It is correct, essential and compliant with IFRS to update constant items by means of the monthly change in the CPI during low 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 within an economy or monetary union. Inflation erodes 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 at a rate equal to the rate of low inflation or deflation, i.e. valued or measured in units of constant purchasing power, in order to maintain their real values constant during low 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 low inflation and deflation. Months of zero annual inflation are very few and far between. Sustainable zero annual inflation has never been achieved before and it does not seem very likely that it will be achieved any time soon in the future.
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 IFRS or GAAP at, for example, fair value, market value, present value, recoverable value, net realizable value, etc which always automatically take inflation – amongst many other items – into account. Variable real value non–monetary items are only valued in units of constant purchasing power during hyperinflation as required in IFRS in IAS 29 since the IASB 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 (sustainable zero inflation). That is not correct. 2% inflation will erode, for example, 51% of the real value of all monetary items and all constant real value non–monetary items never maintained constant, e.g. Retained Profits never maintained constant, over 35 years – all else being equal – when the stable measuring unit assumption is implemented for an indefinite period of time during indefinite low inflation.
It is not necessary to updated by means of the CPI, which is a general price index, variable real value non–monetary items (e.g. properties, plant, equipment, 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 also stated as 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 erosion of the real value of money and other monetary items over time, i.e. an erosion of the general purchasing power of money which is caused by/results in an increase in the general price level over time.
It is thus generally accepted in economics that the word inflation has two different meanings:
(1) inflation meaning the erosion of the real value of only money and other monetary items over time; i.e. an erosion of the general purchasing power of money which is caused by/results in an increase in the general price level over time, and
(2) inflation meaning any single or non-general price increase.
1970–style Constant Purchasing Power Accounting (CPPA) 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 real value non–monetary items and constant real value non–monetary items) equally by means of the Consumer Price Index during high in the 1970´s. 1970–style CPPA inflation accounting was abandoned as a failed and discredited inflation accounting model when general inflation decreased to low levels thereafter.
Constant Item Purchasing Power Accounting (CIPPA) is not an inflation accounting model to be used during high and hyperinflation. IAS 29 requires CPPA for that. CIPPA is the IASB´s alternative to Historical Cost Accounting during low inflation and deflation . CIPPA implements financial capital maintenance in units of constant purchasing power to be used during low inflation and deflation which was authorized in IFRS in the original Framework (1989), Par 104 (a).
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
Friday, 27 May 2011
Thursday, 26 May 2011
Current inflation accounting
Current inflation accounting
Presently, inflation accounting describes a complete price–level accounting model, namely the Constant Purchasing Power Accounting (CPPA) inflation accounting model defined, in principle, in IAS 29 Financial Reporting in Hyperinflationary Economies required to be implemented only during hyperinflation. Hyperinflation is an exceptional circumstance according to the IASB. Hyperinflation is defined in IFRS as cumulative inflation over three years approaching or equal to 100%, i.e. 26% annual inflation for three years in a row. IAS 29 serves to make Historical Cost and Current Cost financial statements more useful at the period-end by requiring all non–monetary items – variable real value non–monetary items and constant real value non–monetary items – to be restated at the period-end by measuring them in units of constant purchasing power by applying the period–end Consumer Price Index only 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 29.2
The fallacy that inflation erodes the real value of non–monetary items is currently still generally accepted. It is still mistakenly accepted as a fact that the erosion of companies´ capital and profits is caused by inflation. “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.
Inflation has no effect on the real value of non–monetary items over time. Not inflation, per se, but the implementation of the very erosive stable measuring unit assumption as it forms part of the traditional Historical Cost Accounting model erodes the real value of constant real value non–monetary items never maintained constant over time as a result of insufficient revaluable fixed assets during low inflation and hyperinflation. There is no substance in the statement that inflation erodes 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.
The late Milton Friedman, US economist and Nobel Laureate, famously stated that “inflation is always and everywhere a monetary phenomenon.” Friedman was not the only economist who understood that.
“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 stable measuring unit assumption unknowingly, unintentionally and unnecessarily erodes and its rejection knowingly maintains (please note: not creates) the real value of constant real value non–monetary items (please note: not variable real value non–monetary items) depending on whether the IFRS–approved traditional Historical Cost Accounting model is chosen under which the very erosive stable measuring unit assumption is implemented for an unlimited period of time during indefinite inflation or the IFRS–authorized constant real value non–monetary item real value maintaining financial capital maintenance in units of constant purchasing power model (Constant Item Purchasing Power Accounting) under which it is selected 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 erode the real value of money and other monetary items over time. It has no effect on the real value of non–monetary items. The traditional Historical Cost Accounting model unknowingly, unintentionally and unnecessarily do the eroding of the real value of constant real value non–monetary items never maintained constant over time, e.g. Retained Earnings, Issued Share capital, other items in Shareholder’s Equity, etc when financial capital maintenance in nominal monetary units as authorized in IFRS in the original Framework (1989), Par 104 (a) is chosen during low inflationary periods.
It is correct, essential and compliant with IFRS to update constant real value non–monetary items by means of the monthly change in the CPI which is a general price index during low inflation and deflation. The reason for this is that constant real value non–monetary 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 within an economy or monetary union. Inflation erodes 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 real value non–monetary items thus have to be updated or inflation–adjusted at a rate equal to the rate of low inflation or deflation, i.e. valued or measured in units of constant purchasing power, in order to maintain their real values constant during low 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 low inflation and deflation. Months of zero annual inflation are very few and far between. Sustainable zero annual inflation has never been achieved before and it does not seem very likely that it will be achieved any time soon in the future.
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 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 real value non–monetary 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 (sustainable zero inflation). That is not correct. 2% inflation will erode, for example, 51% of the real value of all monetary items and all constant real value non–monetary items never maintained constant, e.g. Retained Profits never maintained constant, over 35 years – all else being equal – when the stable measuring unit assumption is implemented for an indefinite period of time during indefinite low 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, plant, equipment, shares, raw material, etc.) which are subject to product specific price increases for the purpose of valuing these variable real value non–monetary items during the accounting period on a primary valuation basis during non–hyperinflationary periods. These variable real value non–monetary 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 erosion of the real value of money and other monetary items over time, i.e. an erosion of the general purchasing power of money which is caused by/results in an increase in the general price level over time. It is thus generally accepted in economics that the word inflation has two different meanings:
(1) inflation meaning the erosion of the real value of only money and other monetary items over time and
(2) inflation meaning any single or non-general price increase
1970–style Constant Purchasing Power Accounting (CPPA) 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 real value non–monetary items and constant real value non–monetary items) equally by means of the Consumer Price Index during high and hyperinflation. 1970–style CPPA inflation accounting was abandoned as a failed and discredited inflation accounting model when general inflation decreased to low levels thereafter.
Constant Item Purchasing Power Accounting (CIPPA) is not an inflation accounting model to be used during high and hyperinflation. IAS 29 requires CPPA for that. CIPPA is the IASB´s alternative to Historical Cost Accounting during low inflation and deflation . CIPPA implements financial capital maintenance in units of constant purchasing power to be used during low inflation and deflation which was authorized in IFRS in the Conceptual Framework (2010), Par 4.59 (a).
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
Presently, inflation accounting describes a complete price–level accounting model, namely the Constant Purchasing Power Accounting (CPPA) inflation accounting model defined, in principle, in IAS 29 Financial Reporting in Hyperinflationary Economies required to be implemented only during hyperinflation. Hyperinflation is an exceptional circumstance according to the IASB. Hyperinflation is defined in IFRS as cumulative inflation over three years approaching or equal to 100%, i.e. 26% annual inflation for three years in a row. IAS 29 serves to make Historical Cost and Current Cost financial statements more useful at the period-end by requiring all non–monetary items – variable real value non–monetary items and constant real value non–monetary items – to be restated at the period-end by measuring them in units of constant purchasing power by applying the period–end Consumer Price Index only 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 29.2
The fallacy that inflation erodes the real value of non–monetary items is currently still generally accepted. It is still mistakenly accepted as a fact that the erosion of companies´ capital and profits is caused by inflation. “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.
Inflation has no effect on the real value of non–monetary items over time. Not inflation, per se, but the implementation of the very erosive stable measuring unit assumption as it forms part of the traditional Historical Cost Accounting model erodes the real value of constant real value non–monetary items never maintained constant over time as a result of insufficient revaluable fixed assets during low inflation and hyperinflation. There is no substance in the statement that inflation erodes 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.
The late Milton Friedman, US economist and Nobel Laureate, famously stated that “inflation is always and everywhere a monetary phenomenon.” Friedman was not the only economist who understood that.
“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 stable measuring unit assumption unknowingly, unintentionally and unnecessarily erodes and its rejection knowingly maintains (please note: not creates) the real value of constant real value non–monetary items (please note: not variable real value non–monetary items) depending on whether the IFRS–approved traditional Historical Cost Accounting model is chosen under which the very erosive stable measuring unit assumption is implemented for an unlimited period of time during indefinite inflation or the IFRS–authorized constant real value non–monetary item real value maintaining financial capital maintenance in units of constant purchasing power model (Constant Item Purchasing Power Accounting) under which it is selected 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 erode the real value of money and other monetary items over time. It has no effect on the real value of non–monetary items. The traditional Historical Cost Accounting model unknowingly, unintentionally and unnecessarily do the eroding of the real value of constant real value non–monetary items never maintained constant over time, e.g. Retained Earnings, Issued Share capital, other items in Shareholder’s Equity, etc when financial capital maintenance in nominal monetary units as authorized in IFRS in the original Framework (1989), Par 104 (a) is chosen during low inflationary periods.
It is correct, essential and compliant with IFRS to update constant real value non–monetary items by means of the monthly change in the CPI which is a general price index during low inflation and deflation. The reason for this is that constant real value non–monetary 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 within an economy or monetary union. Inflation erodes 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 real value non–monetary items thus have to be updated or inflation–adjusted at a rate equal to the rate of low inflation or deflation, i.e. valued or measured in units of constant purchasing power, in order to maintain their real values constant during low 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 low inflation and deflation. Months of zero annual inflation are very few and far between. Sustainable zero annual inflation has never been achieved before and it does not seem very likely that it will be achieved any time soon in the future.
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 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 real value non–monetary 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 (sustainable zero inflation). That is not correct. 2% inflation will erode, for example, 51% of the real value of all monetary items and all constant real value non–monetary items never maintained constant, e.g. Retained Profits never maintained constant, over 35 years – all else being equal – when the stable measuring unit assumption is implemented for an indefinite period of time during indefinite low 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, plant, equipment, shares, raw material, etc.) which are subject to product specific price increases for the purpose of valuing these variable real value non–monetary items during the accounting period on a primary valuation basis during non–hyperinflationary periods. These variable real value non–monetary 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 erosion of the real value of money and other monetary items over time, i.e. an erosion of the general purchasing power of money which is caused by/results in an increase in the general price level over time. It is thus generally accepted in economics that the word inflation has two different meanings:
(1) inflation meaning the erosion of the real value of only money and other monetary items over time and
(2) inflation meaning any single or non-general price increase
1970–style Constant Purchasing Power Accounting (CPPA) 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 real value non–monetary items and constant real value non–monetary items) equally by means of the Consumer Price Index during high and hyperinflation. 1970–style CPPA inflation accounting was abandoned as a failed and discredited inflation accounting model when general inflation decreased to low levels thereafter.
Constant Item Purchasing Power Accounting (CIPPA) is not an inflation accounting model to be used during high and hyperinflation. IAS 29 requires CPPA for that. CIPPA is the IASB´s alternative to Historical Cost Accounting during low inflation and deflation . CIPPA implements financial capital maintenance in units of constant purchasing power to be used during low inflation and deflation which was authorized in IFRS in the Conceptual Framework (2010), Par 4.59 (a).
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
Monday, 23 May 2011
IAS 29 is fundamentally flawed
IAS 29 is fundamentally flawed
Inflation accounting describes financial capital maintenance in units of constant purchasing power as applied only during hyperinflation where under all non-monetary items (variable and constant real value non-monetary items) are updated daily in terms of a daily non-monetary index or in terms of a daily official or unofficial parallel rate, normally the US Dollar parallel rate. The Constant Item Purchasing Power Accounting model under which only constant items (not variable items) are measured in units of constant purchasing power by applying the monthly Consumer Price index ONLY during LOW inflation and deflation. CIPPA is not an inflation accounting model.
Hyperinflation, as defined in IFRS, is cumulative inflation approaching or equal to 100% over three years; i.e., 26% annual inflation for three years in a row. Inflation accounting is implemented in order to stop the erosion of real value in all non-monetary items (both variable and constant real value non-monetary items) caused by the implementation of the very erosive stable measuring unit assumption during hyperinflation.
Under the stable measuring unit assumption it is considered that changes in the purchasing power of money are not sufficiently important to require financial capital maintenance in units of constant purchasing power – normally during low inflation and deflation.
Most entities in low inflationary and deflationary economies implement the Historical Cost Accounting model that is based on the stable measuring unit assumption. This means that all balance sheet constant real value non-monetary items (e.g. shareholders´ equity, trade debtors, trade creditors, provisions, other non-monetary payables, other non-monetary receivables, etc.) and most (not all) income statement items are measured at their historical cost, i.e. financial capital maintenance is measured in nominal monetary units as authorized in IFRS. Some income statement items, e.g. salaries, wages, rentals, etc. are updated annually in terms of the CPI, but, are then paid on a monthly basis implementing the stable measuring unit assumption under HCA. It is impossible to maintain the real value of financial capital constant with financial capital maintenance in nominal monetary units per se during inflation, deflation and hyperinflation. Financial capital maintenance in nominal monetary units during inflation and deflation, although authorized in IFRS, is still a popular accounting fallacy not yet extinct.
Complete inflation accounting, i.e. the use of an accounting model to automatically stop the erosion of real value in all non-monetary items (variable and constant items) in all entities that at least break even, is only possible with financial capital maintenance in units of constant purchasing power by applying a daily non-monetary index or relatively stable daily parallel rate (please note NOT the monthly CPI) to the valuation of (please note NOT the “restatement of” Historical Cost or Current Cost period-end financial statements) all non-monetary items during hyperinflation.
This can be stated differently as follows: Only inflation accounting based on daily updating of all non-monetary items in terms of a daily index or daily parallel rate automatically maintains the real value of all non-monetary items in all entities that at least break even during hyperinflation; i.e. maintains the real of non-monetary economy stable during hyperinflation in the monetary unit / economy.
The best example of successful inflation accounting was the use in Brazil of a daily government-supplied non-monetary index to update all non-monetary items daily during the 30 years of very high and hyperinflation in that country from 1964 to 1994.
The IFRS response to the erosion of real value in non-monetary items caused by the implementation of the HCA model, i.e. the implementation of the stable measuring unit assumption, during hyperinflation is stated in IAS 29 Financial Reporting in Hyperinflationary Economies. IAS 29 requires entities operating in hyperinflationary economies, NOT to value or measure all non-monetary items in terms of a daily non-monetary index or a daily parallel rate, but, to simply restate HISTORICAL COST or Current Cost period-end financial statements in terms of the period-end CPI.
The financial statements of an entity whose functional currency is the currency
of a hyperinflationary economy, whether they are based on a historical cost
approach or a current cost approach, shall be stated in terms of the measuring
unit current at the end of the reporting period. IAS 29 Par 8
PricewaterhouseCoopers state the following regarding the use of the HCA model during hyperinflation:
"Inflation–adjusted financial statements are an extension to, not a departure from, historic cost accounting."
Financial Reporting in Hyperinflationary Economies – Understanding IAS 29, PricewaterhouseCoopers, May 2006, p 5.
The best example of the failure of the implementation of IAS 29 to have any effect at all on a hyperinflationary economy was its application, as duely required by the Zimbabwean Stock Exchange, by listed companies on the ZSE. The Zimbabwean real or non-monetary economy imploded in tandem with Zimbabwe´s monetary unit and monetary economy despite the implementation of IAS 29. The IASB actually officially admitted / agreed that it was impossible to implement IAS 29 during severe hyperinflation in Zimbabwe.
On the other hand, a daily parallel rate was available till the last day of hyperinflation in Zimbabwe, which officially ended on 20th November, 2008, when Gideon Gono, the governor of the Reserve Bank of Zimbabwe issued regulations that closed down the ZSE which stopped the daily Old Mutual Implied Rate (OMIR) being available in Zimbabwe. The (normally unofficial) parallel rate – usually the US Dollar parallel rate, is an excellent, not a perfect, substitute for a daily non-monetary index in a hyperinflationary economy (currently Venezuela). The US Dollar parallel rate was available 24/7, 365 days a year during Zimbabwe´s hyperinflation. Right at the end, during severe hyperinflation when the CPI was not being published any more, the OMIR was still available on a daily basis.
IAS 29 is fundamentally flawed by simply requiring the restatement of HC or CC period-end financial statements in terms of the period-end CPI instead of daily valuation / measurement of all non-monetary items in terms of a daily Brazilian-style index or parallel rate.
Many people are requesting a fundamental review of IAS 29.
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
Inflation accounting describes financial capital maintenance in units of constant purchasing power as applied only during hyperinflation where under all non-monetary items (variable and constant real value non-monetary items) are updated daily in terms of a daily non-monetary index or in terms of a daily official or unofficial parallel rate, normally the US Dollar parallel rate. The Constant Item Purchasing Power Accounting model under which only constant items (not variable items) are measured in units of constant purchasing power by applying the monthly Consumer Price index ONLY during LOW inflation and deflation. CIPPA is not an inflation accounting model.
Hyperinflation, as defined in IFRS, is cumulative inflation approaching or equal to 100% over three years; i.e., 26% annual inflation for three years in a row. Inflation accounting is implemented in order to stop the erosion of real value in all non-monetary items (both variable and constant real value non-monetary items) caused by the implementation of the very erosive stable measuring unit assumption during hyperinflation.
Under the stable measuring unit assumption it is considered that changes in the purchasing power of money are not sufficiently important to require financial capital maintenance in units of constant purchasing power – normally during low inflation and deflation.
Most entities in low inflationary and deflationary economies implement the Historical Cost Accounting model that is based on the stable measuring unit assumption. This means that all balance sheet constant real value non-monetary items (e.g. shareholders´ equity, trade debtors, trade creditors, provisions, other non-monetary payables, other non-monetary receivables, etc.) and most (not all) income statement items are measured at their historical cost, i.e. financial capital maintenance is measured in nominal monetary units as authorized in IFRS. Some income statement items, e.g. salaries, wages, rentals, etc. are updated annually in terms of the CPI, but, are then paid on a monthly basis implementing the stable measuring unit assumption under HCA. It is impossible to maintain the real value of financial capital constant with financial capital maintenance in nominal monetary units per se during inflation, deflation and hyperinflation. Financial capital maintenance in nominal monetary units during inflation and deflation, although authorized in IFRS, is still a popular accounting fallacy not yet extinct.
Complete inflation accounting, i.e. the use of an accounting model to automatically stop the erosion of real value in all non-monetary items (variable and constant items) in all entities that at least break even, is only possible with financial capital maintenance in units of constant purchasing power by applying a daily non-monetary index or relatively stable daily parallel rate (please note NOT the monthly CPI) to the valuation of (please note NOT the “restatement of” Historical Cost or Current Cost period-end financial statements) all non-monetary items during hyperinflation.
This can be stated differently as follows: Only inflation accounting based on daily updating of all non-monetary items in terms of a daily index or daily parallel rate automatically maintains the real value of all non-monetary items in all entities that at least break even during hyperinflation; i.e. maintains the real of non-monetary economy stable during hyperinflation in the monetary unit / economy.
The best example of successful inflation accounting was the use in Brazil of a daily government-supplied non-monetary index to update all non-monetary items daily during the 30 years of very high and hyperinflation in that country from 1964 to 1994.
The IFRS response to the erosion of real value in non-monetary items caused by the implementation of the HCA model, i.e. the implementation of the stable measuring unit assumption, during hyperinflation is stated in IAS 29 Financial Reporting in Hyperinflationary Economies. IAS 29 requires entities operating in hyperinflationary economies, NOT to value or measure all non-monetary items in terms of a daily non-monetary index or a daily parallel rate, but, to simply restate HISTORICAL COST or Current Cost period-end financial statements in terms of the period-end CPI.
The financial statements of an entity whose functional currency is the currency
of a hyperinflationary economy, whether they are based on a historical cost
approach or a current cost approach, shall be stated in terms of the measuring
unit current at the end of the reporting period. IAS 29 Par 8
PricewaterhouseCoopers state the following regarding the use of the HCA model during hyperinflation:
"Inflation–adjusted financial statements are an extension to, not a departure from, historic cost accounting."
Financial Reporting in Hyperinflationary Economies – Understanding IAS 29, PricewaterhouseCoopers, May 2006, p 5.
The best example of the failure of the implementation of IAS 29 to have any effect at all on a hyperinflationary economy was its application, as duely required by the Zimbabwean Stock Exchange, by listed companies on the ZSE. The Zimbabwean real or non-monetary economy imploded in tandem with Zimbabwe´s monetary unit and monetary economy despite the implementation of IAS 29. The IASB actually officially admitted / agreed that it was impossible to implement IAS 29 during severe hyperinflation in Zimbabwe.
On the other hand, a daily parallel rate was available till the last day of hyperinflation in Zimbabwe, which officially ended on 20th November, 2008, when Gideon Gono, the governor of the Reserve Bank of Zimbabwe issued regulations that closed down the ZSE which stopped the daily Old Mutual Implied Rate (OMIR) being available in Zimbabwe. The (normally unofficial) parallel rate – usually the US Dollar parallel rate, is an excellent, not a perfect, substitute for a daily non-monetary index in a hyperinflationary economy (currently Venezuela). The US Dollar parallel rate was available 24/7, 365 days a year during Zimbabwe´s hyperinflation. Right at the end, during severe hyperinflation when the CPI was not being published any more, the OMIR was still available on a daily basis.
IAS 29 is fundamentally flawed by simply requiring the restatement of HC or CC period-end financial statements in terms of the period-end CPI instead of daily valuation / measurement of all non-monetary items in terms of a daily Brazilian-style index or parallel rate.
Many people are requesting a fundamental review of IAS 29.
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
Saturday, 21 May 2011
Constant Item Purchasing Power Accounting is not inflation accounting
Constant Item Purchasing Power Accounting is not inflation accounting
The world only goes round by misunderstanding. Charles Baudelaire
Inflation accounting describes an accounting model used during hyperinflation. The Constant Item Purchasing Power Accounting model is only used during low inflation and deflation. CIPPA is not an inflation accounting model.
Hyperinflation is defined in IFRS as cumulative inflation approaching or equal to 100% over three years; i.e., 26% annual inflation for three years in a row. Inflation accounting is implemented in order to stop the erosion of real value in all non-monetary items (both variable and constant real value non-monetary items) caused by the implementation of the very erosive stable measuring unit assumption during hyperinflation.
Implementing the stable measuring unit assumption implies that changes in the purchasing power of money are not considered as sufficiently important to require financial capital maintenance in units of constant purchasing power.
Most entities in low inflationary and deflationary economies implement the Historical Cost Accounting model that is based on the stable measuring unit assumption. This means that all balance sheet constant real value non-monetary items (e.g. shareholders´ equity, trade debtors, trade creditors, provisions, other non-monetary payables, other non-monetary receivables, etc.) and most (not all) income statement items are measured at their historical cost, i.e. financial capital maintenance is measured in nominal monetary units. Some income statement items, e.g. salaries, wages, rentals, etc. are updated annually in terms of the CPI, but, are then paid on a monthly basis implementing the stable measuring unit assumption under HCA.
IAS 29 Financial Reporting in Hyperinflationary Economies defines the inflation accounting model authorized in IFRS.
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
The world only goes round by misunderstanding. Charles Baudelaire
Inflation accounting describes an accounting model used during hyperinflation. The Constant Item Purchasing Power Accounting model is only used during low inflation and deflation. CIPPA is not an inflation accounting model.
Hyperinflation is defined in IFRS as cumulative inflation approaching or equal to 100% over three years; i.e., 26% annual inflation for three years in a row. Inflation accounting is implemented in order to stop the erosion of real value in all non-monetary items (both variable and constant real value non-monetary items) caused by the implementation of the very erosive stable measuring unit assumption during hyperinflation.
Implementing the stable measuring unit assumption implies that changes in the purchasing power of money are not considered as sufficiently important to require financial capital maintenance in units of constant purchasing power.
Most entities in low inflationary and deflationary economies implement the Historical Cost Accounting model that is based on the stable measuring unit assumption. This means that all balance sheet constant real value non-monetary items (e.g. shareholders´ equity, trade debtors, trade creditors, provisions, other non-monetary payables, other non-monetary receivables, etc.) and most (not all) income statement items are measured at their historical cost, i.e. financial capital maintenance is measured in nominal monetary units. Some income statement items, e.g. salaries, wages, rentals, etc. are updated annually in terms of the CPI, but, are then paid on a monthly basis implementing the stable measuring unit assumption under HCA.
IAS 29 Financial Reporting in Hyperinflationary Economies defines the inflation accounting model authorized in IFRS.
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
Wednesday, 18 May 2011
The high inflation 1970´s
The high inflation 1970´s
During the period of high inflation in the 1970´s various inflation accounting models were tried 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. It was not realized that it was simply the free choice of implementing the stable measuring unit assumption that was eroding the real value of existing constant real value non–monetary items never maintained constant as a result of insufficient revaluable fixed assets (revalued or not) during low inflation. The US FASB did mention the stable measuring unit assumption in FAS 89. The IASB never mentioned it in either IAS 6 or IAS 15. Everybody blamed inflation. “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.
“Relative to most changes in financial reporting, the changes required by Statement 33 were monumental. Because most accountants and users of financial statements have been inculcated with a model of financial reporting that assumes stability of the monetary unit, accepting a change of this consequence would take a lengthy period of time under the best of circumstances.” FAS 89, 1986, p 6.
The implementation of these changes was eventually made voluntary in FAS 89 and the “monumental” changes only materialized as far as the valuation of variable real value non–monetary items in terms of the requirements stipulated in International Financial Reporting Standards and US GAAP were concerned. These changes were developed and implemented by the IASB in the form of IAS and IFRS relating to the valuing of variable real value non–monetary items in the years that followed. The “monumental” changes envisaged in FAS 33 with regard to the valuation of existing constant real value non–monetary items never happened although they were authorized in IFRS in the Framework (1989), Par 104 (a). They were attempted in IAS 29 but with very little success to date. See the implementation of IAS 29 in Zimbabwe.
During the high inflation 1970´s 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 (of variable real value non–monetary items) as well as changes in the general price level (CPI), - i.e., inflation - which ONLY resulted in the erosion of the purchasing power of monetary items (money and other monetary items) and nothing else. 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 as so famously stated by Milton Friedman. It is not inflation, but, the selection of the HCA model which includes the implementation of the very erosive stable measuring unit assumption and financial capital maintenance in nominal monetary units (the first based on the fallacy that money is perfectly stable and the second based on the very popular IFRS–approved accounting fallacy that financial capital maintenance can be measured in nominal monetary units which is impossible per se during inflation and deflation) which unknowingly, unintentionally and unnecessarily erodes the real value of existing constant real value non–monetary items never maintained constant during low inflationary periods in the world´s constant real value non–monetary item economy. One of the inflation accounting models that was tried unsuccessfully in the 1970´s and 1980´s was Constant Purchasing Power Accounting (CPPA) under which all non-monetary items (variable and constant items) were measured in units of constant purchasing power by applying the period end CPI during high inflation.
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 Accounting 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 Accounting 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 daily non–monetary indexes during high and hyperinflation to update constant real value non–monetary items and variable real value 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.
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
During the period of high inflation in the 1970´s various inflation accounting models were tried 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. It was not realized that it was simply the free choice of implementing the stable measuring unit assumption that was eroding the real value of existing constant real value non–monetary items never maintained constant as a result of insufficient revaluable fixed assets (revalued or not) during low inflation. The US FASB did mention the stable measuring unit assumption in FAS 89. The IASB never mentioned it in either IAS 6 or IAS 15. Everybody blamed inflation. “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.
“Relative to most changes in financial reporting, the changes required by Statement 33 were monumental. Because most accountants and users of financial statements have been inculcated with a model of financial reporting that assumes stability of the monetary unit, accepting a change of this consequence would take a lengthy period of time under the best of circumstances.” FAS 89, 1986, p 6.
The implementation of these changes was eventually made voluntary in FAS 89 and the “monumental” changes only materialized as far as the valuation of variable real value non–monetary items in terms of the requirements stipulated in International Financial Reporting Standards and US GAAP were concerned. These changes were developed and implemented by the IASB in the form of IAS and IFRS relating to the valuing of variable real value non–monetary items in the years that followed. The “monumental” changes envisaged in FAS 33 with regard to the valuation of existing constant real value non–monetary items never happened although they were authorized in IFRS in the Framework (1989), Par 104 (a). They were attempted in IAS 29 but with very little success to date. See the implementation of IAS 29 in Zimbabwe.
During the high inflation 1970´s 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 (of variable real value non–monetary items) as well as changes in the general price level (CPI), - i.e., inflation - which ONLY resulted in the erosion of the purchasing power of monetary items (money and other monetary items) and nothing else. 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 as so famously stated by Milton Friedman. It is not inflation, but, the selection of the HCA model which includes the implementation of the very erosive stable measuring unit assumption and financial capital maintenance in nominal monetary units (the first based on the fallacy that money is perfectly stable and the second based on the very popular IFRS–approved accounting fallacy that financial capital maintenance can be measured in nominal monetary units which is impossible per se during inflation and deflation) which unknowingly, unintentionally and unnecessarily erodes the real value of existing constant real value non–monetary items never maintained constant during low inflationary periods in the world´s constant real value non–monetary item economy. One of the inflation accounting models that was tried unsuccessfully in the 1970´s and 1980´s was Constant Purchasing Power Accounting (CPPA) under which all non-monetary items (variable and constant items) were measured in units of constant purchasing power by applying the period end CPI during high inflation.
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 Accounting 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 Accounting 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 daily non–monetary indexes during high and hyperinflation to update constant real value non–monetary items and variable real value 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.
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
Monday, 16 May 2011
What price stability?
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.” SA Reserve Bank.
Absolute price stability is a year–on–year increase in the Consumer Price Index of zero percent. Alan Greenspan defines price stability as follows:
“Price stability obtains when economic agents no longer take account of the prospective change in the general price level in their economic decision–making.”
http://www.kansascityfed.org/PUBLICAT/SYMPOS/1996/pdf/s96green.pdf
, Page 1.
It can be deduced from Alan Greenspan´s excellent definition that price stability can be defined as permanently sustainable zero per cent per annum inflation.
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. 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”.
Accounting, on the other hand, solve the problem of the fact that the monetary unit is never perfectly stable on a sustainable basis by simply assuming that the monetary unit is perfectly stable in the world´s low inflationary economies, but, only for the purpose of valuing balance sheet constant real value non–monetary items and most income statement items which are accounted as Historical Cost items: they are measured in nominal monetary units. In conformity with world practice the stable measuring unit assumption is not applied of the valuing of certain (not all) Income Statement constant real value non–monetary items, namely salaries, wages, rentals, etc. which are measured in units of constant purchasing power on an annual basis in terms of the CPI. These items annually updated items are then paid on a monthly basis again applying the stable measuring unit assumption; they are not updated monthly in terms of the monthly change in the annual rate of inflation. Other income statement items are valued in nominal monetary units, i.e. at HC.
Changes in the general purchasing power or real value of the monetary unit are not regarded to be sufficiently important to continuously measure financial capital maintenance in units of constant purchasing power authorized in IFRS in the original Framework (1989), Par 104 (a). Financial capital maintenance in nominal monetary units (HCA) is generally chosen under which the very erosive stable measuring unit assumption is implemented, also authorized in IFRS in the Framework (1989), Par 104 (a). It is impossible to maintain the existing constant real non-monetary value of existing capital constant 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.
However, this led to the general implementation of the traditional Historical Cost Accounting model during non–hyperinflationary periods. Both variable real value non–monetary items stated at HC in terms of IFRS or GAAP, as well as constant real value non–monetary items also stated at HC in terms of the HCA model, are measured in nominal monetary units during non–hyperinflationary periods. Both HC variable and HC constant real value non–monetary items are thus considered to be simply HC non–monetary items.
There is a fixation in financial reporting that measurement in units of constant purchasing power simply means adjusting HC or CC period-end financial statements in terms of the period-end CPI mainly to make current year financial statements more useful only during hyperinflation. This is called restatement. Measurement in units of constant purchasing power is almost always automatically thought of as inflation accounting applied only during hyperinflation as defined in IAS 29 Financial Reporting in Hyperinflationary Economies. Measurement in units of constant purchasing power is not automatically thought of as affecting the fundamental constant real non-monetary values of existing constant real value non-monetary items (e.g. salaries, wages, rentals, shareholders´ equity, trade debtors, trade creditors, taxes payable, taxes receivable, etc.) in a double entry accounting model although that is what is done with world wide annual measurement in units of constant purchasing power of salaries, wages, rentals, etc. The two processes are seen as different processes – when, in principle, they are not.
Under Constant Item Purchasing Power Accounting financial capital maintenance is measured in units of constant purchasing power as authorized in IFRS. Only constant real value non-monetary items (not variable real value non-monetary items) are measured in units of constant purchasing power in terms of the monthly CPI. CIPPA automatically maintains the existing constant real value of all constant items constant for an indefinite period of time in all entities that at least break even during low inflation and deflation, whether they own any revaluable fixed assets or not
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
“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.” SA Reserve Bank.
Absolute price stability is a year–on–year increase in the Consumer Price Index of zero percent. Alan Greenspan defines price stability as follows:
“Price stability obtains when economic agents no longer take account of the prospective change in the general price level in their economic decision–making.”
http://www.kansascityfed.org/PUBLICAT/SYMPOS/1996/pdf/s96green.pdf
, Page 1.
It can be deduced from Alan Greenspan´s excellent definition that price stability can be defined as permanently sustainable zero per cent per annum inflation.
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. 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”.
Accounting, on the other hand, solve the problem of the fact that the monetary unit is never perfectly stable on a sustainable basis by simply assuming that the monetary unit is perfectly stable in the world´s low inflationary economies, but, only for the purpose of valuing balance sheet constant real value non–monetary items and most income statement items which are accounted as Historical Cost items: they are measured in nominal monetary units. In conformity with world practice the stable measuring unit assumption is not applied of the valuing of certain (not all) Income Statement constant real value non–monetary items, namely salaries, wages, rentals, etc. which are measured in units of constant purchasing power on an annual basis in terms of the CPI. These items annually updated items are then paid on a monthly basis again applying the stable measuring unit assumption; they are not updated monthly in terms of the monthly change in the annual rate of inflation. Other income statement items are valued in nominal monetary units, i.e. at HC.
Changes in the general purchasing power or real value of the monetary unit are not regarded to be sufficiently important to continuously measure financial capital maintenance in units of constant purchasing power authorized in IFRS in the original Framework (1989), Par 104 (a). Financial capital maintenance in nominal monetary units (HCA) is generally chosen under which the very erosive stable measuring unit assumption is implemented, also authorized in IFRS in the Framework (1989), Par 104 (a). It is impossible to maintain the existing constant real non-monetary value of existing capital constant 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.
However, this led to the general implementation of the traditional Historical Cost Accounting model during non–hyperinflationary periods. Both variable real value non–monetary items stated at HC in terms of IFRS or GAAP, as well as constant real value non–monetary items also stated at HC in terms of the HCA model, are measured in nominal monetary units during non–hyperinflationary periods. Both HC variable and HC constant real value non–monetary items are thus considered to be simply HC non–monetary items.
There is a fixation in financial reporting that measurement in units of constant purchasing power simply means adjusting HC or CC period-end financial statements in terms of the period-end CPI mainly to make current year financial statements more useful only during hyperinflation. This is called restatement. Measurement in units of constant purchasing power is almost always automatically thought of as inflation accounting applied only during hyperinflation as defined in IAS 29 Financial Reporting in Hyperinflationary Economies. Measurement in units of constant purchasing power is not automatically thought of as affecting the fundamental constant real non-monetary values of existing constant real value non-monetary items (e.g. salaries, wages, rentals, shareholders´ equity, trade debtors, trade creditors, taxes payable, taxes receivable, etc.) in a double entry accounting model although that is what is done with world wide annual measurement in units of constant purchasing power of salaries, wages, rentals, etc. The two processes are seen as different processes – when, in principle, they are not.
Under Constant Item Purchasing Power Accounting financial capital maintenance is measured in units of constant purchasing power as authorized in IFRS. Only constant real value non-monetary items (not variable real value non-monetary items) are measured in units of constant purchasing power in terms of the monthly CPI. CIPPA automatically maintains the existing constant real value of all constant items constant for an indefinite period of time in all entities that at least break even during low inflation and deflation, whether they own any revaluable fixed assets or not
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
Money illusion
Money illusion
This is the result of money illusion. People make the mistake of thinking that money is stable in real value over time in a low inflationary environment. Inflation always and everywhere erodes the real value of money and other monetary items 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 monetary 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 unit of measure during inflation and deflation. Money, i.e., the unstable monetary unit of measure or unstable monetary unit of account is the only generally accepted unit of measure that is not an absolute value. Money does not contain a fundamental constant. All other generally accepted units of measure 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.
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
This is the result of money illusion. People make the mistake of thinking that money is stable in real value over time in a low inflationary environment. Inflation always and everywhere erodes the real value of money and other monetary items 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 monetary 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 unit of measure during inflation and deflation. Money, i.e., the unstable monetary unit of measure or unstable monetary unit of account is the only generally accepted unit of measure that is not an absolute value. Money does not contain a fundamental constant. All other generally accepted units of measure 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.
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
Saturday, 14 May 2011
No split of non-monetary items under the HCA model
No split of non-monetary items under the HCA model
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 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 entities to choose to implement the very erosive stable measuring unit assumption (based on a fallacy) and measure financial capital maintenance in nominal monetary units (another complete fallacy) as authorized by the IFRS in the Framework (1989), Par 104 (a) during low inflationary periods.
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 real value non–monetary items and constant real value non–monetary items although it is generally accepted under the HC paradigm that there are only two basic economic items, namely, monetary and non–monetary items.
All non–monetary items stated at HC, whether they are variable real value non–monetary HC items (e.g. land and buildings stated at HC) or constant real value non–monetary HC items (e.g. shareholders´ equity stated at HC) are regarded to be fundamentally the same, namely, simply non–monetary items when the very erosive stable measuring unit assumption is implemented as part of the traditional HCA model during low inflationary periods.
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
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 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 entities to choose to implement the very erosive stable measuring unit assumption (based on a fallacy) and measure financial capital maintenance in nominal monetary units (another complete fallacy) as authorized by the IFRS in the Framework (1989), Par 104 (a) during low inflationary periods.
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 real value non–monetary items and constant real value non–monetary items although it is generally accepted under the HC paradigm that there are only two basic economic items, namely, monetary and non–monetary items.
All non–monetary items stated at HC, whether they are variable real value non–monetary HC items (e.g. land and buildings stated at HC) or constant real value non–monetary HC items (e.g. shareholders´ equity stated at HC) are regarded to be fundamentally the same, namely, simply non–monetary items when the very erosive stable measuring unit assumption is implemented as part of the traditional HCA model during low inflationary periods.
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
Friday, 13 May 2011
Price–level accounting does not prevail for balance sheet constant items during low inflation
Price–level accounting does not prevail for balance sheet constant items during low inflation
Price–level accounting as Harvey Kapnick hoped for in 1976 clearly does not prevail for balance sheet constant real value non–monetary items (e.g. equity) and most income statement items during low inflation. Income statement items are all constant real value non–monetary items. Price–level accounting does prevail as far as the income statement constant real value non–monetary items salaries, wages, rentals, etc are concerned since they are updated annually in units of constant purchasing power in terms of the annual change in the Consumer Price Index, but, they are then paid monthly applying the stable measuring unit assumption; i.e. they are not updated monthly in terms of the CPI.
In terms of the Historical Cost Accounting model the stable measuring unit assumption is implemented under which balance sheet constant real value non–monetary items are valued at historical cost, i.e. in nominal monetary units thus eroding the existing constant real value of these constant real value non–monetary items when their existing constant real non–monetary values are never maintained as a result of insufficient revaluable fixed assets (revalued or not) under the HC paradigm during low inflation.
Price–level accounting generally did prevail in the Brazilian economy during the 30 years from 1964 to 1994 when Brazil indexed all non-monetary items (variable real value non–monetary items and constant real value non–monetary items) in their non–monetary or real economy with daily indexation with a daily index value supplied by the different governments during that period. Brazil 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. Brazil stopped daily indexation during hyperinflation which is, in principle, continuous financial capital maintenance in units of constant purchasing power during hyperinflation. They should have changed from daily indexation of all non-monetary items (variable and constant real value non-monetary items) during hyperinflation to financial capital maintenance in units of constant purchasing power (CIPPA) during low inflation where under only constant items (not variable items) are measured in units of constant purchasing power by applying the monthly CPI.
US Professor William Paton noted in 1922, "the value of the dollar — its general purchasing power — is subject to serious change over a period of years... Accountants... deal with an unstable, variable unit; and comparisons of unadjusted accounting statements prepared at intervals are accordingly always more or less unsatisfactory and are often positively misleading.”
As quoted in FAS 33 p. 29.
Shareholder’s equity forms part of an entity’s financial resources.
“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.” IASB Exposure Draft: Management Commentary, June 2009, Par 29.
Shareholders´ equity is a financial resource with a constant real non–monetary value expressed in terms of an unstable monetary unit of measure under the HCA model. The IASB statement in the Framework (1989), Par 104 (a) that “financial capital maintenance can be measured in nominal monetary units” is clearly a fallacy since it is impossible to maintain the existing constant real non–monetary value of capital constant “in nominal monetary units” during inflation and deflation.
There is no substance in the claim that the existence and value of economic resources, for example shareholders´ equity items, exists independently of how we measure them – and that the choice of the measuring unit does not affect their fundamental value, only how we choose to represent that value – and that we can use any monetary unit, Dollars of constant purchasing power, US Dollars, whatever we think best represents that value and will make sense to whoever is using the information produced. See Paton above. There is no substance in the claim that it is fine to represent value in terms of constant purchasing power and to argue that that would be a better method than using historic cost and maintaining a fiction as to the stability of the measuring unit – but that doesn't affect the nature of the underlying resources. There is no substance in the claim that the choices made in accounting will not change that value and will not affect the economy. Measuring constant real value non-monetary items in units of constant purchasing power does affect the economy. That is generally known and a fact.
If it were generally realized that the implementation of the stable measuring unit assumption during low inflation results in the unknowing, unnecessary and unintentional erosion by the implementation of the Historical Cost Accounting model (the stable measuring unit assumption) of hundreds of billions of US Dollars of real value in constant real value non–monetary items (e.g. banks´ and companies´ equity) never maintained in the world´s constant real value non–monetary item economy year in year out, the HCA model would have been rejected by now.
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
Price–level accounting as Harvey Kapnick hoped for in 1976 clearly does not prevail for balance sheet constant real value non–monetary items (e.g. equity) and most income statement items during low inflation. Income statement items are all constant real value non–monetary items. Price–level accounting does prevail as far as the income statement constant real value non–monetary items salaries, wages, rentals, etc are concerned since they are updated annually in units of constant purchasing power in terms of the annual change in the Consumer Price Index, but, they are then paid monthly applying the stable measuring unit assumption; i.e. they are not updated monthly in terms of the CPI.
In terms of the Historical Cost Accounting model the stable measuring unit assumption is implemented under which balance sheet constant real value non–monetary items are valued at historical cost, i.e. in nominal monetary units thus eroding the existing constant real value of these constant real value non–monetary items when their existing constant real non–monetary values are never maintained as a result of insufficient revaluable fixed assets (revalued or not) under the HC paradigm during low inflation.
Price–level accounting generally did prevail in the Brazilian economy during the 30 years from 1964 to 1994 when Brazil indexed all non-monetary items (variable real value non–monetary items and constant real value non–monetary items) in their non–monetary or real economy with daily indexation with a daily index value supplied by the different governments during that period. Brazil 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. Brazil stopped daily indexation during hyperinflation which is, in principle, continuous financial capital maintenance in units of constant purchasing power during hyperinflation. They should have changed from daily indexation of all non-monetary items (variable and constant real value non-monetary items) during hyperinflation to financial capital maintenance in units of constant purchasing power (CIPPA) during low inflation where under only constant items (not variable items) are measured in units of constant purchasing power by applying the monthly CPI.
US Professor William Paton noted in 1922, "the value of the dollar — its general purchasing power — is subject to serious change over a period of years... Accountants... deal with an unstable, variable unit; and comparisons of unadjusted accounting statements prepared at intervals are accordingly always more or less unsatisfactory and are often positively misleading.”
As quoted in FAS 33 p. 29.
Shareholder’s equity forms part of an entity’s financial resources.
“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.” IASB Exposure Draft: Management Commentary, June 2009, Par 29.
Shareholders´ equity is a financial resource with a constant real non–monetary value expressed in terms of an unstable monetary unit of measure under the HCA model. The IASB statement in the Framework (1989), Par 104 (a) that “financial capital maintenance can be measured in nominal monetary units” is clearly a fallacy since it is impossible to maintain the existing constant real non–monetary value of capital constant “in nominal monetary units” during inflation and deflation.
There is no substance in the claim that the existence and value of economic resources, for example shareholders´ equity items, exists independently of how we measure them – and that the choice of the measuring unit does not affect their fundamental value, only how we choose to represent that value – and that we can use any monetary unit, Dollars of constant purchasing power, US Dollars, whatever we think best represents that value and will make sense to whoever is using the information produced. See Paton above. There is no substance in the claim that it is fine to represent value in terms of constant purchasing power and to argue that that would be a better method than using historic cost and maintaining a fiction as to the stability of the measuring unit – but that doesn't affect the nature of the underlying resources. There is no substance in the claim that the choices made in accounting will not change that value and will not affect the economy. Measuring constant real value non-monetary items in units of constant purchasing power does affect the economy. That is generally known and a fact.
If it were generally realized that the implementation of the stable measuring unit assumption during low inflation results in the unknowing, unnecessary and unintentional erosion by the implementation of the Historical Cost Accounting model (the stable measuring unit assumption) of hundreds of billions of US Dollars of real value in constant real value non–monetary items (e.g. banks´ and companies´ equity) never maintained in the world´s constant real value non–monetary item economy year in year out, the HCA model would have been rejected by now.
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
Accounting cannot and does not create real value out of nothing
Accounting cannot and does not create real value out of nothing
It must be clearly understood, however, that accounting per se cannot and does not create real value out of thin air – out of nothing. Accounting cannot and does not create real value or wealth by simply passing some update or financial capital maintenance in units of constant purchasing power accounting entries when no real value actually exists. Constant real value non–monetary items, e.g. salaries, wages, rentals, issued share capital, share premium, retained profits, capital reserves, other items in shareholders´ equity, trade debtors, trade creditors, provisions, taxes payable, taxes receivable, etc., first have to actually exist for the accounting model (CIPPA) to be able to automatically maintain the real values of those existing constant real value non–monetary items constant for an indefinite period of time in all entities that at least break even by continuously measuring financial capital maintenance in units of constant purchasing power as authorized in IFRS and by continuously valuing income statement constant real value non–monetary items in terms of units of constant purchasing power in order to determine profit or loss in units of constant purchasing power during low inflation and deflation.
The IASB has, amazingly, authorized the fallacy of financial capital maintenance in nominal monetary units per se during inflation and deflation as well as its remedy (CIPPA) during inflation and deflation in one and the same statement in 1989.
Obviously, at sustainable zero inflation constant real value non–monetary items will maintain their real values constant in all companies that at least break even. Sustainable zero inflation has never been achieved in the past and is not likely soon to be achieved in the future. Sustainable zero inflation is thus simply a theoretical option.
The IASB confirms the fact that the Historical Cost paradigm is firmly in place when it states in IAS 29 and in the Framework (1989) 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 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 other exception, namely, that salaries, wages, rentals, etc. are generally measured in units of constant purchasing power when they are updated on an annual basis.
The IASB does not mention the erosion of the real value of balance sheet constant real value non–monetary items never maintained constant when the stable measuring unit assumption is implemented during low inflationary periods in companies that lack sufficient revaluable fixed assets (revalued or not) because this process of erosion of the real value of constant real value non–monetary items never maintained is not generally realized. The IASB, like the FASB and most others, mistakenly believe that the erosion of companies´ capital and profits is caused by inflation as specifically stated by the FASB and IASB. They also support the stable measuring unit assumption which is based on the fallacy that money is perfectly stable as well as the fallacy of financial capital maintenance in nominal monetary units during low inflation and deflation.
The erosion of real value of constant real value non–monetary items by implementation of the stable measuring unit assumption is very well understood – and compensated for by updating them by applying the annual CPI – in the case of the income statement constant real value non–monetary items salaries, wages, rentals, etc. The real value maintaining effect on balance sheet constant real value non–monetary items is not realized of freely choosing to continuously measure financial capital maintenance in units of constant purchasing power instead of in nominal monetary units – both models being approved in IFRS in the Framework (1989), 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. The FASB mentioned the stable measuring unit assumption in FAS 33 and FAS 89.
“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
The IASB never mentioned the stable measuring unit assumption in either IAS 6 Accounting Response to Changing Prices or IAS 15. IAS 15 completely superseded IAS 6. IAS 15 was eventually withdrawn.
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
It must be clearly understood, however, that accounting per se cannot and does not create real value out of thin air – out of nothing. Accounting cannot and does not create real value or wealth by simply passing some update or financial capital maintenance in units of constant purchasing power accounting entries when no real value actually exists. Constant real value non–monetary items, e.g. salaries, wages, rentals, issued share capital, share premium, retained profits, capital reserves, other items in shareholders´ equity, trade debtors, trade creditors, provisions, taxes payable, taxes receivable, etc., first have to actually exist for the accounting model (CIPPA) to be able to automatically maintain the real values of those existing constant real value non–monetary items constant for an indefinite period of time in all entities that at least break even by continuously measuring financial capital maintenance in units of constant purchasing power as authorized in IFRS and by continuously valuing income statement constant real value non–monetary items in terms of units of constant purchasing power in order to determine profit or loss in units of constant purchasing power during low inflation and deflation.
The IASB has, amazingly, authorized the fallacy of financial capital maintenance in nominal monetary units per se during inflation and deflation as well as its remedy (CIPPA) during inflation and deflation in one and the same statement in 1989.
Obviously, at sustainable zero inflation constant real value non–monetary items will maintain their real values constant in all companies that at least break even. Sustainable zero inflation has never been achieved in the past and is not likely soon to be achieved in the future. Sustainable zero inflation is thus simply a theoretical option.
The IASB confirms the fact that the Historical Cost paradigm is firmly in place when it states in IAS 29 and in the Framework (1989) 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 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 other exception, namely, that salaries, wages, rentals, etc. are generally measured in units of constant purchasing power when they are updated on an annual basis.
The IASB does not mention the erosion of the real value of balance sheet constant real value non–monetary items never maintained constant when the stable measuring unit assumption is implemented during low inflationary periods in companies that lack sufficient revaluable fixed assets (revalued or not) because this process of erosion of the real value of constant real value non–monetary items never maintained is not generally realized. The IASB, like the FASB and most others, mistakenly believe that the erosion of companies´ capital and profits is caused by inflation as specifically stated by the FASB and IASB. They also support the stable measuring unit assumption which is based on the fallacy that money is perfectly stable as well as the fallacy of financial capital maintenance in nominal monetary units during low inflation and deflation.
The erosion of real value of constant real value non–monetary items by implementation of the stable measuring unit assumption is very well understood – and compensated for by updating them by applying the annual CPI – in the case of the income statement constant real value non–monetary items salaries, wages, rentals, etc. The real value maintaining effect on balance sheet constant real value non–monetary items is not realized of freely choosing to continuously measure financial capital maintenance in units of constant purchasing power instead of in nominal monetary units – both models being approved in IFRS in the Framework (1989), 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. The FASB mentioned the stable measuring unit assumption in FAS 33 and FAS 89.
“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
The IASB never mentioned the stable measuring unit assumption in either IAS 6 Accounting Response to Changing Prices or IAS 15. IAS 15 completely superseded IAS 6. IAS 15 was eventually withdrawn.
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
Wednesday, 11 May 2011
Capital deficiency during sub–prime crisis
Capital deficiency during sub–prime crisis
The world economy would be more robust today if only continuous financial capital maintenance in units of constant purchasing power were authorized in the Framework (1989), Par 104 (a). The implementation of the Constant Item Purchasing Power Accounting model would today automatically maintain the existing constant real values of all companies´ and banks´ shareholders´ equity and all other constant items constant since then in companies and banks that at least break even, instead of the erosive stable measuring unit assumption unknowingly, unintentionally and unnecessarily eroding their real values never maintained as it forms part of traditional Historical Cost Accounting at a rate equal to the annual rate of inflation year in year out during low inflationary periods. The stable measuring unit assumption is based on the fallacy that the erosion of the real value of the monetary unit (money) is not sufficiently important to implement continuous financial capital maintenance in units of constant purchasing power during low inflation. The HCA model is implemented because financial capital maintenance in nominal monetary units – a complete fallacy - was also approved in IFRS in the exact same Framework (1989), Par 104 (a).
If only real value maintaining financial capital maintenance in units of constant purchasing power (CIPPA) were approved in 1989 it would have made a significant difference over this period as verified by the huge capital injections required as a result of the capital deficiency problems caused by the continuous unknowing, unnecessary and unintentional erosion by the implementation of the very erosive stable measuring unit assumption of the existing constant real value of banks´ and companies´ shareholders´ equity never maintained constant under the HCA model as evidenced during the recent sub–prime financial crisis.
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
The world economy would be more robust today if only continuous financial capital maintenance in units of constant purchasing power were authorized in the Framework (1989), Par 104 (a). The implementation of the Constant Item Purchasing Power Accounting model would today automatically maintain the existing constant real values of all companies´ and banks´ shareholders´ equity and all other constant items constant since then in companies and banks that at least break even, instead of the erosive stable measuring unit assumption unknowingly, unintentionally and unnecessarily eroding their real values never maintained as it forms part of traditional Historical Cost Accounting at a rate equal to the annual rate of inflation year in year out during low inflationary periods. The stable measuring unit assumption is based on the fallacy that the erosion of the real value of the monetary unit (money) is not sufficiently important to implement continuous financial capital maintenance in units of constant purchasing power during low inflation. The HCA model is implemented because financial capital maintenance in nominal monetary units – a complete fallacy - was also approved in IFRS in the exact same Framework (1989), Par 104 (a).
If only real value maintaining financial capital maintenance in units of constant purchasing power (CIPPA) were approved in 1989 it would have made a significant difference over this period as verified by the huge capital injections required as a result of the capital deficiency problems caused by the continuous unknowing, unnecessary and unintentional erosion by the implementation of the very erosive stable measuring unit assumption of the existing constant real value of banks´ and companies´ shareholders´ equity never maintained constant under the HCA model as evidenced during the recent sub–prime financial crisis.
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
Monday, 9 May 2011
The school of thought that 2% inflation is completely unharmful
The school of thought that 2% inflation is completely unharmful
Also approving the traditional Historical Cost Accounting model in the Framework (1989), Par 4.59 (a) has been very costly for the world economy as amply illustrated by the deficiency in bank and company capital during the recent financial crisis. This clearly illustrates the very erosive effect of the stable measuring unit assumption on balance sheet constant real value non–monetary items (e.g. shareholders´ equity) during low inflationary periods.
The school of thought that the effects of 2% inflation are not more harmful than zero per cent inflation may have contributed to this. This school of thought is incorrect in two of the three valuation processes in our current HC economy and is also mistaken in one of the three valuation processes under continuous financial capital maintenance in units of constant purchasing power, i.e. a Constant Item Purchasing Power paradigm during low inflation. The three valuation processes in our economy under both the HC and Constant Item Purchasing Power paradigms are the valuation of monetary items, variable real value non–monetary items and constant real value non–monetary items.
Variable items are valued in terms of International Financial Reporting Standards under both the Historical Cost and Constant Item Purchasing Power paradigms with the stable measuring unit assumption being applied under HCA. The stable measuring unit assumption is rejected under the Constant Item Purchasing Power Accounting option.
In the first instance, the view that a high degree of price stability of a positive inflation rate of up to two per cent per annum is completely unharmful and that it has no disadvantages compared to absolute price stability is never true in the case of monetary items under any accounting model – either the HCA model or the Constant Item Purchasing Power Accounting model – since monetary items are incapable of being updated as a result of the current nature of fiat money. A high degree of price stability of two per cent per annum in this case erodes two per cent per annum of the real value of money and other monetary items that cannot be updated in any way or form; that equates to the erosion of 51 per cent of real value in all current monetary items over the next 35 years and will over a long enough time period lead to all current monetary items arriving at the point of being completely worthless in economies with continuous 2% inflation. See the Real Value Table for other levels of real value erosion over the respective time periods involved.
In the case of monetary items we can thus confidently disagree completely with those who assume that a high degree of price stability of above zero and up to two per cent per annum is unharmful in all respects and that it has absolutely no disadvantages compared to absolute price stability or zero inflation.
The assumption that 2% inflation is unharmful and that it has no disadvantages compared to zero inflation is acceptable in the case of variable real value non–monetary items valued continuously in terms of IFRS under both the HC model and the Constant Item Purchasing Power Accounting model. The nature of the valuing processes in valuing variable real value non–monetary items continuously, for example, at fair value or net realizable value or market value, etc., as applicable, in terms IFRS, allows this idea to be justifiable under both models.
The above view is acceptable in this instance, because, in principle, any level of inflation or deflation – high or low – is automatically adjusted for in determining the price of a variable real value non–monetary item in terms of IFRS excluding, of course, valuation at historical cost.
2% inflation erodes 2% per annum – i.e. 51% over 35 years – of the real value of constant real value non–monetary items never maintained, e.g. retained profits and issued share capital, under the current HC paradigm. The only constant items generally maintained constant with annual measurement in units of constant purchasing power under the HC paradigm are certain (not all) income statement items, namely, salaries, wages, rentals, etc. They are, however, paid monthly at the same value after being updated annually. All existing constant real value non–monetary items´ real values would be maintained constant with continuous measurement in units of constant purchasing power at any level of inflation or deflation under the Constant Item Purchasing Power paradigm for an unlimited period of time in companies that at least break even – all else being equal.
We can thus safely disagree in the case of constant real value non–monetary items under the HC paradigm too, that the effects of 2% inflation is completely unharmful. 2% inflation – in fact, any level of inflation or deflation – would be the same as zero inflation as far as the valuation of constant real value non–monetary items under the Constant Item Purchasing Power paradigm is concerned.
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
Also approving the traditional Historical Cost Accounting model in the Framework (1989), Par 4.59 (a) has been very costly for the world economy as amply illustrated by the deficiency in bank and company capital during the recent financial crisis. This clearly illustrates the very erosive effect of the stable measuring unit assumption on balance sheet constant real value non–monetary items (e.g. shareholders´ equity) during low inflationary periods.
The school of thought that the effects of 2% inflation are not more harmful than zero per cent inflation may have contributed to this. This school of thought is incorrect in two of the three valuation processes in our current HC economy and is also mistaken in one of the three valuation processes under continuous financial capital maintenance in units of constant purchasing power, i.e. a Constant Item Purchasing Power paradigm during low inflation. The three valuation processes in our economy under both the HC and Constant Item Purchasing Power paradigms are the valuation of monetary items, variable real value non–monetary items and constant real value non–monetary items.
Variable items are valued in terms of International Financial Reporting Standards under both the Historical Cost and Constant Item Purchasing Power paradigms with the stable measuring unit assumption being applied under HCA. The stable measuring unit assumption is rejected under the Constant Item Purchasing Power Accounting option.
In the first instance, the view that a high degree of price stability of a positive inflation rate of up to two per cent per annum is completely unharmful and that it has no disadvantages compared to absolute price stability is never true in the case of monetary items under any accounting model – either the HCA model or the Constant Item Purchasing Power Accounting model – since monetary items are incapable of being updated as a result of the current nature of fiat money. A high degree of price stability of two per cent per annum in this case erodes two per cent per annum of the real value of money and other monetary items that cannot be updated in any way or form; that equates to the erosion of 51 per cent of real value in all current monetary items over the next 35 years and will over a long enough time period lead to all current monetary items arriving at the point of being completely worthless in economies with continuous 2% inflation. See the Real Value Table for other levels of real value erosion over the respective time periods involved.
In the case of monetary items we can thus confidently disagree completely with those who assume that a high degree of price stability of above zero and up to two per cent per annum is unharmful in all respects and that it has absolutely no disadvantages compared to absolute price stability or zero inflation.
The assumption that 2% inflation is unharmful and that it has no disadvantages compared to zero inflation is acceptable in the case of variable real value non–monetary items valued continuously in terms of IFRS under both the HC model and the Constant Item Purchasing Power Accounting model. The nature of the valuing processes in valuing variable real value non–monetary items continuously, for example, at fair value or net realizable value or market value, etc., as applicable, in terms IFRS, allows this idea to be justifiable under both models.
The above view is acceptable in this instance, because, in principle, any level of inflation or deflation – high or low – is automatically adjusted for in determining the price of a variable real value non–monetary item in terms of IFRS excluding, of course, valuation at historical cost.
2% inflation erodes 2% per annum – i.e. 51% over 35 years – of the real value of constant real value non–monetary items never maintained, e.g. retained profits and issued share capital, under the current HC paradigm. The only constant items generally maintained constant with annual measurement in units of constant purchasing power under the HC paradigm are certain (not all) income statement items, namely, salaries, wages, rentals, etc. They are, however, paid monthly at the same value after being updated annually. All existing constant real value non–monetary items´ real values would be maintained constant with continuous measurement in units of constant purchasing power at any level of inflation or deflation under the Constant Item Purchasing Power paradigm for an unlimited period of time in companies that at least break even – all else being equal.
We can thus safely disagree in the case of constant real value non–monetary items under the HC paradigm too, that the effects of 2% inflation is completely unharmful. 2% inflation – in fact, any level of inflation or deflation – would be the same as zero inflation as far as the valuation of constant real value non–monetary items under the Constant Item Purchasing Power paradigm is concerned.
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
Friday, 6 May 2011
Financial capital maintenance in units of constant purchasing power
Financial capital maintenance in units of constant purchasing power
Constant Item Purchasing Power Accounting is a price–level accounting model where under only constant items (not variable items) are continuously measured in units of constant purchasing power, i.e., updated every time the real value of the unstable monetary unit of account (money) changes; namely, when the CPI changes - month after month during low inflation and deflation.
Value accounting has been defined in since 1976 via IFRS relating to variable items. Value accounting thus clearly prevails in the valuation and accounting of variable items in terms of IFRS during low inflation and deflation.
Continuous financial capital maintenance in units of constant purchasing power during low inflation and deflation has also been authorized by the IASC Board thirteen years after Harvey Kapnick´s 1976 prediction. The IASC Board approved the Framework (1989), Par 104 (a) which states that “Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power.” However, the enormous real value eroding effect of the very erosive stable measuring unit assumption when entities choose in terms of the exact same Framework (1989), Par 104 (a), the IASB–approved very popular accounting fallacy of financial capital maintenance in nominal monetary units (the traditional Historical Cost Accounting model) and apply it in the valuing of constant items never maintained, e.g. retained earnings in most entities, in low inflationary economies when they implement stable measuring unit assumption during inflation, is not generally realized. This is clearly verified by the fact that both financial capital maintenance in nominal monetary units (a popular accounting fallacy) as well as real value maintaining continuous financial capital maintenance in units of constant purchasing power during inflation and deflation were approved in IFRS in the Framework (1989), Par 104 (a). Entities can choose the one or the other and state that they have prepared primary financial statements in terms of IFRS. However, when the the traditional HCA model is chosen, the stable measuring unit assumption unknowingly, unintentionally and unnecessarily erodes hundreds of billions of US Dollars in real value in the world´s constant item economy during low inflation. When they choose IFRS–approved continuous financial capital maintenance in units of constant purchasing power they maintain the real values of all constant items constant during inflation and deflation in companies which at least break even, empowering and enriching those companies, their shareholders and the economy in general with the accompanying benefits to workers and employment for an unlimited period of time – all else being equal.
As the Deutsche Bundesbank stated:
“The benefits of price stability, on the other hand, can scarcely be overestimated, especially as these are, in principle, unlimited in duration and accrue year after year.”
Deutsche Bundesbank, 1996 Annual Report, P 83.
Financial capital maintenance in units of constant purchasing power during inflation and deflation results in absolute price stability only in constant items for an unlimited period of time in companies that at least break even – all else being equal – without the need for extra capital from capital providers or more retained earnings simply to maintain the existing constant real value of existing constant items constant. This happens whether these entities own any fixed assets or not.
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
Constant Item Purchasing Power Accounting is a price–level accounting model where under only constant items (not variable items) are continuously measured in units of constant purchasing power, i.e., updated every time the real value of the unstable monetary unit of account (money) changes; namely, when the CPI changes - month after month during low inflation and deflation.
Value accounting has been defined in since 1976 via IFRS relating to variable items. Value accounting thus clearly prevails in the valuation and accounting of variable items in terms of IFRS during low inflation and deflation.
Continuous financial capital maintenance in units of constant purchasing power during low inflation and deflation has also been authorized by the IASC Board thirteen years after Harvey Kapnick´s 1976 prediction. The IASC Board approved the Framework (1989), Par 104 (a) which states that “Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power.” However, the enormous real value eroding effect of the very erosive stable measuring unit assumption when entities choose in terms of the exact same Framework (1989), Par 104 (a), the IASB–approved very popular accounting fallacy of financial capital maintenance in nominal monetary units (the traditional Historical Cost Accounting model) and apply it in the valuing of constant items never maintained, e.g. retained earnings in most entities, in low inflationary economies when they implement stable measuring unit assumption during inflation, is not generally realized. This is clearly verified by the fact that both financial capital maintenance in nominal monetary units (a popular accounting fallacy) as well as real value maintaining continuous financial capital maintenance in units of constant purchasing power during inflation and deflation were approved in IFRS in the Framework (1989), Par 104 (a). Entities can choose the one or the other and state that they have prepared primary financial statements in terms of IFRS. However, when the the traditional HCA model is chosen, the stable measuring unit assumption unknowingly, unintentionally and unnecessarily erodes hundreds of billions of US Dollars in real value in the world´s constant item economy during low inflation. When they choose IFRS–approved continuous financial capital maintenance in units of constant purchasing power they maintain the real values of all constant items constant during inflation and deflation in companies which at least break even, empowering and enriching those companies, their shareholders and the economy in general with the accompanying benefits to workers and employment for an unlimited period of time – all else being equal.
As the Deutsche Bundesbank stated:
“The benefits of price stability, on the other hand, can scarcely be overestimated, especially as these are, in principle, unlimited in duration and accrue year after year.”
Deutsche Bundesbank, 1996 Annual Report, P 83.
Financial capital maintenance in units of constant purchasing power during inflation and deflation results in absolute price stability only in constant items for an unlimited period of time in companies that at least break even – all else being equal – without the need for extra capital from capital providers or more retained earnings simply to maintain the existing constant real value of existing constant items constant. This happens whether these entities own any fixed assets or not.
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
Thursday, 5 May 2011
Price-level accounting
Price–level accounting
Entities generally choose to measure financial capital maintenance in nominal monetary units and thus apply the very erosive stable measuring unit assumption as part of the traditional HCA model. They generally value balance sheet constant items (e.g. equity) as well as most income statement items – which are all constant items – at Historical Cost. They value them in nominal monetary units as a result of the fact that they assume that changes in the purchasing power of the monetary unit are not sufficiently important to require financial capital maintenance in units of constant purchasing power during low inflation and deflation. Entities do not regard changes in the real value of money during low inflation and deflation as important enough for them to maintain the real value of capital constant with financial capital maintenance in units of constant purchasing power as they have been authorized in IFRS in the original Framework (1989) Par. 104 (a). Entities, in principle, assume there has never ever been inflation or deflation in the past, there is no inflation and deflation in the present and there never will be inflation and deflation in the future as far as the valuation of most constant items is concerned. They only value certain income statement constant real value non-monetary items, e.g. salaries, wages, rentals, etc in real value maintaining units of constant purchasing power and update them annually by means of the annual CPI during low inflation. They then pay these annually updated values monthly again implementing the stable measuring unit assumption.
Complete price–level accounting also called Constant Purchasing Power Accounting (CPPA) is an inflation accounting model whereby all non–monetary items – variable and constant items – are measured / valued in units of constant purchasing power by means of the daily US Dollar or other relatively stable foreign currency parallel rate or a daily index rate in order to maintain the real or non-monetary economy relatively stable during hyperinflation. IAS 29 does not require the valuation of all non-monetary items in units of constant purchasing power at the time of the transaction or event. IAS 29 and PricewaterhouseCoopers (amongst most others) accept the implementation of Historical Cost Accounting or Current Cost Accounting during the accounting period. IAS 29 requires the restatement of the HC or CC financial statements in terms of the period–end CPI in order to make them more useful during hyperinflation. The non–monetary or real economy of a hyperinflationary economy can only be maintained relatively stable by applying the daily parallel US Dollar exchange rate or a Brazilian–style daily index to the valuation of all non–monetary items instead of simply the restatement of HC or CC financial statement in terms of the period–end CPI as required by IAS 29.
The Framework is applicable
The implementation of the concepts of capital, the capital maintenance concepts and the profit/loss determination concepts during non–hyperinflationary periods are not covered in IAS, IFRS or Interpretations. These concepts are covered in the Conceptual Framework (2010), Par 4.57 to 110. There are no specific IAS or IFRS relating to these concepts. The Framework is thus applicable as per IAS8.11.
Deloitte states:
"In the absence of a Standard or an Interpretation that specifically applies to a transaction, management must use its judgement in developing and applying an accounting policy that results in information that is relevant and reliable. In making that judgement, IAS 8.11 requires management to consider the definitions, recognition criteria, and measurement concepts for assets, liabilities, income, and expenses in the Framework. This elevation of the importance of the Framework was added in the 2003 revisions to IAS 8."
IAS8 Par. 11 states:
“In making the judgement, management shall refer to, and consider the applicability of, the following sources in descending order: (a) the requirements and guidance in Standards and Interpretations dealing with similar and related issues; and (b) the definitions, recognition criteria and measurement concepts for assets, liabilities, income and expenses in the Framework.”
The valuation of the constant real value non–monetary items Issued Share capital, Retained Earnings, other items in Shareholders´ Equity and other constant items is thus covered in IFRS in the original Framework (1989), Pa. 104 (a).
Harvey Kapnick in the Sax Lecture in 1976 correctly predicted the course of the development of International Financial Reporting Standards:
“Confusion constantly arises between changes in value and changes in purchasing power. The fact is both are occurring and, while there may be an interrelationship, the effects of each should be accounted for separately. Thus, the debate concerning whether value accounting or price–level accounting should prevail is not on point, because in the long run both should prevail. The real changes in value should be segregated from changes resulting only from changes in price levels.”
Harvey Kapnick, Chairman, Arthur Andersen & Company, “Value Based Accounting – Evolution or Revolution”, Sax Lecture, 1976.
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
Entities generally choose to measure financial capital maintenance in nominal monetary units and thus apply the very erosive stable measuring unit assumption as part of the traditional HCA model. They generally value balance sheet constant items (e.g. equity) as well as most income statement items – which are all constant items – at Historical Cost. They value them in nominal monetary units as a result of the fact that they assume that changes in the purchasing power of the monetary unit are not sufficiently important to require financial capital maintenance in units of constant purchasing power during low inflation and deflation. Entities do not regard changes in the real value of money during low inflation and deflation as important enough for them to maintain the real value of capital constant with financial capital maintenance in units of constant purchasing power as they have been authorized in IFRS in the original Framework (1989) Par. 104 (a). Entities, in principle, assume there has never ever been inflation or deflation in the past, there is no inflation and deflation in the present and there never will be inflation and deflation in the future as far as the valuation of most constant items is concerned. They only value certain income statement constant real value non-monetary items, e.g. salaries, wages, rentals, etc in real value maintaining units of constant purchasing power and update them annually by means of the annual CPI during low inflation. They then pay these annually updated values monthly again implementing the stable measuring unit assumption.
Complete price–level accounting also called Constant Purchasing Power Accounting (CPPA) is an inflation accounting model whereby all non–monetary items – variable and constant items – are measured / valued in units of constant purchasing power by means of the daily US Dollar or other relatively stable foreign currency parallel rate or a daily index rate in order to maintain the real or non-monetary economy relatively stable during hyperinflation. IAS 29 does not require the valuation of all non-monetary items in units of constant purchasing power at the time of the transaction or event. IAS 29 and PricewaterhouseCoopers (amongst most others) accept the implementation of Historical Cost Accounting or Current Cost Accounting during the accounting period. IAS 29 requires the restatement of the HC or CC financial statements in terms of the period–end CPI in order to make them more useful during hyperinflation. The non–monetary or real economy of a hyperinflationary economy can only be maintained relatively stable by applying the daily parallel US Dollar exchange rate or a Brazilian–style daily index to the valuation of all non–monetary items instead of simply the restatement of HC or CC financial statement in terms of the period–end CPI as required by IAS 29.
The Framework is applicable
The implementation of the concepts of capital, the capital maintenance concepts and the profit/loss determination concepts during non–hyperinflationary periods are not covered in IAS, IFRS or Interpretations. These concepts are covered in the Conceptual Framework (2010), Par 4.57 to 110. There are no specific IAS or IFRS relating to these concepts. The Framework is thus applicable as per IAS8.11.
Deloitte states:
"In the absence of a Standard or an Interpretation that specifically applies to a transaction, management must use its judgement in developing and applying an accounting policy that results in information that is relevant and reliable. In making that judgement, IAS 8.11 requires management to consider the definitions, recognition criteria, and measurement concepts for assets, liabilities, income, and expenses in the Framework. This elevation of the importance of the Framework was added in the 2003 revisions to IAS 8."
IAS8 Par. 11 states:
“In making the judgement, management shall refer to, and consider the applicability of, the following sources in descending order: (a) the requirements and guidance in Standards and Interpretations dealing with similar and related issues; and (b) the definitions, recognition criteria and measurement concepts for assets, liabilities, income and expenses in the Framework.”
The valuation of the constant real value non–monetary items Issued Share capital, Retained Earnings, other items in Shareholders´ Equity and other constant items is thus covered in IFRS in the original Framework (1989), Pa. 104 (a).
Harvey Kapnick in the Sax Lecture in 1976 correctly predicted the course of the development of International Financial Reporting Standards:
“Confusion constantly arises between changes in value and changes in purchasing power. The fact is both are occurring and, while there may be an interrelationship, the effects of each should be accounted for separately. Thus, the debate concerning whether value accounting or price–level accounting should prevail is not on point, because in the long run both should prevail. The real changes in value should be segregated from changes resulting only from changes in price levels.”
Harvey Kapnick, Chairman, Arthur Andersen & Company, “Value Based Accounting – Evolution or Revolution”, Sax Lecture, 1976.
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
Wednesday, 4 May 2011
Value accounting
Value accounting
There is, on the other hand, also strong awareness in the accounting profession that accounting is actually about value and not simply about Historical Cost.
"...it is really values that are the basic data of accounting, and costs are important only because they are the most dependable measures of initial values of goods and services flowing into the enterprise through ordinary market transactions”
Paton W. A., "Accounting Procedures and Private Enterprise", The Journal of Accountancy, April 1948, p.288.
It is generally accepted that accounting should be value based. By value based it is meant that variable real value non-monetary items cannot always be valued at HC, but, are to be valued in terms of specific measurement bases defined in IFRS or GAAP; for example, market value, net realizable value, fair value, present value, recoverable value, etc.
Value accounting has been defined in International Standards since 1976 via International Accounting Standards and IFRS relating to variable items. Value accounting thus clearly prevails in the valuation and accounting of variable items in terms of IFRS.
Value accounting also prevails as far as the valuing and accounting of monetary items during the current accounting period are concerned. Monetary items are measured in nominal monetary units no matter which accounting model is used under whatever economic environment: low inflation, deflation and hyperinflation. The real value of monetary items is kept always current, i.e. generally lower by inflation, generally higher by deflation and generally very much lower by hyperinflation since the nominal value of monetary items is not and cannot be updated or measured in units of constant purchasing power during the current accounting period in an inflationary, a deflationary or a hyperinflationary economy.
The CPI which quantifies the erosion of the real value of only monetary items by low inflation and the creation of real value by deflation in only monetary items is published on a monthly basis. The hyper-erosion of the real value of only monetary items is normally known via the daily US Dollar parallel rate or daily index rate or even every 8 hours during hyperinflation. The nominal value of monetary items in actual accounts stays the same forever under any accounting model and under any economic environment, but, the real value is automatically adjusted by inflation, deflation and hyperinflation. The real value of monetary items can be halved every 24.7 hours as it happened recently during hyperinflation in Zimbabwe. According to Prof Steve Hanke from John Hopkins University prices halved every 15.6 hours during hyperinflation in Hungary in 1946.
The net monetary loss or net monetary gain in monetary items caused by inflation, deflation and hyperinflation resulting from holding net monetary item assets or net monetary item liabilities is calculated and accounted in terms of IAS 29 in hyperinflationary economies and in terms of CIPPA in low inflationary and deflationary economies. The calculation and accounting of net monetary losses and gains during low inflation and deflation have thus been authorized in IFRS since 1989. They are not calculated and accounted under the traditional Historical Cost Accounting model, although it can be done according to Harvey Kapnick.
"Computing the gains or losses from holding monetary items can be done and the information disclosed when the books are maintained on a historical–cost basis."
Harvey Kapnick, Chairman of Arthur Anderson & Company, Value based accounting: Evolution or revolution, Saxe Lecture, 1976, Page 6.
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
There is, on the other hand, also strong awareness in the accounting profession that accounting is actually about value and not simply about Historical Cost.
"...it is really values that are the basic data of accounting, and costs are important only because they are the most dependable measures of initial values of goods and services flowing into the enterprise through ordinary market transactions”
Paton W. A., "Accounting Procedures and Private Enterprise", The Journal of Accountancy, April 1948, p.288.
It is generally accepted that accounting should be value based. By value based it is meant that variable real value non-monetary items cannot always be valued at HC, but, are to be valued in terms of specific measurement bases defined in IFRS or GAAP; for example, market value, net realizable value, fair value, present value, recoverable value, etc.
Value accounting has been defined in International Standards since 1976 via International Accounting Standards and IFRS relating to variable items. Value accounting thus clearly prevails in the valuation and accounting of variable items in terms of IFRS.
Value accounting also prevails as far as the valuing and accounting of monetary items during the current accounting period are concerned. Monetary items are measured in nominal monetary units no matter which accounting model is used under whatever economic environment: low inflation, deflation and hyperinflation. The real value of monetary items is kept always current, i.e. generally lower by inflation, generally higher by deflation and generally very much lower by hyperinflation since the nominal value of monetary items is not and cannot be updated or measured in units of constant purchasing power during the current accounting period in an inflationary, a deflationary or a hyperinflationary economy.
The CPI which quantifies the erosion of the real value of only monetary items by low inflation and the creation of real value by deflation in only monetary items is published on a monthly basis. The hyper-erosion of the real value of only monetary items is normally known via the daily US Dollar parallel rate or daily index rate or even every 8 hours during hyperinflation. The nominal value of monetary items in actual accounts stays the same forever under any accounting model and under any economic environment, but, the real value is automatically adjusted by inflation, deflation and hyperinflation. The real value of monetary items can be halved every 24.7 hours as it happened recently during hyperinflation in Zimbabwe. According to Prof Steve Hanke from John Hopkins University prices halved every 15.6 hours during hyperinflation in Hungary in 1946.
The net monetary loss or net monetary gain in monetary items caused by inflation, deflation and hyperinflation resulting from holding net monetary item assets or net monetary item liabilities is calculated and accounted in terms of IAS 29 in hyperinflationary economies and in terms of CIPPA in low inflationary and deflationary economies. The calculation and accounting of net monetary losses and gains during low inflation and deflation have thus been authorized in IFRS since 1989. They are not calculated and accounted under the traditional Historical Cost Accounting model, although it can be done according to Harvey Kapnick.
"Computing the gains or losses from holding monetary items can be done and the information disclosed when the books are maintained on a historical–cost basis."
Harvey Kapnick, Chairman of Arthur Anderson & Company, Value based accounting: Evolution or revolution, Saxe Lecture, 1976, Page 6.
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
Tuesday, 3 May 2011
The monetary nature of money
The monetary nature of money
Money is an economic item very different from the other two basic economic items because of its monetary nature, namely the unique combination of the following:
its three functions, namely
unstable medium of exchange,
unstable store of value and
unstable unit of account,
portability,
it is generally available in small change,
it is only money within (not outside) an economy (foreign exchange is a non-monetary item),
it is legal tender,
it is always automatically valued by inflation (hyperinflation) and deflation,
which affects all units of money evenly,
when it has no exchangeability it is worthless, etc.
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
Money is an economic item very different from the other two basic economic items because of its monetary nature, namely the unique combination of the following:
its three functions, namely
unstable medium of exchange,
unstable store of value and
unstable unit of account,
portability,
it is generally available in small change,
it is only money within (not outside) an economy (foreign exchange is a non-monetary item),
it is legal tender,
it is always automatically valued by inflation (hyperinflation) and deflation,
which affects all units of money evenly,
when it has no exchangeability it is worthless, etc.
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
Monday, 2 May 2011
Testimonials
Testimonials
"Good work."
David Mosso
Chairman of the US Federal Accounting Standards Advisory Board (1997-2006)
US Financial Accounting Standards Board member (1979-1986)
Top Accounting Blog Award
"Your site is amazing. We hope you'll find this award as motivation to persevere in your blog.
All in all, we thank and appreciate you for writing and posting great content and hope you'll continue to do so. "
Angela Turner
http://www.onlineaccountingdegree.net/
"Theoretically I totally agree with you."
Dr. Cemal Kucuksozen
Head of the Turkish International Accounting Standards Department, 2005
"Good work."
David Mosso
Chairman of the US Federal Accounting Standards Advisory Board (1997-2006)
US Financial Accounting Standards Board member (1979-1986)
Top Accounting Blog Award
"Your site is amazing. We hope you'll find this award as motivation to persevere in your blog.
All in all, we thank and appreciate you for writing and posting great content and hope you'll continue to do so. "
Angela Turner
http://www.onlineaccountingdegree.net/
"Theoretically I totally agree with you."
Dr. Cemal Kucuksozen
Head of the Turkish International Accounting Standards Department, 2005
The three fundamentally different parts of the economy
The three fundamentally different, basic economic items in the economy are:
a) Monetary items
b) Variable real value non–monetary items
c) Constant real value non–monetary items
The economy consequently consists of not just two parts – the monetary and non–monetary economy, but, three parts:
1. Monetary economy
2. Variable item economy
3. Constant item economy
Buy the book at Amazon.com
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
Saturday, 30 April 2011
Three popular accounting fallacies
Three popular accounting fallacies
Updated on 14-06-2016
The real values of many constant real value non–monetary items, for example, that portion of shareholders´ equity never maintained constant by sufficient revaluable fixed assets (revalued or not) under the HCA model, are not automatically maintained constant (as they are under Capital Maintenance in Units of Constant Purchasing Power in terms of the Daily CPI) in the world´s low inflation economies. This was clearly evident during the recent financial crisis that necessitated huge amounts of additional capital for under–capitalized banks and companies whose capital has been eroded by the stable measuring unit assumption (not inflation - as generally accepted) during low inflation. Inflation has no effect on the real value of non-monetary items. The constant real non–monetary values of their capital are still unnecessarily, unknowingly and unintentionally being eroded at a rate equal to the annual rate of inflation by the implementation of the very erosive stable measuring unit assumption as it forms part of the traditional HCA model. HCA is based on the accounting fallacy that financial capital maintenance can be measured (implied: maintained) in nominal monetary units per se during inflation and deflation as originally authorized in IFRS in the Framework (1989), Par 104 (a) as well as approved in the FASB´s Statement of Financial Accounting Concepts No. 5, Recognition and Measurement in Financial Statements of Business Enterprises (1984).
Many people see financial reporting as simply providing historic economic information. It is not realized that it is a basic objective of accounting (financial reporting) to automatically maintain the constant purchasing power of capital constant in all entities that at least break even in real value for an indefinite period of time by continuously measuring all constant real value non–monetary items in units of constant purchasing power in terms of the Daily CPI during inflation, deflation and hyperinflation.
The reasons for this are:
(1) The Three Popular Accounting Fallacies.
(a) The stable measuring unit assumption based on the fallacy that changes in the purchasing power of money (the montary unit of measure) are not sufficiently important to require the measurement of financial capital maintenance in units of constant purchasing power in terms of the Daily CPI during low inflation, deflation and hyperinflation originally authorized in IFRS in the Framework (1989), Par 104 (a) and in the FASB´s FA Concepts No. 5.
(b) Financial capital maintenance in nominal monetary units per se (the belief that the real value of financial capital can be maintained in nominal monetary units per se) during low inflation and deflation originally authorized in IFRS in the Framework (1989), Par 104 (a) and in the FASB´s FA Concepts No. 5.
(c) The generally accepted belief that the erosion of companies´ profits and capital is caused by inflation fully supported in IFRS and by the FASB.
(2) It is not realized (understood) that it is the stable measuring unit assumption and not inflation that erodes the real value of constant real value non–monetary items never maintained constant when financial capital maintenance in nominal monetary units (the traditional HCA model) is implemented during low inflationary and hyperinflationary periods. Reject the stable measuring unit assumption, i.e., implement financial capital maintenance in units of constant purchasing power in terms of the Daily CPI) and the real value of capital is automatically maintained constant in all entities that at least break even in real value, ceteris paribus.
(3) It is not realized (understood) that continuous measurement of financial capital maintenance in units of constant purchasing power (Capital Maintenance in Units of Constant Purchasing Power in terms of the Daily CPI) automatically remedies this erosion by the stable measuring unit assumption during low inflation and hyperinflation.
If the above were generally understood then the stable measuring unit assumption / financial capital maintenance in nominal monetary units, i.e. the HCA model, would have been stopped during low inflation, deflation and hyperinflation by now.
Although the principle of financial capital maintenance in units of constant purchasing power in terms of the Daily CPI during inflation and hyperinflation was authorized in IFRS in 1989, it has not been implemented generally during low inflations and hyperinflation because the eroding effect of the stable measuring unit assumption on the real value of constant items never maintained constant is not recognized (understood) as such. It is generally believed that it is inflation doing the eroding in, for example, companies´ invested capital and profits – as specifically stated in FAS 89 - when this erosion in constant item real value is, in fact, caused by the stable measuring unit assumption. Inflation has no effect on the real value of non–monetary items. Capital and profits are constant real value non–monetary items.
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
Updated on 14-06-2016
The real values of many constant real value non–monetary items, for example, that portion of shareholders´ equity never maintained constant by sufficient revaluable fixed assets (revalued or not) under the HCA model, are not automatically maintained constant (as they are under Capital Maintenance in Units of Constant Purchasing Power in terms of the Daily CPI) in the world´s low inflation economies. This was clearly evident during the recent financial crisis that necessitated huge amounts of additional capital for under–capitalized banks and companies whose capital has been eroded by the stable measuring unit assumption (not inflation - as generally accepted) during low inflation. Inflation has no effect on the real value of non-monetary items. The constant real non–monetary values of their capital are still unnecessarily, unknowingly and unintentionally being eroded at a rate equal to the annual rate of inflation by the implementation of the very erosive stable measuring unit assumption as it forms part of the traditional HCA model. HCA is based on the accounting fallacy that financial capital maintenance can be measured (implied: maintained) in nominal monetary units per se during inflation and deflation as originally authorized in IFRS in the Framework (1989), Par 104 (a) as well as approved in the FASB´s Statement of Financial Accounting Concepts No. 5, Recognition and Measurement in Financial Statements of Business Enterprises (1984).
Many people see financial reporting as simply providing historic economic information. It is not realized that it is a basic objective of accounting (financial reporting) to automatically maintain the constant purchasing power of capital constant in all entities that at least break even in real value for an indefinite period of time by continuously measuring all constant real value non–monetary items in units of constant purchasing power in terms of the Daily CPI during inflation, deflation and hyperinflation.
The reasons for this are:
(1) The Three Popular Accounting Fallacies.
(a) The stable measuring unit assumption based on the fallacy that changes in the purchasing power of money (the montary unit of measure) are not sufficiently important to require the measurement of financial capital maintenance in units of constant purchasing power in terms of the Daily CPI during low inflation, deflation and hyperinflation originally authorized in IFRS in the Framework (1989), Par 104 (a) and in the FASB´s FA Concepts No. 5.
(b) Financial capital maintenance in nominal monetary units per se (the belief that the real value of financial capital can be maintained in nominal monetary units per se) during low inflation and deflation originally authorized in IFRS in the Framework (1989), Par 104 (a) and in the FASB´s FA Concepts No. 5.
(c) The generally accepted belief that the erosion of companies´ profits and capital is caused by inflation fully supported in IFRS and by the FASB.
(2) It is not realized (understood) that it is the stable measuring unit assumption and not inflation that erodes the real value of constant real value non–monetary items never maintained constant when financial capital maintenance in nominal monetary units (the traditional HCA model) is implemented during low inflationary and hyperinflationary periods. Reject the stable measuring unit assumption, i.e., implement financial capital maintenance in units of constant purchasing power in terms of the Daily CPI) and the real value of capital is automatically maintained constant in all entities that at least break even in real value, ceteris paribus.
(3) It is not realized (understood) that continuous measurement of financial capital maintenance in units of constant purchasing power (Capital Maintenance in Units of Constant Purchasing Power in terms of the Daily CPI) automatically remedies this erosion by the stable measuring unit assumption during low inflation and hyperinflation.
If the above were generally understood then the stable measuring unit assumption / financial capital maintenance in nominal monetary units, i.e. the HCA model, would have been stopped during low inflation, deflation and hyperinflation by now.
Although the principle of financial capital maintenance in units of constant purchasing power in terms of the Daily CPI during inflation and hyperinflation was authorized in IFRS in 1989, it has not been implemented generally during low inflations and hyperinflation because the eroding effect of the stable measuring unit assumption on the real value of constant items never maintained constant is not recognized (understood) as such. It is generally believed that it is inflation doing the eroding in, for example, companies´ invested capital and profits – as specifically stated in FAS 89 - when this erosion in constant item real value is, in fact, caused by the stable measuring unit assumption. Inflation has no effect on the real value of non–monetary items. Capital and profits are constant real value non–monetary items.
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
Friday, 29 April 2011
Monetary meltdown
Monetary meltdown
The monetary economy (the total real value of a fiat money supply) can disappear completely. It happened three times during three months towards the end of hyperinflation in Yugoslavia. It happened at the end of hyperinflation in Zimbabwe in 2008, terminating hyperinflation in that country. Zimbabwe did not try hyperinflation again like Yugoslavia which has the distinction of having wiped out the real value of their entire monetary economy three times in three months. In Zimbabwe the economy dollarized spontaneously after a decision by the Reserve Bank of Zimbabwe to close the Zimbabwe Stock Exchange which stopped the Old Mutual Implied Rate being the final exchange rate of the Zimbabwe Dollar with a foreign currency – the British Pound. The Zimbabwean economy dollarized spontaneously after that because it was a sufficiently open economy right next to the stable South African and Botswana and other stable economies in the Southern African region. Those stable economies supplied the Zimbabwean economy with essential goods and services. Zimbabwe then had the opportunity to slowly recover from total monetary meltdown and the devastating effect of implementing the very erosive stable measuring unit assumption – the Historical Cost Accounting model - during hyperinflation as authorized in International Financial Reporting Standards and supported by Big Four accounting firms like PricewaterhouseCoopers. Zimbabwe spontaneously adopted a multi-currency dollarization model using the US Dollar, the Euro, the SA Rand, the British Pound and the Botswana Pula as relatively stable foreign currencies in the Zimbabwean economy.
The variable real value non-monetary item economy (property, plant, equipment, inventory, etc) cannot disappear because of wrong monetary policies. Inflation is always and everywhere a monetary phenomenon. Inflation and hyperinflation have no effect on the real value of non-monetary items. After monetary meltdown in Zimbabwe the properties, plant, equipment, raw materials, finished goods, etc., were still there. The variable item economy can be destroyed by natural disasters like earth quakes and tsunamis and by man-made events like war.
The constant item economy (shareholders´ equity, trade debtors, trade creditors, salaries, wages, rentals, etc.) also cannot be eroded by inflation and hyperinflation because inflation and hyperinflation have no effect on the real value of non-monetary items: both variable and constant real value non-monetary items. However, the stable measuring unit assumption (i.e. the Historical Cost Accounting model or financial capital maintenance in nominal monetary units per se during inflation and hyperinflation) erodes the constant real non-monetary value of constant items not maintained constant during inflation and hyperinflation, e.g. trade debtors, trade creditors, salaries, wages, rentals, that portion of shareholder´s equity never maintained constant as a result of insufficient revaluable fixed assets (revalued or not), all other non-monetary payables and receivables, etc., at a rate equal to the annual rate of inflation or hyperinflation.
Equity is equal to net assets; i.e., the constant real non-monetary value of shareholders´ equity is equal to the constant real value of net assets. Under Constant Item Purchasing Power Accounting (CIPPA) the constant real non-monetary value of equity is automatically maintained constant in all entities that at least break even for an unlimited period of time (forever) during low inflation and deflation whether these entities own any revaluable fixed assets or not.
Only capital maintenance in units of constant purchasing power in terms of the daily US Dollar or other hard currency parallel rate or a daily Brazilian-style index under Constant Purchasing Power Accounting (CPPA) will automatically maintain the constant real value of constant items constant for an indefinite period of time in all entities that at least break even during hyperinflation. This includes shareholders´ equity whether these entities own any revaluable fixed assets or not.
The monetary economy can be totally eroded like in the case of the Zimbabwe Dollar, not simply as a result of hyperinflation, but, as a result of a monetary meltdown after a period of severe hyperinflation. Hyperinflation is defined by Cagan as 50% monthly inflation and in International Financial Reporting Standards as cumulative inflation approaching or equal to 100% over three years; i.e. 26% annual inflation for three years in a row. The IFRS definition is followed in this book. Severe hyperinflation is normally the final stage of a devastating hyperinflationary spiral with a continuously super-increasing rate of hyperinflation when hyperinflation reaches millions of percent per annum. Exchangeability of the monetary unit, under those conditions, becomes limited to very few or just one single foreign currency like in the case of the Zimbabwe where the Zimbabwe Dollar only had exchangeability with the British Pound via the Old Mutual Implied Rate as derived from continued trade in Old Mutual shares on the Zimbabwe Stock Exchange even during severe hyperinflation. A monetary meltdown takes place when a monetary unit stops having exchangeability with all foreign currencies normally after, first, a period of hyperinflation and then a period of severe hyperinflation.
Hyperinflation only erodes the real value of the monetary unit extremely rapidly. Hyperinflation has no effect on the real value of non-monetary items. All non-monetary items (variable and constant items) maintain their real values during hyperinflation when they are updated (measured in units of constant purchasing power) daily in terms of a daily parallel rate (a black market or street rate) normally the daily unofficial US Dollar or other hard currency exchange rate or a daily non-monetary index normally almost totally based on the daily US Dollar exchange rate as Brazil did during 30 years of very high and hyperinflation.
The stable measuring unit assumption (Historical Cost Accounting) – not hyperinflation – unknowingly, unnecessarily and unintentionally erodes the real value of constant real value non-monetary items, e.g. salaries, wages, rents, shareholders´ equity, trade debtors, trade creditors, etc. not maintained constant as fast as hyperinflation erodes the real value of the local currency and other monetary items, e.g. loans stated in the local currency. A monetary meltdown erodes all real value only in the monetary economy; i.e. in the local currency money supply.
Hyperinflation is not always stopped with first a period of severe hyperinflation in the final stage and then a complete monetary meltdown. Hyperinflation was successfully overcome by various countries, e.g. Turkey, Brazil and Angola, without dollarization or a monetary meltdown. However, severe hyperinflation (hyperinflation at millions of per cent per annum) would normally lead to a complete monetary meltdown as happened in Zimbabwe in 2008.
Brazil actually grew their non-monetary economy in real value during 30 years of very high and hyperinflation of up to 2000 per cent per annum from 1964 to 1994 and never had severe hyperinflation followed by a complete monetary meltdown at the end. Brazil managed to have positive GDP growth during 30 years of very high and hyperinflation because the various governments during those three decades supplied the population with a daily non-monetary index based almost entirely on the daily US Dollar exchange rate with their monetary unit which was used to update all non-monetary items (variable and constant real value non-monetary items), e.g. goods, services, equity, trade debtors, trade creditors, salaries, wages, taxes, etc., in the economy daily.
Brazil would not have been able to do that if they had applied the IASB´s IAS 29 Financial Reporting in Hyperinflationary Economies simply because IAS 29 does not provide for continuous daily updating of all non-monetary items during hyperinflation. IAS 29 was authorized in 1989. IAS 29 does not provide for continuous daily updating in terms of the US Dollar parallel rate or a Brazilian-style daily index rate. IAS 29 simply requires restatement of Historical Cost and Current Cost financial statements during hyperinflation applying the monthly Consumer Price Index at the end of the reporting period (monthly, quarterly, six monthly or annual) - generally available a month or two months after the current month - to make these financial statements more useful. It is not the intention of IAS 29 to, and in its current form it cannot, stop the continuous daily rapid erosion of the real value of constant real value non-monetary items as Brazil did for 30 years of high and hyperinflation generating positive economic growth.
This daily very rapid erosion of constant items is caused, not by hyperinflation, but, by the implementation of the stable measuring unit assumption (HCA) during hyperinflation. Applying the monthly CPI a month or two months after the current month is very ineffective during hyperinflation as far as the constant real value of salaries, wages, rentals, equity, trade debtors, trade creditors, positive economic growth, economic stability, the maintenance of internal demand and the continuous daily maintenance of the constant real value of these items are concerned. All non-monetary items (variable and constant items) have to be updated daily in terms of the parallel US Dollar rate or a Brazilian-style daily index rate in order to maintain the real economy relatively stable during hyperinflation in the monetary unit. That is financial capital maintenance in units of constant purchasing power during hyperinflation as originally authorized in IFRS in the Framework (1989), Par 104 (a).
The Framework (1989), Par. 104 (a) states:
Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power.
The original Framework (1989), Par 104 (a) authorizes financial capital maintenance in units of constant purchasing power during low inflation and deflation (Constant Item Purchasing Power Accounting - CIPPA) under which only constant real value non-monetary items (not variable real value non-monetary items) are measured in units of constant purchasing power by applying the monthly change in the annual CPI during low inflation and deflation. It is also applicable during hyperinflation (Constant Purchasing Power Accounting - CPPA) where under all non-monetary items - constant and variable real value non-monetary items - are updated daily in terms of the US Dollar parallel rate or a Brazilian-style daily index rate. IFRS authorize financial capital maintenance in units of constant purchasing power at all levels of inflation and deflation.
The stable measuring unit assumption (HCA or financial capital maintenance in nominal monetary units, also originally authorized in IFRS in the Framework (1989), Par 104 a ) assumes, in principle, that there was, is and never ever will be inflation, deflation or hyperinflation as far as the valuation of constant real value non-monetary items never maintained constant are concerned. The stable measuring unit assumption (HCA) assumes, in principle, that money was forever in the past, is and will always in the future be perfectly stable under all levels of inflation, hyperinflation and deflation.
Various authoritative commentators in the accounting profession are requesting a fundamental revision of IAS 29.
Severe hyperinflation is defined as a period at the end of completely uncontrolled hyperinflation when exchangeability between the hyperinflationary monetary unit and most relatively stable foreign currencies does not exist. However, at least one exchangeability has to exist for prices to be established in the hyperinflationary monetary unit; i.e. for hyperinflation to exist. Severe hyperinflation is only possible when there is exchangeability with at least one relatively stable foreign currency in order for prices to continue to be set in the hyperinflationary monetary unit in terms of this final exchangeability. The one exchange rate that lasted till the end of hyperinflation in Zimbabwe was the Old Mutual Implied Rate (OMIR).
The ratio of the Old Mutual share price in Harare to that in London equals the Zimbabwe dollar/sterling exchange rate. p8 1
Severe hyperinflation stops the moment exchangeability between the currency and all foreign currencies does not exist.
Zimbabwe’s hyperinflation came to an abrupt halt. The trigger was an intervention by the Reserve Bank of Zimbabwe. On November 20, 2008, the Reserve Bank’s governor, Dr. Gideon Gono, stated that the entire economy was “being priced via the Old Mutual rate whose share price movements had no relationship with economic fundamentals, let alone actual corporate performance of Old Mutual itself” (Gono 2008: 7–8). In consequence, the Reserve Bank issued regulations that forced the Zimbabwe Stock Exchange to shut down. This event rapidly cascaded into a termination of all forms of non-cash foreign exchange trading and an accelerated death spiral for the Zimbabwe dollar. Within weeks the entire economy spontaneously “dollarized” and prices stabilized. p 9-10 2
There was severe hyperinflation in Zimbabwe while there was exchangeability (prices could still be set in the ZimDollar) with at least one relatively stable foreign currency – the British Pound in this case as it was made possible via the OMIR. When this last exchangeability stopped it was not possible to set prices in the ZimDollar anymore and severe hyperinflation stopped: no exchangeability means no hyperinflation. That was a monetary meltdown. The entire ZimDollar money supply had no value as from that moment. Monetary items expressed in the ZimDollar had no value as from that moment. All variable real value non-monetary items maintained their real values despite the monetary meltdown. The IASB authorized an addition to IAS 1 in 2011 to allow for the fair value valuation of all non-monetary items in the opening balance sheet of companies after severe hyperinflation and a monetary meltdown. Inflation and hyperinflation have no effect on the real value of non-monetary items.
No exchangeability with all relatively stable foreign currencies means no exchange rates which means no severe hyperinflation (no prices being set in the local currency) and vice versa: no exchange rate with any relatively stable foreign currency means no exchangeability which means no hyperinflation (no prices being set in the local currency).
No prices being set in the local currency means monetary meltdown: the total money supply and all money and other monetary items stated in the local currency have no value.
The real or non-monetary economy (houses, properties, buildings, infrastructure, inventories, finished goods, consumer goods, trademarks, goodwill, logos, copyright, trade debtors, trade creditors, royalties payable, royalties receivable, taxes payable, taxes receivable, all other non-monetary payables, all other non-monetary receivables, etc,) cannot be eroded by hyperinflation or a total monetary meltdown: inflation is always and everywhere a monetary phenomenon. Inflation and hyperinflation have no effect on the real value of non-monetary items.
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
The monetary economy (the total real value of a fiat money supply) can disappear completely. It happened three times during three months towards the end of hyperinflation in Yugoslavia. It happened at the end of hyperinflation in Zimbabwe in 2008, terminating hyperinflation in that country. Zimbabwe did not try hyperinflation again like Yugoslavia which has the distinction of having wiped out the real value of their entire monetary economy three times in three months. In Zimbabwe the economy dollarized spontaneously after a decision by the Reserve Bank of Zimbabwe to close the Zimbabwe Stock Exchange which stopped the Old Mutual Implied Rate being the final exchange rate of the Zimbabwe Dollar with a foreign currency – the British Pound. The Zimbabwean economy dollarized spontaneously after that because it was a sufficiently open economy right next to the stable South African and Botswana and other stable economies in the Southern African region. Those stable economies supplied the Zimbabwean economy with essential goods and services. Zimbabwe then had the opportunity to slowly recover from total monetary meltdown and the devastating effect of implementing the very erosive stable measuring unit assumption – the Historical Cost Accounting model - during hyperinflation as authorized in International Financial Reporting Standards and supported by Big Four accounting firms like PricewaterhouseCoopers. Zimbabwe spontaneously adopted a multi-currency dollarization model using the US Dollar, the Euro, the SA Rand, the British Pound and the Botswana Pula as relatively stable foreign currencies in the Zimbabwean economy.
The variable real value non-monetary item economy (property, plant, equipment, inventory, etc) cannot disappear because of wrong monetary policies. Inflation is always and everywhere a monetary phenomenon. Inflation and hyperinflation have no effect on the real value of non-monetary items. After monetary meltdown in Zimbabwe the properties, plant, equipment, raw materials, finished goods, etc., were still there. The variable item economy can be destroyed by natural disasters like earth quakes and tsunamis and by man-made events like war.
The constant item economy (shareholders´ equity, trade debtors, trade creditors, salaries, wages, rentals, etc.) also cannot be eroded by inflation and hyperinflation because inflation and hyperinflation have no effect on the real value of non-monetary items: both variable and constant real value non-monetary items. However, the stable measuring unit assumption (i.e. the Historical Cost Accounting model or financial capital maintenance in nominal monetary units per se during inflation and hyperinflation) erodes the constant real non-monetary value of constant items not maintained constant during inflation and hyperinflation, e.g. trade debtors, trade creditors, salaries, wages, rentals, that portion of shareholder´s equity never maintained constant as a result of insufficient revaluable fixed assets (revalued or not), all other non-monetary payables and receivables, etc., at a rate equal to the annual rate of inflation or hyperinflation.
Equity is equal to net assets; i.e., the constant real non-monetary value of shareholders´ equity is equal to the constant real value of net assets. Under Constant Item Purchasing Power Accounting (CIPPA) the constant real non-monetary value of equity is automatically maintained constant in all entities that at least break even for an unlimited period of time (forever) during low inflation and deflation whether these entities own any revaluable fixed assets or not.
Only capital maintenance in units of constant purchasing power in terms of the daily US Dollar or other hard currency parallel rate or a daily Brazilian-style index under Constant Purchasing Power Accounting (CPPA) will automatically maintain the constant real value of constant items constant for an indefinite period of time in all entities that at least break even during hyperinflation. This includes shareholders´ equity whether these entities own any revaluable fixed assets or not.
The monetary economy can be totally eroded like in the case of the Zimbabwe Dollar, not simply as a result of hyperinflation, but, as a result of a monetary meltdown after a period of severe hyperinflation. Hyperinflation is defined by Cagan as 50% monthly inflation and in International Financial Reporting Standards as cumulative inflation approaching or equal to 100% over three years; i.e. 26% annual inflation for three years in a row. The IFRS definition is followed in this book. Severe hyperinflation is normally the final stage of a devastating hyperinflationary spiral with a continuously super-increasing rate of hyperinflation when hyperinflation reaches millions of percent per annum. Exchangeability of the monetary unit, under those conditions, becomes limited to very few or just one single foreign currency like in the case of the Zimbabwe where the Zimbabwe Dollar only had exchangeability with the British Pound via the Old Mutual Implied Rate as derived from continued trade in Old Mutual shares on the Zimbabwe Stock Exchange even during severe hyperinflation. A monetary meltdown takes place when a monetary unit stops having exchangeability with all foreign currencies normally after, first, a period of hyperinflation and then a period of severe hyperinflation.
Hyperinflation only erodes the real value of the monetary unit extremely rapidly. Hyperinflation has no effect on the real value of non-monetary items. All non-monetary items (variable and constant items) maintain their real values during hyperinflation when they are updated (measured in units of constant purchasing power) daily in terms of a daily parallel rate (a black market or street rate) normally the daily unofficial US Dollar or other hard currency exchange rate or a daily non-monetary index normally almost totally based on the daily US Dollar exchange rate as Brazil did during 30 years of very high and hyperinflation.
The stable measuring unit assumption (Historical Cost Accounting) – not hyperinflation – unknowingly, unnecessarily and unintentionally erodes the real value of constant real value non-monetary items, e.g. salaries, wages, rents, shareholders´ equity, trade debtors, trade creditors, etc. not maintained constant as fast as hyperinflation erodes the real value of the local currency and other monetary items, e.g. loans stated in the local currency. A monetary meltdown erodes all real value only in the monetary economy; i.e. in the local currency money supply.
Hyperinflation is not always stopped with first a period of severe hyperinflation in the final stage and then a complete monetary meltdown. Hyperinflation was successfully overcome by various countries, e.g. Turkey, Brazil and Angola, without dollarization or a monetary meltdown. However, severe hyperinflation (hyperinflation at millions of per cent per annum) would normally lead to a complete monetary meltdown as happened in Zimbabwe in 2008.
Brazil actually grew their non-monetary economy in real value during 30 years of very high and hyperinflation of up to 2000 per cent per annum from 1964 to 1994 and never had severe hyperinflation followed by a complete monetary meltdown at the end. Brazil managed to have positive GDP growth during 30 years of very high and hyperinflation because the various governments during those three decades supplied the population with a daily non-monetary index based almost entirely on the daily US Dollar exchange rate with their monetary unit which was used to update all non-monetary items (variable and constant real value non-monetary items), e.g. goods, services, equity, trade debtors, trade creditors, salaries, wages, taxes, etc., in the economy daily.
Brazil would not have been able to do that if they had applied the IASB´s IAS 29 Financial Reporting in Hyperinflationary Economies simply because IAS 29 does not provide for continuous daily updating of all non-monetary items during hyperinflation. IAS 29 was authorized in 1989. IAS 29 does not provide for continuous daily updating in terms of the US Dollar parallel rate or a Brazilian-style daily index rate. IAS 29 simply requires restatement of Historical Cost and Current Cost financial statements during hyperinflation applying the monthly Consumer Price Index at the end of the reporting period (monthly, quarterly, six monthly or annual) - generally available a month or two months after the current month - to make these financial statements more useful. It is not the intention of IAS 29 to, and in its current form it cannot, stop the continuous daily rapid erosion of the real value of constant real value non-monetary items as Brazil did for 30 years of high and hyperinflation generating positive economic growth.
This daily very rapid erosion of constant items is caused, not by hyperinflation, but, by the implementation of the stable measuring unit assumption (HCA) during hyperinflation. Applying the monthly CPI a month or two months after the current month is very ineffective during hyperinflation as far as the constant real value of salaries, wages, rentals, equity, trade debtors, trade creditors, positive economic growth, economic stability, the maintenance of internal demand and the continuous daily maintenance of the constant real value of these items are concerned. All non-monetary items (variable and constant items) have to be updated daily in terms of the parallel US Dollar rate or a Brazilian-style daily index rate in order to maintain the real economy relatively stable during hyperinflation in the monetary unit. That is financial capital maintenance in units of constant purchasing power during hyperinflation as originally authorized in IFRS in the Framework (1989), Par 104 (a).
The Framework (1989), Par. 104 (a) states:
Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power.
The original Framework (1989), Par 104 (a) authorizes financial capital maintenance in units of constant purchasing power during low inflation and deflation (Constant Item Purchasing Power Accounting - CIPPA) under which only constant real value non-monetary items (not variable real value non-monetary items) are measured in units of constant purchasing power by applying the monthly change in the annual CPI during low inflation and deflation. It is also applicable during hyperinflation (Constant Purchasing Power Accounting - CPPA) where under all non-monetary items - constant and variable real value non-monetary items - are updated daily in terms of the US Dollar parallel rate or a Brazilian-style daily index rate. IFRS authorize financial capital maintenance in units of constant purchasing power at all levels of inflation and deflation.
The stable measuring unit assumption (HCA or financial capital maintenance in nominal monetary units, also originally authorized in IFRS in the Framework (1989), Par 104 a ) assumes, in principle, that there was, is and never ever will be inflation, deflation or hyperinflation as far as the valuation of constant real value non-monetary items never maintained constant are concerned. The stable measuring unit assumption (HCA) assumes, in principle, that money was forever in the past, is and will always in the future be perfectly stable under all levels of inflation, hyperinflation and deflation.
Various authoritative commentators in the accounting profession are requesting a fundamental revision of IAS 29.
Severe hyperinflation is defined as a period at the end of completely uncontrolled hyperinflation when exchangeability between the hyperinflationary monetary unit and most relatively stable foreign currencies does not exist. However, at least one exchangeability has to exist for prices to be established in the hyperinflationary monetary unit; i.e. for hyperinflation to exist. Severe hyperinflation is only possible when there is exchangeability with at least one relatively stable foreign currency in order for prices to continue to be set in the hyperinflationary monetary unit in terms of this final exchangeability. The one exchange rate that lasted till the end of hyperinflation in Zimbabwe was the Old Mutual Implied Rate (OMIR).
The ratio of the Old Mutual share price in Harare to that in London equals the Zimbabwe dollar/sterling exchange rate. p8 1
Severe hyperinflation stops the moment exchangeability between the currency and all foreign currencies does not exist.
Zimbabwe’s hyperinflation came to an abrupt halt. The trigger was an intervention by the Reserve Bank of Zimbabwe. On November 20, 2008, the Reserve Bank’s governor, Dr. Gideon Gono, stated that the entire economy was “being priced via the Old Mutual rate whose share price movements had no relationship with economic fundamentals, let alone actual corporate performance of Old Mutual itself” (Gono 2008: 7–8). In consequence, the Reserve Bank issued regulations that forced the Zimbabwe Stock Exchange to shut down. This event rapidly cascaded into a termination of all forms of non-cash foreign exchange trading and an accelerated death spiral for the Zimbabwe dollar. Within weeks the entire economy spontaneously “dollarized” and prices stabilized. p 9-10 2
There was severe hyperinflation in Zimbabwe while there was exchangeability (prices could still be set in the ZimDollar) with at least one relatively stable foreign currency – the British Pound in this case as it was made possible via the OMIR. When this last exchangeability stopped it was not possible to set prices in the ZimDollar anymore and severe hyperinflation stopped: no exchangeability means no hyperinflation. That was a monetary meltdown. The entire ZimDollar money supply had no value as from that moment. Monetary items expressed in the ZimDollar had no value as from that moment. All variable real value non-monetary items maintained their real values despite the monetary meltdown. The IASB authorized an addition to IAS 1 in 2011 to allow for the fair value valuation of all non-monetary items in the opening balance sheet of companies after severe hyperinflation and a monetary meltdown. Inflation and hyperinflation have no effect on the real value of non-monetary items.
No exchangeability with all relatively stable foreign currencies means no exchange rates which means no severe hyperinflation (no prices being set in the local currency) and vice versa: no exchange rate with any relatively stable foreign currency means no exchangeability which means no hyperinflation (no prices being set in the local currency).
No prices being set in the local currency means monetary meltdown: the total money supply and all money and other monetary items stated in the local currency have no value.
The real or non-monetary economy (houses, properties, buildings, infrastructure, inventories, finished goods, consumer goods, trademarks, goodwill, logos, copyright, trade debtors, trade creditors, royalties payable, royalties receivable, taxes payable, taxes receivable, all other non-monetary payables, all other non-monetary receivables, etc,) cannot be eroded by hyperinflation or a total monetary meltdown: inflation is always and everywhere a monetary phenomenon. Inflation and hyperinflation have no effect on the real value of non-monetary items.
Nicolaas Smith
Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.
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