding monetary items is accounted in the income statement during low inflation.

This requires the CORRECT definition of monetary items.

Why?

Because both I and the IASB agree that non-monetary items are all items that are not monetary items.

Thus: define monetary items wrongly - as it is defined incorrectly in IFRS and US GAAP and by PricewaterhouseCoopers, and, we have the wrong split (classification) of monetary and non-monetary items - as we do have at the moment.

Here is the correct definition of monetary items:

Monetary items are money held and items with an underlying monetary nature.

Here is the IFRS (wrong) definition of monetary items:

Monetery items are money held and items to be received of paid in money. IAS 29, Par 12

Almost all non-monetary items are also received or paid in money.

Kindest regards

Nicolaas Smith
realvalueaccounting@yahoo.com

Copyright © 2010 Nicolaas J Smith

9 Fundamental flaws in IFRS and US GAAP

There are nine Fundamental flaws in IFRS and US GAAP

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Nicolaas Smith
realvalueaccounting@yahoo.com

Copyright © 2010 Nicolaas J Smith

Four accounting models authorized in IFRS.

A: Financial capital maintenance in nominal monetary units during low inflation and deflation: traditional Historical Cost Accounting (see the Framework, Par 104 (a))

B: Financial capital maintenance in units of constant purchasing power; i.e. Constant ITEM Purchasing Power Accounting under which ONLY constant real value non-monetary items (NOT variable items) are inflation-adjusted during low inflation and deflation. This is NOT Constant Purchasing Power Accounting which is an inflation-accounting model required ONLY during hyperinflation under which ALL non-monetary items – BOTH variable and constant items – are inflation-adjusted. (see the Framework, Par 104 (a)). This accounting model is unique to IFRS. It is not authorized under US GAAP.

IFRS also specifically requires

C: Current Cost Accounting when an entity selects physical capital maintenance in terms of the Framework, Par 102 and 104 (b).

IAS 29 Financial Reporting in Hyperinflationary Economies requires

D: Constant Purchasing Power Accounting, i.e. inflation-accounting under which all non-monetary items – both variable and constant items – are inflation-adjusted ONLY during hyperinflation (different from the above Constant ITEM Purchasing Power Accounting authorized in Par 104 (a) during LOW inflation and deflation under which ONLY constant items – NOT variable items – are inflation-adjusted during LOW inflation and deflation).

Kindest regards

Nicolaas Smith
realvalueaccounting@yahoo.com

Copyright © 2010 Nicolaas J Smith

Value does not exist independently of how we measure it.

The best example is a salary: when it is measured at Historical Cost, it has one value and when it is inflation-adjusted, i.e. measured in units of constant purchasing power, it has another - totally different - value.

This is also true for wages, rentals, etc.

Salaries, wages, rentals, etc are constant real value non-monetary items.

The same is true for all constant real value non-monetary items. Other examples are trade debtors, trade creditors, taxes payable, taxes receivable, etc.

Trade debtors, trade creditors and other non-monetary payables and receivables are mostly incorrectly defined by PricewaterhouseCoopers, the FASB, the IASB and others as monetary items and measured at Historical Cost in today´s economy.

185 million Brazilians measured all trade debtors, trade creditors, all other non-monetary payables and receivables daily in units of constant purchasing power by indexing them daily during 30 years from 1964 to 1994 with reference to a daily index supplied by the various governments during that period in the entire Brazilian economy.

This is totally ignored by PricewaterhouseCoopers, the FASB and the IASB today.

PricewaterhouseCoopers´auditors must have audited many Brazilian companies doing that during those 30 years. The message never got through to the PwC accountants who wrote their publication: Understanding IAS 29 - Financial Reporting In Hyperinflationary Economies in which PwC define trade debtors and trade creditors as monetary items. The FASB also specifically define trade debtors and trade creditors as monetary items.

Dr Gustavo Franco was the Governor of the Central Bank of Brazil during the last few years of that period of indexation. He was the head of the team that famously killed hyperinflation in Brazil in 1994 (they took 10 years to do it) with their Unidade Real de Valor (URV) or Real Value Unit.

I sent him the following email:

Dear Dr Franco,
>
> I would appreciate it very much if you could perhaps clear up a point for me regarding trade debtors and trade creditors under the URV.
>
> Were trade debtors and trade creditors treated as monetary items under the URV and not updated or were they treated as non-monetary items an updated in terms of the URV?
>
> What are trade debtors and trade creditors in your opinion? Are they monetary or non-monetary items?

He answered as follows:

"Dear Mr. Smith


Two observations are in order. First, for spot transactions the existence of the URV is immaterial, sums of means of payment are surrendered in exchange for goods, all delivered and liquidated on spot. Second, the unit of account enters the picture only when at least one leg of a commercial transaction is deferred. In this case, the URV serves the purpose of defining the price at the day of the contract. The same quantities of URVs are to be paid at the payment day, though this should represent LARGER QUANTITIES OF WHATEVER MEANS OF PAYMENT IS USED. (my capitals)


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


Att


GF"

So: there it is from the best possible source: trade debtors and trade creditors are non-monetary items.

PricewaterhouseCoopers, the IASB and the FASB and all of us can be educated about financial capital maintenance in units of constant purchasing power as authorized in IFRS in the Framework, Par 104 (a) from what Dr Franco confirmed.

Equity is measured at Historical Cost during low inflation and deflation in all economies world wide.

Equity is measured, not at Historical Cost, but, in units of constant purchasing power in terms of IAS 29 in Venezuela today by all Venezuelan companies which implement IFRS as well as foreign holding companies (applying IFRS) of Venezuelan subsidiaries and in all hyperinflationary economies

So, it is very clear that the value of any economic resource does not exist independently of how it is measured.

That statement is ONLY true in the case of

(1) variable real value non-monetary items, e.g. property, plant, equipment, inventory, etc. and monetary items - per se - under all accounting and economic models

and
(2) ONLY equity (not all constant items) during low inflation and deflation under Historical Cost Accounting ONLY when 100% of the updated original real value of all contributions to the equity balance are continuously invested in revaluable fixed assets (revalued or not) with an equivalent updated real value. This is – generally – rarely the case. It is most probably the case in property, hospital and hotel companies.

The statement that “value exists irrespective of how it is accounted” is thus the fourth accounting fallacy not yet extinct.

The four accounting fallacies not yet extinct are:

1.Financial capital maintenance in nominal monetary units: it is impossible to maintain the real value of financial capital constant - per se - with measurement in nominal monetary units during inflation and deflation.

2.The stable measuring unit assumption that is based on the fallacy that changes (up to 25% annual inflation for three years in a row) in the real value of the monetary unit of account are not sufficiently important for accountants to choose financial capital maintenance in units of constant purchasing power during low inflation and deflation as authorized in IFRS in the Framework, Par 104 (a).

3.The erosion of business profits and invested capital is caused by inflation as wrongly stated by the FASB in FAS 33 in 1979. This is believed by almost all accountants and economists. In fact: “inflation is always and everywhere a monetary phenomenon” as so famously stated by Milton Friedman, the late Noble Laureate. Inflation has no effect on the real value of any nonmonetary item ever. It is impossible for inflation – per se - to erode, distort or destroy any non-monetary item ever. This is confirmed by two top Turkish academics who state:

“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.

4. “Value exists irrespective of how it is accounted.” This is only true in the case of variable and monetary items per se under all accounting and economic models and only equity during HCA during low inflation and deflation if the 100% investment requirement of the updated original real value of all contributions to the equity balance in revaluable fixed assets with an equivalent updated real value is met.

Copyright © 2010 Nicolaas J Smith

f

Statement regarding inflation destroying the real value of non-monetary items have no substance at all.

After 2008 it became very clear to me that inflation is only a monetary phenomenon and can only destroy the real value of money and other monetary items.

It is very clear that inflation has no effect on the real value of non-monetary items as Milton Friedman, the late American Noble Laureate stated so famously: "Inflation is always and everywhere a monetary phenomenon." It is impossible for inflation per se to destroy the real value of any non-monetary item ever.

I am not the only person stating and understanding that. This is what two Turkish academics state:

“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

The statement that inflation destroys the real value of non-monetary items that do not hold their real value has no substance at all. Just like the statement that valuing items in units of constant purchasing power makes no difference to the economy as well as the statement that inflation does the destroying in companies´capital and profits and not accountants.

The statement correctly confirms that there are two types of non-monetary items. Those that hold their real values in terms of purchasing power and those that do not hold their real values in terms of purchasing power under HCA during low inflation; i.e., as a result of the stable measuring unit assumption. These are constant real value non-monetary items incorrectly measured in nominal monetary units instead of in units of constant purchasing power as authorized in IFRS in the Framework, Par 104 (a) in 1989 which states:

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

The IASB only makes a distinction between monetary and non-monetary items. The stable measuring unit assumption allows the IASB to side-step the split between variable and constant real value non-monetary items.

Copyright © 2010 Nicolaas J Smith

Variable items exist independently of how SA accountants value them

Variable items are non-monetary items with variable real values over time.

Measurement is the process of determining the monetary amounts at which variable items are to be accounted/recognised and carried in the financial reports. This involves the selection of a particular basis of measurement. SA accountants value variable items in terms of IFRS or SA GAAP.

Variable items in the SA non-monetary or real economy are valued at, for example, fair value or the lower of cost and net realizable value or recoverable value or market value or present value in terms of IFRS or SA GAAP. “Listed companies use IFRS and the unlisted companies could use either IFRS or Statements of GAAP.”

SA accountants value variable items correctly in terms of IFRS or SA GAAP at the financial report date – excluding those variable items valued at original nominal Historical Cost when that original date is not the financial report date on a primary valuation basis. The fundamental real values of variable items exist independently of being valued at their original nominal HC values after the original date they came about or were acquired by the entity. Valuing a variable item at its original nominal HC during its lifetime does not destroy its real value because it would be valued at its current market value whenever it is finally exchanged or sold or disposed of in the future.

All items in financial statements - monetary, variable and constant items - were valued at Historical Cost before there were any GAAPs and IFRS, since money – the monetary unit of account – was generally assumed to be stable in real value over time: the infamous stable measuring unit assumption. Today, SA accountants maintain this very destructive and very economically destabilizing assumption only for the valuation of the majority of income statement items (excluding salaries, wages, rents, etc which SA accountants generally value in units of constant purchasing power) and all balance sheet constant items during low inflation and deflation.

SA accountants implement the HC model when they choose to measure financial capital maintenance in nominal monetary units per se (which is a fallacy during inflation and deflation) in terms of the IASB´s Framework, Par 104 (a). They implement their very destructive stable measuring unit assumption. In so doing, they- and not inflation - are unknowingly destroying the real value of constant items never maintained during low inflation.

Kindest regards

Nicolaas Smith
realvalueaccounting@yahoo.com

Copyright © 2010 Nicolaas J Smith

Salaries and wages would never be decreased in line with monthly deflation.

Salaries and wages would never be decreased in line with monthly deflation.
Effects of rejecting the current 3000-year-old Historical Cost paradigm and changing over to a Constant Item Purchasing Power paradigm:

All non-monetary receivables and payables would be updated monthly with the change in the CPI. E.g. trade debtors, trade creditors, taxes payable, taxes receivable, etc would be updated monthly.

Salaries and wages would be updated monthly.

Result: a law would be rushed through parliament in the first month of monthly deflation (as already happened in one American state very recently) to prevent salaries from being decreased in line with monthly deflation (as they should be in order to maintain economic stability).

This would result in an increase in the real value of salaries and wages when they are kept the same during a month of monthly deflation.

Kindest regards

Nicolaas Smith
realvalueaccounting@yahoo.com

Copyright © 2010 Nicolaas J Smith

PricewaterhouseCoopers, the IASB and the FASB bamboozled by accountants´ notorious stable measuring unit assumption

Most accountants and economists will confirm that real value is being destroyed in banks´ and companies´ capital over time. The banking crisis – remember?

Most of them blame inflation – except two Turkish academics, the head of the Turkish Accounting Standards Department, the late Milton Friedman – and I.

It is not inflation doing the destroying as someone stated. It is them assuming there is no inflation when they never update companies´ and banks´ capital when they implement their very destructive stable measuring unit assumption.

Most of them believe the FASB when it tells them that the erosion of business profits and invested capital is caused by inflation.

They are all dead wrong: Friedman was right: inflation is always and everywhere a monetary phenomenon: inflation per se has no effect on any non-monetary item ever – as confirmed by the two Turkish academics.

What will happen when we change the global 3000 year old Historical Cost paradigm to the IFRS approved units of constant purchasing power regime?

First of all: accountants´ brains get filled by one word when they read or hear the term units of constant purchasing power:

INFLATION-ACCOUNTING!!!

Accountants forget that most of them inflation-adjust salaries, wages, rentals, etc annually.

However, IFRS authorized financial capital maintenance in units of constant purchasing power at ALL levels of inflation and deflation in the Framework, Par 104 (a) twenty one years ago.

Inflation-adjusting ONLY constant real value non-monetary items during low inflation (not all non-monetary items as required by inflation-accounting during hyperinflation) would mean that SA accountants would knowingly maintain about R167 billion in the constant real value of existing constant items currently unknowingly and unnecessarily being destroyed by them PER ANNUM in the SA real economy in, for example, that portion of companies´ capital not backed by sufficient revaluable fixed assets as a result of them implementing the stable measuring unit assumption.

The magic of accounting is that it is double entry: for every debit there is an equivalent credit.

So, if companies´ equity is to be inflation-adjusted (an increase in nominal credit values to maintain real values constant during low inflation) where does the opposite increase in nominal debit values come from?

For example from trade debtors: currently trade debtors are incorrectly classified by the IASB, the FASB, PricewaterhouseCoopers, etc, as monetary items. They are constant real value non-monetary items.
Copyright © 2010 Nicolaas J Smith

Would we be able to borrow more?

Bertie: Nicholaas, how would business be different in SA if that value was not being destroyed? In practical terms. I now buy into your point. But blog for us on what difference the opposite approach would have for everyday business in SA. Would we be able to borrow more? Lend more? Produce more? Market more lavishly?

Would we be able to borrow more?

Yes.

With all capital and retained profits revalued monthly, it means that the real value of the part of SA´s investment capital base represented by companies´ equity will be maintained constant in real value terms on a national and company by company basis: in units of constant purchasing power.

The company with R1 million in capital on 1st Jan 1981 still has R1 million today under the current 3000-year-old Historical Cost paradigm and is able to borrow accordingly from the banks today as well as in 29 years time from today if inflation is exactly the same over the next 29 years as it was over the last 29 years and we maintain the Historical Cost paradigm. In 29 years´ time the company will still have R1 million capital - but at the 2039 price level; i.e. 1/14th of today´s real value exactly the same when today´s R1 million is 1/14th of the real value of what it was on 1st Jan 1981.

Under the Constant Item Constant Purchasing Power (CICPP) paradigm, the company with R14 million in capital on 1st Jan 1981 (today´s price level; R1 million at 1981 price level: the 1981 value simply being a Historical Cost reference item, not a value in terms of today´s price level) would still have R14 million at today´s price level and would be able to borrow accordingly from the banks today as well a in 29 years time from today when the nominal value would be 14 X 14 million at the 2039 price level but still R14 million for us at today´s price level. We live today. Our minds can only evaluate the value of the Rand at today´s price level. We cannot put our minds (value evaluation mind processes) back or forward – although we imagine that we are doing that today and did in the past.

The multiplier effect would come into play and the economy as a whole would benefit.

We would have fewer banking crises as a result of insufficient bank capital. Banks´ capital would be automatically maintained at its constant real value over time - not like today when that portion of banks´ (and companies´) capital NEVER backed by sufficient revaluable fixed assets is unknowingly and unnecessarily being destroyed by the banks´ accountants implementing the stable measuring unit assumption as part of the Historical Cost Accounting model.

The CICPP paradigm would be the same as zero inflation ONLY for constant real value non-monetary items, e.g. companies´ shareholders´ equity, salaries, wages, rentals, all other items in the income statement, trade debtors, trade creditors, taxes payable, taxes receivable, all non-montary payables, all non-monetary receivables, provisions, etc.

Kindest regards

Nicolaas Smith
realvalueaccounting@yahoo.com

Copyright © 2010 Nicolaas J Smith

How would business be different in SA? - Part 1

Bertie: Nicholaas, how would business be different in SA if that value was not being destroyed? In practical terms. I now buy into your point. But blog for us on what difference the opposite approach would have for everyday business in SA. Would we be able to borrow more? Lend more? Produce more? Market more lavishly?

The opposite approach means a once-in-3000-year paradigm change. Everything used to be accounted at historical cost. It could also be seen as the last step in a 100 year process of changing this global 3000 year old Historical Cost paradigm.

Over the last 100 years or so, accountants have realized that variable real value non-monetary items, e.g. property, plant, equipment, shares, inventories, etc cannot be accounted/valued/measured at their 200 year old or 20 year old or 1 year old or any historic price that is not the price/fair value at the balance sheet date.

IFRS and US GAAP are really about defining rules for the measurement of the above mentioned variable items.

Both US GAAP and IFRS value constant real value non-monetary items, e.g. issued share capital, retained profits, capital reserves, equity and most items in the profit and loss account still at Historical Cost as they have been for the last 3000 years: they ASSUME there was no inflation, there is no inflation and there never will be inflation ONLY as far as these items are concerned: they, in principle, ASSUME all monetary units are perfectly stable during low inflation and deflation ONLY for this purpose.

By doing this SA accountants unknowingly, unnecessarily and unintentionally destroy about R167 billion per annum in the real value of SA companies´ equity never backed by sufficient revaluable fixed assets (revalued or not) as well as other constant items never maintained PER ANNUM under HCA as long as annual inflation stays at more or less 5%.

Luckily for workers, they do change their minds for the constant items salaries, wages, rentals, etc. They value them in units of constant purchasing power: i.e. they inflation-adjust them annually. But, ONLY for a selected few profit and loss account items: no balance sheet constant items at all.

Only IFRS, not US GAAP, authorized accountants 21 years ago already, to inflation-adjust all constant items: all profit and loss account and all balance sheet constant items during low inflation and deflation. SA accountants would knowingly maintain instead of destroy about R167 billion PER ANNUM in the real value of all constant items of all SA companies´ that at least break even whether they own any revaluable fixed assets or not – ceteris paribus – forever, when they freely change over to financial capital maintenance in units of constant purchasing power during low inflation: inflation-adjusting ONLY constant items (NOT variable items) during low inflation (this is not inflation-accounting required to be implemented only during hyperinflation).

No-one does it.

Why?

Because they all believe that inflation is doing the destroying because they have been taught like that and everyone “knows” that to be a “fact”. In SA someone stated that in so many words and someone else  confirmed that: accountants have no control over inflation; so, it has nothing to do with them: they can not fix it: they can not stop the destruction.

However, inflation is always and everywhere a monetary phenomenon: it is impossible for inflation per se to destroy the real value of any non-monetary item ever. All items in shareholders´ equity are constant real value non-monetary items: all accountants would confirm that. So, it is not inflation doing the destroying: it is accountants´ free choice of implementing the stable measuring unit assumption as part of traditional HCA. When they reject the stable measuring unit assumption and implement financial capital maintnenance in units of constant purchasing power as authorized in IFRS in the Framework, Par 104 (a) twenty one years ago, the destruction stops - in all entities that at least break even.

How would business in SA be different when SA accountants implement financial capital maintenance in units of constant purchasing power during low inflation: inflation-adjusting ONLY constant items as authorized in IFRS in the Framework, Par 104 (a) in 1989: the opposite approach?

There are obviously two aspects to the change-over from the current Historical Cost paradigm to a units of constant purchasing power paradigm or Constant Purchasing Power (CPP) paradigm: (1) the actual change-over which would be a once-in-3000-year event and then (2) the actual effects of the change. Bertie´s questions are about Nº 2: the actual effects of the change-over. The US regards changing from US GAAP to IFRS as a once-in-a-100-year event. Imagine when they then have to change again in this once-in-a-3000-year event? Accounting, auditing and consulting companies are going to make billions in extra retraining fees.

In general

Everybody will have to get used to think in real terms or CPP terms instead of Historical Cost terms. Everybody in SA will have to get used to the fact that the value of the Rand changes once a month: that the Rand is not perfectly stable as all SA accountants ASSUME only for this ONE purpose and that all EXISTING constant items´ nominal values would be revalued/remeasured/updated correctly and automatically in businesses (in the whole real or non-monetary economy) to maintain their EXISTING CONSTANT real values constant forever in all entities that at least break even and that all financial statements would show this monthly - once all financial statements are updated automatically digitally on a montly basis: no real value would be destroyed any more by accountants simply in the way they do accounting. But, the EXISTING CONSTANT real value of EXISTING CONSTANT REAL VALUE ITEMS would be maintained automatically by the way accountants do accounting in a better way.

Hard copy printed financial statements would be correct only for the first month after the year-end or period-end – in general - and only if the first set of statements were produced within the first month after the year-end or period-end: during the month of the year-end or period-end CPI. Sometimes SA has two or even three months of zero MONTHLY inflation (I remember that): the CPI stays the same for two or even three months in a row. No change would be made to financial statements only during those zero MONTHLY inflation months. Otherwise all financial statements would change monthly: i.e. every time the CPI changes.

It would be best for companies to keep their financial statements only in digital form so they can be updated monthly with the change in the CPI. Companies would end up with a digital set of financial statements only in digital form that would automatically be updated monthly. Only the latest updated version would be correct. There will always only be one set of financial statements that are correct, namely, the latest ones updated at the latest CPI. No copies of statements at previous CPI levels will be kept - ever - because it is not possible for us to put our minds and thinking and evaluating processes back in time: it is impossible to do that - although that is how we have been doing accounting (wrongly) for the last 3000 years.

I will answer more of Bertie´s questions tomorrow. This blog is getting rather long.
Copyright © 2010 Nicolaas J Smith

It´s the stable measuring unit assumption, stupid!

We have seen so far that accountants implement the Historical Cost Accounting model because it is the traditional model for the last 3000 years – or more.

Historical Cost Accounting is based on the fallacy of financial capital maintenance in nominal monetary units: it is impossible to maintain the real value of financial capital constant in nominal monetary units per se during inflation and deflation.

They accept and admit that companies´ capital and retained profits are constantly being eroded (which is the same as destroyed). They all believe and are taught that this erosion is caused by inflation. They are told as much by the FASB and the IASB.

However:

It´s the stable measuring unit assumption, stupid! as Bill Clinton would have said.

Accountants unknowingly, unnecessarily and unintentionally destroy the real value of that portion of companies´ equity never maintained constant by sufficient revaluable fixed assets under HCA during inflation because they implement the stable measuring unit assumption.

They would stop this destruction when they freely change over to financial capital maintenance in units of constant purchasing power as they have been authorized in IFRS in the Framework, Par 104 (a) in 1989. It states:

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

When SA accountants do that they will knowingly maintain about R167 billion per annum in the SA real economy for as long as annual inflation stays at about 5%.
Copyright © 2010 Nicolaas J Smith

Accountants do not understand what they are doing.

So, we have seen so far that accountants don’t really understand what they are doing: they simply just keep on doing what all accountants before them have been doing and what all accountants currently are doing: Historical Cost Accounting.

Naturally, they state that they do accounting in terms of IFRS and that IFRS pass through a very rigorous due process before they are approved. Well, the IASB and the FASB have been discussing Measurement for the last 6 years in their joint Conceptual Framework project and have not once discussed units of constant purchasing power as a primary measurement basis: very clear proof that they do not understand what they are doing.

If you knew what you were doing in basic accounting with the stable measuring unit assumption and if you understood the effects of measuring items in units of constant purchasing power, you would discuss units of constant purchasing power at least once during six years of high-level discussions about the concepts of measurement, wouldn´t you?

Measuring constant items, e.g. salaries, wages, rentals, equity, etc, in units of constant purchasing power does affect the nature of the underlying resources and does affect the economy.
Accountants are completely inconsistent: they measure salaries, wages, rentals, etc (constant items) in units of constant purchasing power, but they measure capital and retained profits (also constant items) in nominal monetary units.

Very inconsistent and very destructive.

Accountants ignore the whole problem by stating that this destruction of value is caused by inflation: they all believe that. The FASB, the IASB and everyone tell them that. They must be right.

They are dead wrong – as I have proved in the previous blogs.

How is this value destroyed: I have shown how in an example in a previous blog.

Basically, SA accountants unknowingly destroy the real value of all SA companies´ equity never covered or backed by revaluable fixed assets under HCA during inflation at a rate equal to the annual rate of inflation.

They all believe it is inflation doing the destroying.

We know now very clearly – confirmed by the two Turkish academics and Milton Friedman – that inflation can only destroy the real value of money and other monetary items – nothing else.

So that is settled then: accountants destroy real value with normal traditional Historical Cost Accounting to the tune of about R167 billion per annum in the SA real economy.

How can this be stopped?

See my next blog.
Copyright © 2010 Nicolaas J Smith

Accountants are inconsistent.

Why don’t SA accountants value companies´ issued share capital and retained profits - which are constant real value non-monetary items - in units of constant purchasing power as they value salaries, wages, rentals – which are also constant real value non-monetary items?

Why do they refuse to value capital and retained profits in units of constant purchasing power like they do with salaries and wages?

Well, they don’t actually refuse to do it. They just don’t do it that way: that’s it!! Everybody in the world values capital and retained profits in nominal monetary units for at least the last 3000 years! It must be correct when everybody is doing it for the last 3000 years, isn’t it?

Everybody once thought the sun turns around the earth because they could actually see the sun turning around the earth.

Everybody once thought the earth is flat because they could actually go outside and see that the earth is flat all around them.

No, valuing capital and profits at historical cost is wrong during inflation and deflation! Proof: accountants assume money is perfectly stable for this purpose and we all know money is never perfectly stable for more than a month or two at a time. (Check out CPI data). Accountants apply their notorious stable measuring unit assumption: they assume the measuring unit is stable: we all know that the measuring unit – money – is never stable on a sustainable basis. So: they are wrong as well as inconsistent!! :-)

So, if SA inflation stayed at 13.8% (where it got to some months back - for the next 50 years), SA accountants would carry on assuming it is perfectly stable - zero percent - and they would just have carried on valuing SA companies´ capital and profits at historical cost as they do today at 4.2%. They would carry on doing that all the way till 25% for three years or 300 years in a row. They would not change - in terms of IFRS.

By the way, after three years of 25% inflation - which is immaterial as far as SA accountants are concerned (in terms of IFRS) - they would have unknowingly destroyed 100% of all equity not backed by revaluable fixed assets in the SA economy.

Historical Cost Accounting is the existing paradigm in the world economy for the last 3000 years – at least.

In fact, accountants know and admit that there is inflation and that inflation destroys the real value of the Rand over time. They just assume that it makes no difference. They assume that inflation from 0.0001% per annum till 25% per annum for three years in a row is immaterial: that it is not harmful to the economy. But, ONLY in the case of companies´ issued share capital, retained profits, all other items in shareholders´ equity, etc. These are all constant real value non-monetary items.

Salaries, wages, rentals, etc are also constant items. In this case accountants value them in units of constant purchasing power. They are not at all consistent in their way of reasoning.

“Historical Cost” accounting means that – originally: a very long time ago – all economic items were valued at their original Historical Cost values. 500 years ago the East Indian Company accountants valued all company fixed property at historical cost. The historical cost stayed the same from 1500 to 1800. Today fixed property can be revalued in terms of IFRS. Today all variable real value non-monetary items are valued in terms of IFRS which are – by and large – based on market value or fair value: the destruction of the real value of the monetary unit of account is allowed for in the valuation process of determining the values of variable items in the financial statements.

More in the next blog.

Kindest regards

Nicolaas Smith
realvalueaccounting@yahoo.com

Copyright © 2010 Nicolaas J Smith

Inflation myths in layman terms – Part 4

3. "Inflation destroys the value of non-monetary items which do not hold their value in terms of purchasing power" is authoritatively stated.

I agreed with that when it was stated in 2008. My first book Real Value Accounting (2005) was based on the premise that inflation has two components: a monetary and a non-monetary component. I have since realized that it was a mistake. We often advance science from making mistakes. It was definitely worth my while writing the first book. It helped me to realize that inflation per se does not destroy the real value of non-monetary items.

Inflation can only destroy the real value of monetary items - nothing else. Inflation - per se - 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.

I am not the only person understanding that and stating that.

This is what two Turkish academics state:

“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.

What destroys the real value of non-monetary items if it is not inflation?

There are three fundamentally different economic items in the economy:

1.Monetary items

2.Variable real value non-monetary items

3.Constant real value non-monetary items

We all know that inflation destroys the real value of monetary items over time – and nothing else. So, that is settled: the real value of money and other monetary items are destroyed by inflation over time. Obviously if you burn bank notes or they are physically destroyed in some other way, their real values are destroyed too: they do not physically exist any more. All central banks replace very worn-out bank notes in the physical money supply.

Variable items are things like property, plant, equipment, foreign exchange, raw material and finished goods stock, consumer items, etc. Their real values can be destroyed in many different ways: they go out of fashion, they become useless, they stop working, better products are developed, etc, etc.

Inflation can not destroy their real value: when you own a variable item, for example, a house, and you know many very similar houses sell for R1 million Rand, you know your house is worth R1 million. If nothing except inflation changes to 4% over a year, you adjust your value for your house to R1 040 000.

You cannot do that with R1 million you keep in a zero interest bank account.

The third item, constant items are items like salaries, wages, rentals, issued share capital, retained profits, trade debtors, trade creditors, etc. Accountants account all these items in terms of money (the Rand) in the books of account – like everything they account.

All SA accountants accept without a shadow of doubt that any level of inflation – whether 0.0001% or 25% or whatever level per annum - destroys the real value of the Rand and they inflation-adjust the nominal values of salaries, wages, rentals, etc on an annual basis: they choose / decide / accept / agree to value these items in unit of constant purchasing power. They are all very well educated in accounting. Accounting is a very well developed discipline: measurement in units of constant purchasing power is a well known and well established generally accepted accounting practice over the last 100 years or more of maintaining the real value of an economic item during inflation. SA accountants are all very well educated in implementing measurement in units of constant purchasing power: the proof? They apply it every year to salaries, wages, rentals, etc. There is absolutely no doubt about the fact that SA accountants understand the concept of measurement in units of constant purchasing power to maintain the real value of an economic item during inflation. They know that they have to increase the nominal values of these items by an amount at least equal to the annual rate of inflation because they are accounting them in terms of the Rand and inflation destroys the real value of the Rand. That is why they value / measure them in units of constant purchasing power.

So, they accept and admit what we all know: there is no such thing as perfectly stable money or a perfectly stable monetary measuring unit. They maintain the real value of salaries, wages, rentals, etc by implementing measurement in units of constant purchasing power. How clever and how reasonable and how intelligent and how normal of them. SA accountants are really well-educated and very normal professionals in this respect.

However, you will not believe what I am going to tell you next!!

When it comes to items like issued share capital and retained profits SA accountants suddenly change their very educated attitude completely: now they suddenly assume the Rand is perfectly stable. They suddenly forget everything they have learnt and know about inflation: they, in principle, suddenly assume there has never been inflation in the past, there is no inflation in the present and there will never ever be inflation in the future.

What in fact happens is that whereas they accept that any level of inflation destroys the real value of salaries, wages, rentals, etc, they now suddely assume the following: inflation from 0.001% to 25.9% for three years in a row is now, suddenly, immaterial: for example 25% inflation for three years in a row (which – by the way – will wipe out 100% of the real value of constant items never maintained under HCA) is now immaterial and will not do any harm to the economy.

They implement their notorious and very destructive stable measuring unit assumption: they account companies´ issued share capital, retained profits, etc at their original nominal historical costs: they measure them in nominal monetary units.

Crazy is it not?

Well, that is how all accountants in SA - including the 30 404 CA(SA)s - do accounting.

So, what happens?

Obviously they destroy the real value of companies´ capital, retained profits and other constant items never maintained at a rate equal to the annual rate of inflation because they refuse to measure them in units of constant purchasing power although they have been authorized to do that 21 years ago: they measure them in nominal monetary units.

This time they actually destroy the real value of these constant items never maintained because they refuse point blank to value them in units of constant purchasing power. It is not inflation doing the destroying (as their accounting professors tell them) because they can freely stop their unnecessary destruction by valuing these items in units of constant purchasing power like they do with salaries and wage and rentals, etc. They refuse to do that.

They are told at university that it is inflation doing the destroying.
Why do they do this?

I will explain next time.
Copyright © 2010 Nicolaas J Smith

Inflation myths in layman terms – Part 2

SA accountants, implementing traditional 700-year-old Historical Cost Accounting, unknowingly, unnecessarily and unintentionally destroy the real value of that portion of SA companies´ equity (capital) that is not backed or covered 100% by revaluable fixed assets at a rate EQUAL TO the annual inflation rate - because they account companies´ capital in money - the Rand in SA - and inflation destroys the real value of the Rand, but, SA accountants ignore that basic fact when they value companies´ equity (capital) and most other constant real value non-monetary items at original historical cost.

How do SA accountants destroy the real value of SA companies´ capital doing traditional Historical Cost Accounting?

As follows:

They implement the stable measuring unit assumption during inflation. They accept that inflation destroys the real value of the Rand, but, they assume that makes no real difference and is not harmful at all (from 0.001 to 25% per annum for three years in a row). So, for certain items, not all items, they, in principle, assume there is no inflation; they assume the Rand is perfectly stable even at 25% per annum inflation for three years in a row recurring.

Which items? Issued share capital, retained profits, capital reserves, all other items in shareholders´ equity, for example.

R1 million on 1st Jan 1981 was the same as R14 million today.

So if you invested the R1 million on 1st Jan 1981 in revaluable fixed property your balance sheet from 1st Jan 1981 till today would always be the same: Capital R1 million and Fixed Property R1 million. You can keep it like that forever. The real value of your capital would be maintained although you value both Capital and Fixed Property in nominal monetary units, i.e. at Historical Cost. You can only maintain the real value of your capital like that if you invest 100% of the original real value of all contributions to equity in revaluable fixed property – under HCA during inflation.

Let´s say you only invested half in fixed property and half in beer for resale on 1st Jan 1981, you pay all your profit out in dividends and you keep on buying R500 000 in beer stock for resale. You keep doing that from Jan 1981 till today. Your balance sheet today will be: Capital R1 million, Fixed Property R500 000 and Stock R500 000.

Your R1 million capital on 1st Jan 1981 was worth R14 million in today´s money.

Today you can sell the property in your books at a Historical Cost of R500 000 for R7 million and the R500 000 beer stock (greatly reduced in units of beer) for a profit. So, you have paid away R6.5 million of the real value of your capital you started your business with in dividends.

That is how SA accountants, including CA(SA)s, unknowingly, unnecessarily and unintentionally destroy about R167 billion PER ANNUM in the investment base of SA companies – the S A real economy - doing traditional Historical Cost Accounting: with their stable measuring unit assumption. They, the IASB and FASB blame inflation and, they say, there is absolutely nothing they can do about it. They are all dead wrong.

All of them also do not understand the above: if they understood it, they would have done something about it by now.

What would have happened if they had inflation-adjusted their equity as they had been authorized by the International Accounting Standards Board in International Financial Reporting Standards in the Framework, Par 104 (a) in 1989?

I will explain next time.
Copyright © 2010 Nicolaas J Smith

Inflation myths in layman terms – Part 1

1. "Inflation erodes companies´ invested capital and profits" - as per the FASB.

The FASB is the US Financial Accounting Standards Board. They set accounting standards in the US. In the 1970´s their Mr Mosso famously stated the above term in one of their standards, either Financial Accounting Standard 33 or FAS 89 which superceded FAS 33.

All accountants will tell you that inflation “erodes” companies´ capital and profits. They never use the term destroy: always “erode”. Well, erode and destroy is the same thing.

Accountants truly believe that. They are trained at university like that. They write their CA exams and pass and become CA (SA)s in the best Financial Director and CEO positions in SA believing that.

One of their arguments goes something like this: the cost of an item sold is not inflation-adjusted. The selling price is at the current price level while the cost of the item is at another, past or historic, price level. So, the profit is overstated. These overstated profits eventually may all be paid out in dividends. This basically results in the capital of the company not being maintained: it may be paid away in dividends. So, companies´ capital is eroded by inflation.

Accountants do not control the level of inflation. That is determined by the central bank and the government’s economic policy. So, this happens, but, accountants can do absolutely nothing about it. It is out of their hands.

This is an absolutely generally accepted “fact” appearing in most accounting and economics text books.

However: inflation is always and everywhere a monetary phenomenon as so eloquently stated by the late American Nobel Laureate Milton Friedman. Inflation can only affect, i.e. destroy, the real value of money and other monetary items, i.e. items with an underlying monetary nature – nothing else. Inflation per se has no effect on the real value of any non- monetary item ever. It is impossible for inflation to destroy the real value of any non-monetary item – ever.

Companies´ issues share capital and retained profits are all non-monetary items. All accountants would confirm that. So, it is impossible for inflation to erode or destroy companies´ invested capital and profits.

I am not the only person understanding that and stating that.

This is what two Turkish academics state:

“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

So, if it is not inflation eroding or destroying companies´ capital - then, what is?

It is accountants´ choice of accounting model; more specifically the stable measuring unit assumption that is part of the traditional Historical Cost Accounting model.

Accountants choose the accounting model? Not really. Historical Cost Accounting is the generally accepted basic accounting model world-wide for more than 700 years.

However, they are not forced to use HCA. No-one forces them.

In 1989 the International Accounting Standards Board, the other main accounting standard setter, authorized the following in their Framework, Par 104 (a):

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

So, all accountants in companies implementing International Financial Reporting Standards, i.e. in SA all JSE listed companies, actually do have to choose: they are given a specific choice in the Framework, Par 104 (a): either the one of the other: they all “choose” HCA. In fact, when they changed over to IFRS they just carried on doing traditional HCA. Most probably not a single accountant in the world implementing IFRS realized that they are actually given a choice in IFRS.

What is the stable measuring unit assumption?

SA accountants simple assume that the Rand is perfectly stable; i.e. that there is no inflation, only as far as certain, not all, items in their companies are concerned.

However, we all know that money is not perfectly stable. There is something called inflation and deflation.

So, under inflation SA accountants unknowingly destroy the real value of that portion of SA companies´ equity (capital) that is not backed or covered by revaluable fixed assets.

I will explain how tomorrow.
Copyright © 2010 Nicolaas J Smith

Inflation myths - updated

INFLATION MYTHS

1. "Inflation erodes companies´ invested capital and profits" - as per the FASB.

Inflation is always and everywhere a monetary phenomenon – Milton Friedman. Inflation only destroys the real value of money and other monetary items – nothing else. Inflation has no effect on the real value of any non-monetary item.

Historical Cost accountants unknowingly destroy companies´ invested capital and profits with their stable measuring unit assumption. The moment they freely change over from traditional Historical Cost Accounting to financial capital maintenance in units of constant purchasing power as they have been authorized in IFRS in the Framework, Par 104 (a) in 1989, they would stop destroying real value in constant items never maintained.


2. "Inflation influences reported results"

The basic accounting model chosen influences reported results. Inflation - per se - can only influence or destroy the real value of monetary items - nothing else. Choose financial capital maintenance in nominal monetary units, i.e. Historical Cost Accounting (which includes the stable measuring unit assumption) and you have one result. Choose financial capital maintenance in units of constant purchasing power and you have another (the correct) result. Unfortunately, both options are authorized in IFRS.


3. "Inflation destroys the value of non-monetary items which do not hold their value in terms of purchasing power"


Inflation can only destroy the real value of monetary items - nothing else. Inflation - per se - 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.


4. There is no inflation or money is perfectly stable as far as balance sheet constant real value non-monetary items (e.g. shareholders´ equity) are concerned:

I.e. the stable measuring unit assumption or financial capital maintenance in nominal monetary units (the traditional Historical Cost Accounting model) or, shareholders´ equity can be accounted at Historical Cost.

Inflation only destroys the real value of money and other monetary items. All constant real value non-monetary items expressed in the normal monetary unit of account have to be inflation-adjusted; i.e. accounted in units of constant purchasing power during inflation and deflation in order to maintain their real values constant in all entities that at least break even.
Copyright © 2010 Nicolaas J Smith