HCA is not an appropriate accounting policy

HCA is not an appropriate accounting policy


Auditors state in the audit report that the directors´ responsibility for the financial statements includes selecting and applying appropriate accounting policies. The audit report also normally states under the Auditors´ Responsibility that an audit includes evaluating the appropriateness of accounting policies used in a company. So, both the directors and the auditors have a responsibility with regards to the appropriateness of accounting policies for a company.

The implementation of the very erosive stable measuring unit assumption which is based on a fallacy and financial capital maintenance in nominal monetary units per se which is a fallacy during inflation and deflation means that the use of the HCA model is – in principle - not an appropriate accounting policy for companies during inflation and deflation.

The IASB, on the one hand, agrees that the stable measuring unit assumption and financial capital maintenance in nominal monetary units per se are not appropriate accounting policies in hyperinflationary economies.

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

Very unfortunately, the IASB, on the other hand – in the same standard, authorizes and supports the use of the HCA model during hyperinflation:

“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

Big Four audit firms, e.g. PricewaterhouseCoopers, also support the use of HCA 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.

When it is clearly demonstrated and the board of directors knows that a company’s HC accounting policy - freely selected by the board - continuously erodes a significant amount of the existing constant real non-monetary value of the company´s Shareholders´ Equity as a result of the company’s implementation of the very erosive stable measuring unit assumption when the company assumes that it would be for an unlimited period of time during indefinite inflation, then the traditional HCA model is , in principle, not an appropriate accounting policy. When the board knows that financial capital maintenance in units of constant purchasing power during low inflation (CIPPA) - as approved by the IASB in the original Framework (1989), Par 104 (a) - is an IFRS–compliant alternative freely available to the company and when the board knows that CIPPA would automatically stop the unnecessary erosion of existing constant real non–monetary value in existing constant items never maintained constant for an indefinite period of time in all entities that at least break even during low inflation – ceteris paribus - then the traditional HCA model is , in principle, not an appropriate accounting policy.

The principle of financial capital maintenance in units of constant purchasing power during low inflation and deflation has been subjected to a “thorough, open, participatory and transparent, due process” at the IASB, and elsewhere, before it was approved in the original Framework (1989), Par 104 (a) twenty two years ago. The principle is thus generally accepted in the accounting and auditing professions. However, the practice of financial capital maintenance in unit of constant purchasing power during low inflation and deflation (CIPPA) is not yet generally accepted sine the due process is not yet complete. Neither have accounting software packages been adapted for the implementation of CIPPA, nor has accounting personnel been trained to implement financial capital maintenance in units of constant purchasing power during low inflation and deflation, nor have audit procedures been adapted by auditors to audit companies implementing the Constant Item Purchasing Accounting model. That is: the due process is not yet complete for CIPPA.

Currently financial capital maintenance in units of constant purchasing power during low inflation and deflation (CIPPA) is thus an appropriate accounting policy in principle but is not yet generally implemented in practice. HCA is thus not an appropriate accounting policy, in principle, but, is generally implemented in practice. The current implementation of the HCA model is thus still an appropriate (very costly to the world economy) accounting policy, in practice, but not in principle. However, as soon as the practical implementation of financial capital maintenance in units of constant purchasing power accounting during low inflation and deflation (CIPPA) has passed proper due process; accounting software packages have been adapted to CIPPA; accounting personnel have been trained to implement CIPPA and audit procedures have been adapted by audit firms to audit companies implementing CIPPA, then the HCA model will certainly not be an appropriate accounting policy – in principle and in practice.

This will not happen overnight. As was stated in US FAS 89 in 1986:

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

and

“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.”

Any single entity can now implement CIPPA since non-monetary items have been properly split in variable and constant items since 2005.


Nicolaas Smith

Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Nine requirements for audited HC financial statement to fairly present an entity´s financial position

Nine requirements for audited HC financial statement to fairly present an entity´s financial position

Audited annual financial statements provided by companies which prepare them using the traditional Historical Cost Accounting model, i.e., when the board of directors choose to measure financial capital maintenance in nominal monetary units during low inflation and deflation instead of in units of constant purchasing power in terms of the IASB´ original Framework (1989), Par 104 (a), are compliant with IFRS, but, do not - in principle - fairly present the financial position of the companies.
The SA Companies Act, No 71 of 2008, Article 29.1 (b), for example, states:
“If a company provides any financial statements, including any annual financial statements, to any person for any reason, those statements must –

(b) present fairly the state of affairs and business of the company, and explain the transactions and financial position of the business of the company;”

Audited financial statements prepared in terms of the HCA model do not - in principle - fairly present the financial position of companies during low inflation when the directors do not:

(1) state in the annual financial statements that their choice of the traditional Historical Cost Accounting model which includes the very erosive stable measuring unit assumption, erodes the constant real value of constant real value non–monetary items never maintained constant at a rate equal to the annual rate of inflation;

(2) state that this includes the erosion of the constant real value of Shareholders´ Equity when the company does not have sufficient revaluable fixed assets that are or can be revalued via the Revaluation Reserve with an updated fair value equal to the updated original constant real non-monetary value of all contributions to Shareholders’ Equity under the HCA model during low inflation;

(3) state the percentage and updated amount of constant real non-monetary value of Shareholders´ Equity that are not being maintained constant; i.e., the percentage and updated amount of constant real non-monetary value of Shareholders´ Equity that are subject to constant real value erosion at a rate equal to the annual inflation rate because of the directors´ free choice, in terms of the original Framework (1989), Par 104 (a), to measure financial capital maintenance in nominal monetary units (which is a popular accounting fallacy since it is impossible per se during inflation) – i.e. their free choice to implement the very erosive stable measuring unit assumption during inflation - instead of automatically maintaining the constant real value of Shareholders´ Equity constant for an indefinite period of time in units of constant purchasing power (both methods being compliant with IFRS) when their companies at least break even – ceteris paribus.

(4) state the amount of updated constant real non-monetary value eroded during the last and previous financial year in Shareholders´ Equity and all other constant real value non–monetary items never maintained constant because of the directors´ free choice to implement the Historical Cost Accounting model;

(5) state the updated total amount of constant real non-monetary value eroded from the company’s inception to date in this manner in at least Shareholders´ Equity never maintained constant as described above;

(6) state the change in the updated constant real non-monetary value of Shareholders´ Equity if the directors should decide – as they are freely allowed to do at any time – to measure financial capital maintenance in units of constant purchasing power which would automatically maintain the constant purchasing power of Shareholders´ equity constant forever in entities that at least break even during inflation and deflation – ceteris paribus - instead of in nominal monetary units also authorized in IFRS in the original Framework (1989), Par 104 (a);

(7) state the directors´ estimate of the amount of constant real non-monetary value to be eroded by their free choice to implement the very erosive stable measuring unit assumption (which is based on the popular accounting fallacy - also approved by the IASB - that changes in the purchasing power of money are not sufficiently important during low inflation and deflation to require financial capital maintenance in units of constant purchasing power) during the following accounting year under the HC basis;

(8) state that the updated constant real non–monetary value calculated in (7) represents the amount of constant real non–monetary value the company would gain during the following accounting year and every year thereafter for an unlimited period of time as long as the company at least break even during inflation and deflation – ceteris paribus – when the directors choose to measure financial capital maintenance in units of constant purchasing power as authorized in IFRS in the original Framework (1989), Par 104 (a) - which they are free to choose any time they decide;

(9) state the directors´ reason(s) for freely choosing financial capital maintenance in constant real value eroding nominal monetary units which is a fallacy since it is impossible per se during inflation and deflation instead of in real value maintaining units of constant purchasing power which would automatically maintain the constant purchasing power of Shareholders´ Equity constant forever in all entities that at least break even during inflation and deflation – ceteris paribus.


Nicolaas Smith

Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Three concepts of capital maintenance under IFRS

Three concepts of capital maintenance under IFRS

IFRS authorized financial capital maintenance in units of constant purchasing power in the original Framework (1989), Par. 104 (a) which means that there are three concepts of capital maintenance authorized in IFRS since 1989.

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Nicolaas Smith

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Nominal financial capital maintenance concept commonly chosen

Nominal financial capital maintenance concept commonly chosen by entities in the world economy implementing the very erosive stable measuring unit assumption as it forms part of the HCA model responsible for hundreds of billion of US Dollars of erosion of constant item real value per annum in the world´s constant item economy.

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Nicolaas Smith

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No revaluable fixed assets required per se to automatically maintain capital constant forever

No revaluable fixed assets required per se to automatically maintain capital constant forever


A company’s capital is synonymous with its Net Assets or Shareholder´s Equity under a financial concept of capital such as invested money or invested purchasing power.

100% of the updated original constant real value of all contributions to Shareholders´ Equity have to be invested in revaluable fixed assets with an equivalent maintained fair value (revalued or with unrecorded hidden holding gains) in order not to erode any Shareholders´ Equity’s existing constant real non–monetary value during low inflation under the traditional Historical Cost Accounting model – i.e. measuring financial capital maintenance in nominal monetary units as implemented by most entities.

The existing constant real non–monetary value of that portion of existing shareholders´ equity not invested in revaluable fixed assets (revalued or not) is currently unknowingly, unintentionally and unnecessarily being eroded at a rate equal to the annual rate of inflation when the constant real value non–monetary item shareholders equity is measured in nominal monetary units, i.e. implementing the very erosive stable measuring unit assumption as done by most entities when they implement the HCA model for an unlimited period of time during indefinite low inflation.

Most entities do not meet the requirement to investment 100% of the updated original real value of all contributions to Shareholders´ Equity in revaluable fixed assets. Entities that possibly meet the 100% of the updated original real value of all contributions to shareholder´s equity requirement are hotel, hospital, property and similar companies. In practice this means that the real value of Retained Earnings never maintained constant of most companies and banks are unknowingly, unintentionally and unnecessarily being eroded at a rate equal to the annual rate of inflation by entities implementing the IFRS–approved traditional HCA model during low inflation.

Implementing the IFRS–authorized alternative, namely, financial capital maintenance in units of constant purchasing power during low inflation and deflation (CIPPA) as authorized in 1989 in the original Framework (1989), Par 104 (a), automatically stops this unknowing, unintentional and unnecessary erosion by the implement of the stable measuring unit assumption forever at all levels of inflation in all entities that at least break even – ceteris paribus – whether they own revaluable fixed assets or not and without the requirement of more money or more Retained Earnings just to maintain the existing constant real non–monetary value of existing Shareholders´ Equity constant.

No–one will disagree that inflation and not the stable measuring unit assumption erodes the real value of money and other monetary items in the monetary economy despite the fact that central banks and monetary authorities regard the erosion of from 2 to 6% per annum of the real value of the monetary unit as the achievement and maintenance of “price stability” in the economic system. Obviously it is not price stability at all. It is 2 to 6% per annum away from price stability. It is the central bank´s choice of “price stability”: their definition of “price stability”. Absolute price stability is a year–on–year increase of zero percent in the Consumer Price Index. Positive annual inflation of up to 2% is a high degree of price stability. It is not absolute price stability.

The IASB only requires the implementation of IAS 29 Financial Reporting in Hyperinflationary Economies during hyperinflation. The IASB defines hyperinflation as cumulative inflation over three years approaching or equal to 100%, i.e. annual inflation of 26% for three years in a row. This means that central banks could define “price stability” as annual inflation at any rate from 0.001 to 25.99% per annum.


Nicolaas Smith

Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

The difference between deflation, disinflation and inflation

The difference between deflation, disinflation and inflation


Deflation is a sustained absolute decrease in the general price level resulting in a sustained increase in the real value of the monetary unit (money) and other monetary items.

The functional currency is the currency of the primary economic environment in which an entity operates. It is normally the national or regional currency or monetary unit and monetary unit of account in an economy or monetary union like the Rand in South Africa and the Euro in the European Monetary Union. In dollarized economies the functional currency is generally a relatively stable currency of another (generally the US) national or regional economy. The German Mark was also used in the past for the same purpose.

Deflation only happens below zero percent annual inflation. Deflation is not one or two months of month–on–month negative inflation during a twelve month period when it does not result in an absolute year–on–year decrease in the general price level. Deflation is the opposite of annual inflation. Deflation is negative annual inflation.

Money and other monetary items are worth more all the time during deflation as opposed to being worth less all the time during inflation. Inflation erodes the real value of money and other monetary items over time. Deflation creates more real value in money and other monetary items over time.

Disinflation is simply lower inflation. Disinflation is a decrease in the rate of inflation. Prices in an economy are still rising during disinflation, but at a slower rate. The general price level still rises, but, at a slower rate resulting in a continued, but, lower rate of real value erosion in money and other monetary items.

Disinflation is a lowering of the rate of increase in the general price level. A lowering of the absolute value of the general price level is deflation.

Deflation means the general price level is not increasing at all, but, actually decreasing continuously and money and other monetary items are worth more all the time. Deflation causes an increase in the real value of money and other monetary items.

Inflation erodes the real value of money. Disinflation erodes the real value of money at a slower rate. Deflation creates more real value in money.

Inflation is a sustained increase in the general price level. Disinflation is a slower sustained increase in the general price level. Deflation is a sustained decrease in the general price level.

Disinflation happens, for example, after a period of higher inflation in what are normally considered low inflationary economies and often is initially popularly confused with deflation. During disinflation many prominent prices, for example, oil, fuel, property and food prices are falling, but, the general price level is still actually rising, albeit at a slower rate than during normal low inflation. When the slowing annual inflation rate (slowing increase in general price level) moves lower and lower it eventually gets to a zero percent annual rate. When the general price level moves even lower past zero percent, the absolute value of the general price level decrease; i.e. the economy switches over from inflation to deflation: not just a slower increase in the generally increasing price level as during disinflation but actually a sustained decrease in the absolute value of the general price level below zero percent inflation which causes an increase in the real value of money and other monetary items: deflation.

Countries, excluding Japan, have little experience of deflation. Deflation is generally regarded as a very serious economic problem that everyone is trying to avoid at all costs especially after what happened during the Great Depression. Japan, however, has been moving in and out of deflation over the last 15 years or more.


Nicolaas Smith

Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

The Framework applies

The Framework applies
 

Companies listed on stock exchanges have to prepare primary financial reports in terms of the IASB´s International Financial Reporting Standards.  IFRS are Standards, Interpretations and the definitions, recognition criteria and measurement concepts for assets, liabilities, income and expenses in the IASB´s Framework in the absence of a Standard or an Interpretation that specifically applies to a transaction.

“In the absence of a Standard or an Interpretation that specifically applies to a transaction, management must use its judgement in developing and applying an accounting policy that results in information that is relevant and reliable. In making that judgement, IAS 8.11 requires management to consider the definitions, recognition criteria, and measurement concepts for assets, liabilities, income, and expenses in the Framework. This elevation of the importance of the Framework was added in the 2003 revisions to IAS 8." IAS Plus, Deloitte. Date: 21^st March, 2010 http://www.iasplus.com/standard/framewk.htm

IAS 8.11:

“In making the judgement, management shall refer to, and consider the applicability of, the following sources in descending order:

(a) the requirements and guidance in Standards and Interpretations dealing with similar and related issues; and

(b) the definitions, recognition criteria and measurement concepts for assets, liabilities, income and expenses in the Framework.”

There are no specific IFRS relating to the valuation of the constant real value non–monetary items Issued Share Capital, Retained Earnings, most other items in Shareholders Equity, the concepts of capital, the concepts of capital maintenance and the determination of profit or loss. The definitions, the concepts for their measurement and the criteria for their recognition in the Framework are thus applicable in terms of IAS 8.11.

A fundamental attribute of the traditional Historical Cost Accounting model which  boards of directors select when they decide on behalf of companies to measure financial capital maintenance in nominal monetary units (a generally accepted accounting fallacy not yet extinct) in terms of the IASB´s original Framework (1989), Par 104 (a) is that it unknowingly, unnecessarily and unintentionally erodes the existing constant real non–monetary value of that portion of shareholders´ equity never maintained constant as a result of insufficient revaluable fixed assets (revalued or not) with the implementation of the very erosive stable measuring unit assumption during low inflation.

The implementation of the HCA model, on the other hand, unnecessarily, unknowingly and unintentionally creates real value in constant real value non–monetary items never maintained constant (not decreased at a rate equal to the annual rate of deflation) as a result of the implementation of the real value creating stable measuring unit assumption during deflation (recently mainly in Japan).

Nicolaas Smith

Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Objectives of CIPPA

Objectives of CIPPA


The first objective of this book is to undeniably demonstrate that the implementation of the very erosive stable measuring unit assumption (which is based on the fallacy that changes in the purchasing power of the monetary unit of account – money – is not sufficiently important to require financial capital maintenance in units of constant purchasing power during low inflation and deflation) as applied as part of the traditional generally accepted globally implemented HCA model, unnecessarily, unknowingly and unintentionally erodes the real value of existing constant real value non–monetary items never maintained constant, e.g. that portion of shareholders´ equity never maintained constant as a result of insufficient revaluable fixed assets (revalued or not) during low inflation, amounting to hundreds of billions of US Dollars each and every year in the world´s constant item economy because it is freely chosen to measure financial capital maintenance in nominal monetary units (which is a fallacy since it is impossible to maintain the real value of financial capital constant in nominal monetary units per se during inflation and deflation) as authorized in IFRS in the original Framework (1989), Par 104 (a).

The second objective of this book to show that measuring financial capital maintenance in real value maintaining units of constant purchasing power per se during low inflation and deflation (CIPPA) – also authorized in IFRS in the original Framework (1989), Par 104 (a) – which is applicable in the absence of specific IFRS, is the only way to automatically maintain the existing constant real non–monetary value of all existing constant items constant forever in all entities that at least break even whether they own revaluable fixed assets or not – ceteris paribus.


Nicolaas Smith

Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

CIPPA financial statements fairly present an entity´s financial position (where applicable)

CIPPA financial statements fairly present an entity´s financial position (where applicable)

Balance sheet constant real value non–monetary items are valued under HCA using the traditional HC model in terms of which the very erosive stable measuring unit assumption is applied. This unknowingly, unintentionally and unnecessarily erodes the real values of constant real value non–monetary items never maintained constant at a rate equal to the annual rate of inflation. Unknowingly, unintentionally and unnecessarily the wrong choice is made. Since everyone does it, since it is the traditional, generally accepted choice and since it is also authorized in the original Framework (1989), Par 104 (a) which is applicable in the absence of specific IFRS, it results in the Historical Cost Mistake.

On the other hand, the exact opposite is also generally accepted: it is acknowledged that inflation is eroding the real value of the depreciating monetary unit used as the depreciating monetary medium of exchange and depreciating monetary unit of account and some, not all, constant real value non–monetary income statement items like salaries, wages, rentals, etc. are updated or measured in units of constant purchasing power on an annual basis by increasing their nominal values at a rate at least equal to the annual rate of inflation thus keeping their non–monetary real values constant over the time period in question.

So, on the one hand it is currently acknowledged that the nominal values of some (not all) income statement items, e.g. salaries, wages, rentals, etc., have to be indexed or updated by means of the CPI because the stable measuring unit assumption cannot be applied and, on the other hand, it is assumed – at exactly the same time and during exactly the same period – that the constantly depreciating monetary unit is perfectly stable, but, only for the valuation of balance sheet constant real value non–monetary items like retained earnings, issued share capital, capital reserves, provisions, other shareholder equity items, trade debtors, trade creditors, etc. as well as for the other income statement items not updated. The constant real values of all constant items never maintained constant during HCA are thus unknowingly, unintentionally and unnecessarily eroded at a rate equal to the annual rate of inflation amounting of hundreds of billions of US Dollars in the world´s constant item economy, year in year out, decade after decade when the stable measuring unit assumption is implemented during inflation.

Companies listed on stock exchanges comply with IFRS. If a country should enter into hyperinflation they would implement IAS 29. They would then apply the CPPA inflation accounting model and restate all income statement items plus balance sheet constant real value non–monetary items as well as all variable real value non-monetary items (only required during hyperinflation) in their period-end HC or CC financial statements by means of the period-end CPI in an attempt to maintain these items´ real values during hyperinflation. They would restate, for example, issued share capital and retained earnings for all listed companies and banks from the dates these items were originally contributed or came about and attempt to maintain their existing constant real non–monetary values constant, but, only for as long as the economy is in hyperinflation.

When the economy is not in hyperinflation any more they would stop implementing IAS 29 and generally go back to the real value eroding HC model (as Brazil did in 1994 and Turkey did in 2005) and again erode the existing constant real non-monetary values of all constant real value non–monetary items never maintained constant (e.g. the portion of shareholders´ equity not maintained constant with sufficient revaluable fixed assets under HCA) at a rate equal to the annual rate of inflation when they again implement the stable measuring unit assumption during low inflation. When they choose CIPPA it automatically maintains the constant real value of all constant items constant forever in all entities that at least break even during inflation and deflation – ceteris paribus.

Auditors would certify – when applicable – that a company´s financial statements fairly present the financial position of the company and comply with IFRS when boards of directors choose to implement CIPPA, i.e. when they choose to continuously measure financial capital maintenance in units of constant purchasing power during low inflation and deflation as authorized in the original Framework (1989), Par 104 (a).

Nicolaas Smith

Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Salaries and wages maintained constant during low inflation

Salaries and wages maintained constant during low inflation

The annual indexation or measurement in units of constant purchasing power of salaries and wages in a low inflationary environment is a blessing to users since it enables them to maintain the real values of salaries and wages constant during inflation. This often involves labour union negotiations with employer bodies. They usually agree on an annual increase in the depreciating monetary unit payment values for constant real value non–monetary salaries and wages to maintain their purchasing power constant on an annual basis in a low inflationary economy where the real value of the monetary unit of account is continuously being eroded by inflation. The nominal values of constant real value non–monetary salaries and wages are thus updated or indexed in terms of the annual CPI to cover or compensate for at least the expected annual rate of erosion in the real value of the depreciating monetary unit which is the depreciating monetary unit of account for accounting purposes as well as the depreciating monetary medium of exchange for payment purposes in the economy during low inflation. The period is normally for the year ahead. They often agree on an additional percentage increase for increases in productivity and / or for social security reasons.

Both parties to the salary and wage negotiations agree that constant real value non–monetary salaries and wages cannot be accounted or valued at traditional nominal Historical Cost implementing the very erosive stable measuring unit assumption whereby it is simply assumed that changes in the purchasing power of depreciating money are not sufficiently important to require measurement in units of constant purchasing power during inflation. Workers would not receive the constant purchasing power values of their salaries and wages when fixed HC salaries and wages are paid in depreciated monetary units whose real values are continuously being eroded by inflation. They would not receive the full constant real non–monetary values of their salaries and wages.

“Inflation is always and everywhere a monetary phenomenon.” Milton Friedman.

Inflation can only erode the real value of the depreciating monetary medium of exchange (depreciating money, i.e. the depreciating monetary unit inside an inflationary economy) and other depreciating monetary items.

Inflation has no effect on the real values of salaries and wages which are constant real value non–monetary items. Inflation can only erode the real value of money and other monetary items – nothing else. Inflation has no effect on the real value of non-monetary items. The very erosive stable measuring unit assumption implemented as part of the traditional HCA model when salaries and wages are fixed over time, unknowingly, unintentionally and unnecessarily erodes the real value of salaries and wages when they are not measured in units of constant purchasing power in terms of the monthly CPI during low inflation.

Inflation cannot erode the real value of non–monetary items. Inflation can only erode the real value of the unstable monetary medium of exchange (the unstable monetary unit – unstable money) used to transfer the constant real non–monetary values of salaries and wages from the employer to the employee.

“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 erosion at a rate equal to the annual rate of inflation of all constant real value non–monetary items never maintained constant under HCA during inflation automatically stops forever the very moment the Boards of Directors of companies implement the IFRS–approved financial capital maintenance in units of constant purchasing power model (CIPPA) in all entities that at least break even during low inflation – all else being equal. The choice is theirs. The power to stop the erosion of real value in the real economy is in their hands – as authorized in IFRS since 1989 in the IASB´s original Framework (1989), Par 104 (a) which is applicable in the absence of specific IFRS. It is the choice of the accounting model (CIPPA or HCA) and not inflation that automatically maintains or generally erodes the existing constant real non–monetary value of constant real value non–monetary items never maintained constant in low inflationary economies.

The constant real non–monetary values of salaries and wages expressed in terms of the depreciating unstable monetary unit as the depreciating unstable monetary unit of account are presently being maintained constant on an annual basis in the first month of payment in low inflationary economies when their nominal monetary values are indexed or updated by means of the CPI in low inflationary environments. This happens not because of a lowering of inflation, but because of employers and trade unions valuing salaries and wages in units of constant purchasing power on an annual basis instead of the Historical Cost measurement basis for this particular purpose. Salaries and wages are then normally kept fixed for the 12 month period of the accounting year; i.e. they are not updated or measured in units of constant purchasing power on a monthly basis. The stable measuring unit assumption is generally applied with monthly payments after the annual update.

If the parties to the salary and wage determination process were to agree to value salaries and wages annually at fixed Historical Cost (in nominal monetary units) – like Iceland recently decided to freeze salaries because of their financial crisis –  then their annual constant real non–monetary values are eroded at a rate equal to the annual rate of inflation because constant real value non–monetary salaries and wages are expressed in term of the depreciating monetary unit of account and are normally paid in depreciating monetary units. Salaries and wages are not depreciating monetary items. They are constant real value non–monetary items on an annual and on a monthly basis. They are, however, - after the annual update - normally paid monthly in depreciating money during low inflation.

“Income Statement

This standard requires that all items in the income statement are expressed in terms of the measuring unit current at the balance sheet date.” IAS 29, Par 26.

All items in the income statement are constant real value non–monetary items to be continuously updated by applying the monthly change in the annual CPI during low inflation and deflation. The real values of salaries and wages would thus not be eroded by inflation if they were valued in nominal monetary units (fixed salaries and wages), but by the choice of the measurement basis, namely, Historical Cost, i.e. in nominal monetary units, which means the implementation of the very erosive stable measuring unit assumption whereby it is considered that the continuous erosion of the purchasing power of the monetary unit is not sufficiently important during low inflation in order to require the indexation or measurement in units of constant purchasing power of the existing constant real values of constant real value non–monetary salaries and wages by means of the monthly CPI in order to maintain their existing constant real non–monetary values constant. What is done, in essence, is it is assumed that the constantly depreciating monetary unit of account – the depreciating monetary unit – is perfectly stable when the stable measuring unit assumption is applied. It is assumed, in principle, that the depreciating monetary unit is perfectly stable whenever the stable measuring is implemented.

Nicolaas Smith.

  Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

CIPPA is not inflation accounting

CIPPA is not inflation accounting


This project is not about inflation accounting during high and hyperinflationary periods.

This project is not about implementing 1970–style inflation accounting in low inflationary economies by inflation–adjusting all non–monetary items equally by means of the CPI.

The following peer reviewed article Financial Statements, Inflation & The Audit Report I wrote was published in SAICA´s journal– Accountancy SA – in September 2007.

“In most countries, primary financial statements are prepared on the historical cost basis of accounting without regard either to changes in the general level of prices or to increases in specific prices of assets held, except to the extent that property, plant and equipment and investments may be revalued.” ¹


The International Accounting Standards Board (IASB) only recognizes two economic items:


1.) Monetary items defined as “money held and items to be received or paid in money;” and


2.) Non–monetary items: All items that are not monetary items.


Non–monetary items include variable real value non–monetary items valued, for example, at fair value, market value, present value, net realizable value or recoverable value.


They also include Historical Cost items based on the stable measuring unit assumption.


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.” ²


This makes these Historical Cost items equal to monetary items in the case of companies´ Retained Income balances and the issued share capital values of companies with no well located and well maintained land and/or buildings or other variable real value non–monetary items able to be revalued at least equal to the original real value of each contribution of issued share capital.


Retained Income is a constant real value non–monetary item valued at Historical Cost which makes it subject to the destruction of its real value by inflation – exactly the same as in cash.


It is an undeniable fact that South Africa’s monetary unit’s internal real value is constantly being destroyed by inflation in the case of our low inflationary economy, but this is not considered important enough to adjust the real values of constant real value non–monetary items in the financial statements – the universal stable measuring unit assumption.


The combination of the Historical Cost Accounting model and low inflation is thus indirectly responsible for the destruction of the real value of Retained Income equal to the annual average value of Retained Income times the average annual rate of inflation. This value is easy to calculate in the case of each and every company in South Africa with Retained Income. It is also possible to calculate this value for all companies in the world economy with Retained Income.


It is broadly known that the destruction of the internal real value of the monetary unit of account is a very important matter and that inflation thus destroys the real value of all variable real value non–monetary items when they are not valued at fair value, market value, present value, net realizable value or recoverable value.


But, everybody suddenly agrees, in the same breath, that for the purpose of valuing Retained Income – a constant real value non–monetary item – the change in the real value of money is not regarded as important to update the value of Retained Income in the financial statements. Everybody suddenly then agrees to destroy hundreds of billions of Dollars in real value in all companies´ Retained Income balances all around the world.


Yes, inflation is very important!


All central banks and thousands of economists and commentators spend huge amounts of time on the matter. Thousands of books are available on the matter. Financial newspapers and economics journals dedicate thousands of columns to the fight against inflation.


But, when it comes to constant real value non–monetary items, it doesn’t seem as if inflation is important. We happily destroy hundreds of billions of Dollars in Retained Income real value year in year out.


However, when you are operating in an economy with hyperinflation (perhaps only Zimbabwe at the moment with 3 713% inflation), then we all agree that you have to update everything in terms of International Accounting Standard IAS 29 Financial Reporting in Hyperinflationary Economies. You have to update variable AND constant real value non–monetary items.


But, ONLY as long as your annual inflation rate has been 26% for three years in a row adding up to 100% – the rate required for the implementation of IAS 29.


Once you are not in hyperinflation anymore, for example, 15% annual inflation for as many years as you want, then you are not allowed to update constant real value non–monetary items any more. Then you must destroy their real value again – at 15% per annum. Or 7.0% per annum in the case of South Africa (April 2007).


For example:


Shareholder value permanently  destroyed by the implementation of the Historical Cost Accounting model in Exxon Mobil's Retained Income during 2005 exceeded $4.7bn for the first time. This compares to the $4.5bn shareholder real value permanently destroyed in 2004 in this manner. (Dec 2005 values).


The application by BP, the global energy and petrochemical company, of the stable measuring unit assumption in the accounting of their Retained Income resulted in the destruction of at least $1.3bn of shareholder value during 2005. (Dec 2005 values).


Royal Dutch Shell Plc, a global group of energy and petrochemical companies, permanently destroyed $2.974 billion of shareholder value during 2005 as a result of the application of the stable measuring unit assumption in the accounting of their Retained Income. (Dec 2005 values).


Should this value be reflected in the financial statements?


Maybe it should.


Nicolaas Smith”


Footnotes

¹ International Accounting Standards Committee, (1995), International Accounting Standard 1995, London, IASC, Page 502


² Paul H. Walgenbach, Norman E. Dittrich and Ernest I. Hanson, (1973), Financial Accounting, New York: Harcourt Brace Javonovich, Inc. Page 429.

http://www.accountancysa.org.za/resources/ShowItemArticle.asp?ArticleId=1235&issue=857

This article was first published in Accountancy SA (September 2007, pg 38). Accountancy SA is published by the South African Institute of Chartered Accountants. www.accountancysa.org.za

The understanding of the global, economy–wide erosion of banks´ and companies´ capital and profits (equity) during low inflation caused by the implementation of the stable measuring unit assumption is an ongoing process. In 2007 I, like almost everyone else, still believed that inflation eroded the real value of non–monetary items. Since then I have realized that I made a mistake by believing what everyone else believes and state with regard to the erosive effect of inflation on the real value of non–monetary items. I realized since then that inflation is in fact always and everywhere only a monetary phenomenon, as the late Milton Friedman so eloquently stated. I realized since then that inflation can only erode the real value of money and other monetary items – nothing else. I realized since then that inflation has, in fact, no effect on the real value of non–monetary items as so correctly stated by Prof Dr. Ümit GUCENME and Dr. Aylin Poroy ARSOY from Uludag University, Bursa, Turkey:

“Purchasing power of non monetary items does not change in spite of variation in national currency value.”

The theme of this project is thus not inflation–accounting. Inflation accounting is an accounting model to be applied only during very high and hyperinflation. Inflation accounting is specifically defined in IAS 29 Financial Reporting in Hyperinflationary Economies and required by IFRS only during hyperinflation.

The theme of this project is financial capital maintenance in units of constant purchasing power accounting during low inflation and deflation (as implemented via the Constant Item Purchasing Power Accounting model) as authorized in IFRS in the original Framework (1989), Par 104 (a). Stated differently: the theme of this project is the rejection of the stable measuring unit assumption, i.e. the rejection of the generally accepted, globally implemented, traditional Historical Cost Accounting model, during low inflation and deflation . HCA is also authorized in IFRS in the exact same original Framework (1989), Par 104 (a). The rejection of the stable measuring unit assumption is authorized in IFRS since financial capital maintenance in units of constant purchasing power during low inflation and deflation (CIPPA) is authorized in IFRS as an alternative to financial capital maintenance in nominal monetary units, i.e. the Historical Cost Accounting model under which the stable measuring unit assumption is implemented.

Non–monetary items are subdivided in variable real value non–monetary items and constant real value non–monetary items as published in the above Accountancy SA article. Only constant real value non–monetary items are updated under financial capital maintenance in units of constant purchasing power (CIPPA) to maintain their existing constant real non–monetary values constant during low inflation and deflation in order to measure financial capital maintenance in units of constant purchasing power instead of in nominal monetary units. That is what this project is about. Variable real value non–monetary items are valued in terms of IFRS or GAAP in a manner that takes into account all elements – including inflation – which determine the variable real value non–monetary item’s real value at the date of valuation during low inflation and deflation. Monetary items are always valued at their original nominal monetary values under all accounting models and under all economic environments. Constant real value non–monetary items are also valued in terms of IFRS in units of constant purchasing power when financial capital maintenance is measured in units of constant purchasing power during low inflation and deflation by implementing the CIPPA model.

This project is about the existing real values of constant real value non–monetary items – e.g., banks´ and companies´ shareholders´ equity – automatically being maintained constant forever in all entities that at least break even – ceteris paribus – during low inflation and deflation by continuously implementing the real value maintaining financial capital maintenance in units of constant purchasing power model (CIPPA) as approved in the IFRS in the original Framework (1989), Par 104 (a).

This project is about knowingly indexing or updating or measuring in units of constant purchasing power only constant real value non–monetary items by implementing the CIPPA model during low inflation and deflation as approved in IFRS in the original Framework (1989), instead of unknowingly, unintentionally and unnecessarily eroding their real values on a massive scale with the implementation of the very erosive stable measuring unit assumption as it forms part of the traditional HCA model when financial capital maintenance is measured in nominal monetary units during inflation.

This project is about knowingly choosing to measure financial capital maintenance in banks and companies in real value maintaining units of constant purchasing power during low inflation and deflation as approved in IFRS instead of in real value eroding nominal monetary units as a result of the choice to implement the very erosive stable measuring unit assumption during low inflation also authorized in IFRS in the same original Framework (1989), Par 104 (a).

This project is about rejecting the stable measuring unit assumption and instead adopting IFRS–approved real value maintaining constant purchasing power units as the measurement basis for only constant real value non–monetary items including banks´ and companies´ shareholders´ equity and not only for income statement constant real value non–monetary items, e.g. salaries, wages, rentals, etc during non–hyperinflationary conditions.

This project is about stopping the implementation of the Historical Cost Accounting model which unknowingly, unintentionally and unnecessarily erodes hundreds of billions of US Dollars per annum of existing constant real value in existing constant real value non–monetary items (bank´s and companies´ capital) in the constant item economy because the traditional HCA model is chosen when the very erosive stable measuring unit assumption is implemented during inflation instead of the IFRS–approved real value maintaining CIPPA model.

The Historical Cost Mistake is the implementation of the very erosive stable measuring unit assumption as part of the traditional HCA model during inflation.

This project is about knowingly, automatically maintaining hundreds of billions of US Dollars per annum of existing constant real non–monetary value in the real economy for an unlimited period of time in all entities that at least break even complying with IFRS instead of unknowingly, unintentionally and unnecessarily eroding that value year in year out as is unknowingly being done at the moment with the implementation of the stable measuring unit assumption during inflation.

This project is about abandoning the very erosive traditional HCA model and adopting the real value maintaining CIPPA model in low inflationary and deflationary economies as 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.

Hurdles to CIPPA

Hurdles to CIPPA


Financial capital maintenance in units of constant purchasing power during low inflation and deflation (CIPPA) which automatically maintains the constant purchasing power of financial capital constant in all entities that at least break even for an indefinite period of time – ceteris paribus - is not yet generally accepted and accounting students are not yet taught to select the real value maintaining IFRS–approved alternative to the 3000 year old very erosive generally accepted traditional Historical Cost Accounting model because:
(1) The CIPPA due process is an on-going process although the principle of financial capital maintenance in units of constant purchasing power at all levels of inflation and deflation has been authorized in IFRS since 1989.

(2) It is still generally assumed that any price–level accounting model refers to the CPPA inflation accounting model to be used only during hyperinflation.

(3) It is not yet generally realized that the implementation of the traditional Historical Cost Accounting model – in general - unknowingly, unintentionally and unnecessarily erodes real value on a significant scale (hundreds of billions of US Dollars per annum) in the world´s constant item economy when the stable measuring unit assumption is implemented and financial capital maintenance is measured in nominal monetary units during inflation in entities when the constant purchasing power of constant items is never maintained.

(4) It is not yet generally realized that this massive annual erosion of existing constant real value in existing constant real value non–monetary items never maintained constant can be stopped by simply selecting the alternative approved by the IASB predecessor body, the IASC Board in 1989.

(5) The fallacy that "financial capital maintenance can be measured in nominal monetary units" is also approved in IFRS in the original Framework (1989), Par 104 (a).

(6) The stable measuring unit assumption that is based on the fallacy that changes in the real value of the monetary unit of account is not sufficiently important to require financial capital maintenance in units of constant purchasing power during low inflation and deflation is implemented by most entities world-wide.

(7) The fallacy that "the erosion of business profits and invested capital is caused by inflation" as stated by the FASB in FAS 89 is still generally accepted.

(8) The cost of the stable measuring unit assumption (a generally accepted accounting practice) is mistakenly still generally accepted to be the same as the cost of inflation (the net monetary loss from holding a net balance of monetary item assets) and needs to be limited by central banks´ monetary policies: it is not realized that it is the implementation of the stable measuring unit assumption and not inflation that is eroding the real value of constant items never maintained constant.


Nicolaas Smith

Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

CIPPA is authorized during low inflation

CIPPA is authorized during low inflation


The statement that financial capital maintenance can be measured in either constant purchasing power units or in nominal monetary units in the IASB´s original Framework (1989), Par 104 (a) means that CIPPA has been authorized in IFRS since 1989 as an alternative to the traditional HCA model during periods of low inflation and deflation. This means that the international accounting profession has been in agreement regarding the use of financial capital maintenance in units of constant purchasing power during low inflation and deflation since 1989.

Measurement in constant monetary units (e.g. constant Dollars), i.e. in units of constant purchasing power by updating constant real value non–monetary items during low inflation and deflation as an alternative paradigm is authorized not only in IFRS, but, also in particular country´s accounting regulations. An alternative measurement in constant monetary units paradigm has been authorized in Portuguese accounting in the Plano Official de Contas (POC) also since 1989.
“Os registos contabilísticos devem basear–se em custos de aquisição ou de produção, quer a escudos nomonais, quer a escudos constantes.”

Carlos Baptista da Costa and Gabriel Correia Alves, Contabilidade Financeira, Rei dos Livros, 1996, P 79

Income statement constant real value non–monetary items like salaries, wages, rentals, utilities, transport fees, etc., are normally updated annually in units of constant purchasing power during low inflation in most economies. Payments in money for these items are normally updated annually by means of the CPI to compensate for the annual erosion of the real value of the unstable monetary medium of exchange by inflation. Inflation is always and everywhere a monetary phenomenon and can only erode the real value of money (the monetary unit inside an economy) and other monetary items. Inflation cannot and does not erode the real value of non–monetary items. See GUCENME and ARSOY above. These items are then, however, paid on a monthly basis in the new accounting year applying the stable measuring unit assumption, i.e. they are only updated annually, not monthly under the HC paradigm.

Constant real value non–monetary items´ real values can automatically be maintained constant in all entities that at least break even by choosing the CIPPA model as per the IASB´s Framework during low inflation as authorized in 1989 instead of currently unknowingly, unintentionally and unnecessarily being eroded by the implementation of the traditional HCA model when the very erosive stable measuring unit assumption is applied during inflation. It is thus the choice of accounting model and not inflation that maintains or erodes the real value of constant real value non–monetary items like Retained Earnings, Issued Share capital, capital reserves, other shareholder equity items never maintained, etc. when the very erosive stable measuring unit assumption is implemented for during inflation.

Implementing the CIPPA model means the stable measuring unit assumption is rejected which is implemented when it is instead chosen to measure financial capital maintenance in nominal monetary units – also in terms of the original Framework (1989), Par 104 (a).


Nicolaas Smith

Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Benefits of automatic constant purchasing power capital maintenance not generally realized

Benefits of automatic constant purchasing power capital maintenance not generally realized


Continuous financial capital maintenance in units of constant purchasing power during low inflation and deflation (CIPPA), despite being authorized in IFRS in the original Framework (1989), Par 104 (a), is not yet generally realized in low inflationary economies. This is the case despite the fact that CIPPA automatically maintains (as opposed to mostly being eroded under the HCA model) the existing constant real non-monetary values of all constant items in all entities that at least break even whether these entities own revaluable fixed assets or not and without the requirement of extra capital from capital providers in the form of extra money or additional retained profits simply to maintain the existing constant real value of existing Shareholders´ Equity constant for an unlimited period of time during low inflation and deflation. Comprehensive economy–wide continuous financial capital maintenance in units of constant purchasing power automatically stops the unknowing, unnecessary and unintentional eroding of hundreds of billions of US Dollars in the real value of constant real value non–monetary items never maintained constant in the world´s constant item economy each and every year. The implementation of CIPPA would result in accountants knowingly boosting the world´s real economy by hundreds of billions of US Dollars per annum for an unlimited period of time during indefinite low inflation – all else being equal.

The reason automatic financial capital maintenance in units of constant purchasing power is not generally implemented is because any price–level accounting model is generally viewed by almost everyone as a 1970–style failed and discredited inflation accounting model that required all non–monetary items (variable real value non–monetary items and constant real value non–monetary items) to be updated by means of the CPI during high inflation. They seem not to realize the substantial benefits of automatic constant purchasing power capital maintenance in all entities that at least break even.

If the enormous automatic real value maintaining benefits of financial capital maintenance in units of constant purchasing power during low inflation and deflation as authorized in the original Framework (1989), Par 104 (a) were generally realized, the Historical Cost paradigm would have already been abandoned.

The maintenance of the existing constant real non–monetary values of all existing constant real value non–monetary items (eg. companies´ and banks´ equity) for an unlimited period of time in all entities that at least break even would be automatic under the CIPPA model since it would be the result of the normal double-entry accounting model when the stable measuring unit assumption is abandoned and with it the traditional Historical Cost Accounting model under the current 3000 year old historical cost paradigm.

Deloitte, one of the Big Four accounting and auditing multi–nationals, also ignore the paragraphs in the original Framework (1989) that deal with the concepts of capital, capital maintenance and the determination of profit or loss in their presentation of the Framework on their site IAS Plus, Deloitte. Date: 11th March, 2011 http://www.iasplus.com/standard/framewk.htm

Deloitte do not even mention one word in their presentation of the Framework about the fact that entities have been authorized in IFRS since 1989 to measure financial capital maintenance in units of constant purchasing power during low inflation and deflation. This appears to be another example that it is generally not realized that an essential objective of accounting is automatic maintenance of the existing constant purchasing power of capital by continuously maintaining the real value of all constant real value non–monetary items constant in all entities that at least break even for an indefinite period of time at all levels of inflation and deflation. This can only be achieved automatically during low inflation and deflation with IASB–approved financial capital maintenance in units of constant purchasing power (Constant Item Purchasing Power Accounting) as authorized in 1989 in the original Framework (1989), Par 104 (a) under which only constant real value non–monetary items (not variable real value non–monetary items) are continuously measured in units of constant purchasing power in terms of the monthly change in the annual CPI and IAS 29 with valuation of all non–monetary items at the daily parallel rate or a daily Brazilian-style non-monetary index only during hyperinflation.

Similarly the paragraphs in the original Framework (1989) dealing with the concepts of capital, the concepts of financial capital maintenance and units of constant purchasing power were also omitted from the presentation of the Framework in the Wikipedia article on IFRS till they were added very recently. Previously, the whole of the Framework was summarized in the Wikipedia article, except those paragraphs.

The IASB and FASB are jointly updating and converging their Frameworks. “The project's overall objective is to create a sound foundation for future accounting standards that are principles–based, internally consistent and internationally converged”, per the IASB. The joint Conceptual Framework project has eight phases, one of which is the Measurement phase.

The Boards held roundtable discussions on measurement during January and February 2007. No public Discussion Paper has yet been presented for comment.

All items in the IASB´s current Conceptual Framework (2010) are covered in this project, except the concepts of capital and capital maintenance. Reading the reports about the items discussed thus far in the Measurement Phase I noticed that the discussions are almost entirely about variable real value non–monetary items (property, plant, equipment, stock, shares, financial instruments, etc.) and almost nothing about monetary items and constant real value non–monetary items (all items in the income statement, all items in shareholders’ equity, trade debtors, trade creditors, taxes payable, taxes receivable, etc.).

I emailed Kevin McBeth, the FASB Project Manager responsible for the Measurement Phase in the joint project and asked him in which phase the Concepts of Capital and Capital Maintenance are going to be discussed.

He responded by email:

“I cannot speak for the Boards with respect to your query. I can only say that early on in the measurement phase the staff suggested that capital and capital maintenance be discussed in the measurement phase, as it was in the original FASB Conceptual Framework. However, to date the Boards have not taken a decision on where, or even whether, those topics will be included in the converged framework.” (my bold lettering).

I then put the same question to the US Financial Accounting Standards Board.

Ron Lott, the FASB director who is responsible for the joint FASB–IASB Conceptual Framework project responded by email:

“We are of course familiar with paragraphs 4.57 – 110 of the IASB Framework as well as paragraphs 45–48 of FASB Concepts Statement 5. Although not labelled as such, capital maintenance ideas have been raised at various points in the discussions of measurement concepts and will continue to be discussed until the board makes decisions about measurement concepts.


We do not know yet whether there will be a section in the yet–to–be–completed measurement concepts chapter labelled capital maintenance, but the concepts will almost certainly be discussed.”

Kevin McBeth stated the following by email:

“I believe that you may have misunderstood the discussions the FASB and IASB have had about measurement. Those discussions have used examples of various items, some of which you refer to as variable real value non–monetary items. That may have led you to believe that some of your concerns are being ignored. However, the scope of the measurement phase of the Conceptual Framework project does not exclude the items you refer to as constant real value non–monetary items. The Boards are concerned about the effects of selecting measurements on all elements of the financial statements.


Much remains to be done on this project. Although future discussions probably will not use the terminology and classification scheme that you are espousing, there is reason to expect that they will address the items of concern to you.”

The concepts of capital and capital maintenance will thus be discussed in the Measurement Phase.

Possible measurement methods have already been discussed by the FASB and the IASB for six years, but, although the Measurement Phase published material includes the following: “What should the measurement chapter accomplish—The measurement chapter should list and describe possible measurements”, it is quite strange that the term “measurement in units of constant purchasing power” has not yet appeared on the Measurement Phase site as one of “the set of possible measurement methods that are to be considered”.

The concept of automatic financial capital maintenance in units of constant purchasing power during low inflation and deflation seems to have been correctly treated by the IASC Board in 1989 (after proper due process) and then simply just ignored by everyone.

The IASB may be to blame for this by simply stating in the original Framework (1989), Par 104 (a) that financial capital maintenance can be measured in nominal monetary units without qualifying that statement. It is impossible to maintain the constant real value of capital constant with financial capital maintenance in nominal monetary units per se during inflation and deflation. Financial capital maintenance in nominal monetary units is only possible, per se, during sustained zero annual inflation. We have never had sustainable zero inflation on an annual basis in the past and we are not likely to have sustainable zero annual inflation any time soon in the future.

The missing qualification in IFRS is the following: Maintaining the constant real non-monetary value of financial capital constant with financial capital maintenance in nominal monetary units is only possible under the HCA model during low inflation in all entities that at least break even when an entity continuously invests 100% of the updated original real value of all contributions to Shareholders´ Equity in revaluable fixed assets (revalued or not) with an equivalent updated real value. All economic items are valued in accounting and the values are stated in terms of the monetary unit (money) as the unit of account. All functional currencies are unstable in real value: either their real values are being eroded by inflation or, in the case of Japan lately, the Yen’s real value is being increased internally by deflation. It is thus impossible to maintain the constant real non-monetary value of financial capital constant in nominal monetary units – per se – during low inflation and deflation – unless qualified as above.

IFRS did not authorize continuous financial capital maintenance in units of constant purchasing power in the original Framework (1989), Par 104 (a) as an inflation accounting model. They did that with the CPP inflation accounting model in IAS 29 – also in 1989. Constant Item Purchasing Power Accounting as approved in IFRS by continuously measuring financial capital maintenance in units of constant purchasing power constitutes an IASB–authorized alternative to the Historical Cost financial capital concept, HC financial capital maintenance concept and HC profit or loss determination concept, namely a constant purchasing power financial capital concept, constant purchasing power financial capital maintenance concept and constant purchasing power profit or loss determination concept during low inflation and deflation. CIPPA as approved in the Framework only requires all constant real value non–monetary items to be valued in units of constant purchasing power. Variable real value non–monetary items, e.g. property, plant, equipment, listed and unlisted shares, inventory, etc are valued in terms of IFRS or GAAP.


Nicolaas Smith

Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Automatic maintenance of the constant purchasing power of capital

Automatic maintenance of the constant purchasing power of capital

Automatic maintenance of the constant purchasing power of capital can only be achieved by continuously valuing all constant real value non–monetary items in units of constant purchasing power, i.e., by continuously updating all constant items by means of the monthly change in the annual CPI during low inflation and deflation. Valuing / measuring all non-monetary items - both variable real value non–monetary items and all constant items - at the daily parallel rate (usually the daily US Dollar parallel rate) in terms of IAS 29 (or Brazilian–style daily indexation) during hyperinflation results in the real or non-monetary economy being maintained relatively stable during hyperinflation (see Brazil from 1964 to 1994) with real value hyper–erosion in only monetary items.


Historical Cost Accounting has unknowingly, unintentionally and unnecessarily abdicated the essential automatic financial capital maintenance in units of constant purchasing power function of financial reporting to the fiction that money is stable in real value during low inflation and deflation. In so doing, the Historical Cost Accounting model has in the past unknowingly eroded and currently unknowingly, unintentionally and unnecessarily erodes real value on a significant scale (hundreds of billions of US Dollars per annum) in the world´s real economy when the very erosive stable measuring unit assumption is implemented as part of the IFRS–approved traditional HCA model for an unlimited period of time during indefinite inflation.

It is not realized that this unknowing, unintentional and unnecessary erosion can be permanently stopped by simply rejecting the stable measuring unit assumption when the IFRS–compliant Constant Item Purchasing Power Accounting model is implemented during low inflation and deflation.

IFRS do – since 1989 – allow the rejection of the stable measuring unit assumption as an alternative to HCA at all levels of inflation and deflation. The IASB´s original Framework (1989), Par 104 (a) [now the Conceptual Framework (2010), Par 4.59 (a)] states:

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

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

The stable measuring unit assumption is also rejected in IAS 29 Financial Reporting in Hyperinflationary Economies for restatement of Historical Cost or Current Cost financial statements at the period–end CPI to make them more useful during hyperinflation. Simple restatement of HC or CC financial statements in terms of the period-end CPI is not the same as daily measuring or valuing all non-monetary items in terms of a Brazilian-style non-monetary index or a daily hard currency parallel rate. Simple restatement of period-end HC financial statements in terms of IAS 29 had no effect during hyperinflation in Zimbabwe.

It is not generally realized that the very erosive stable measuring unit assumption is unknowingly, unintentionally and unnecessarily responsible for the erosion of the real value of constant real value non–monetary items never maintained constant when the traditional HCA model is implemented for an unlimited period of time during indefinite inflation. It is still generally believed that inflation instead of the stable measuring unit assumption is doing the eroding.

It is also not generally realized that this erosion can be permanently stopped by selecting financial capital maintenance in units of constant purchasing power as authorized in IFRS in the original Framework (1989), Par 104 (a) which is applicable in the absence of specific IFRS.

It is generally accepted and a fact that inflation erodes the real value of money and other monetary items over time. It is also generally accepted and a fact that hyperinflation can erode all the real value of a country’s entire monetary base as happened in Zimbabwe in 2008. That was the result of an extreme increase in the volume and nominal value of bank notes in the country by Gideon Gono, the governor of the Reserve Bank of Zimbabwe, which resulted in an equivalent extreme rate of erosion of the real value of the Zimbabwe Dollar since the nominal increase in the ZimDollar money supply was not an appropriate response to an increase in real value in the real or non–monetary economy of Zimbabwe.

“There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of erosion.”

The Economic Consequences of the Peace by John Maynard Keynes, 1919

http://socserv2.mcmaster.ca/~econ/ugcm/3ll3/keynes/peace

That certainly was true in the case of Zimbabwe.

It is generally accepted and a fact that inflation erodes the real value of money and the capital amounts of monetary savings and money lent over time. It is generally accepted, but not a fact, that inflation erodes the real value of constant real value non–monetary items with fixed nominal payments over time, e.g. fixed salary, wage and rental payments. The implementation of the stable measuring unit assumption (not inflation) erodes the constant real value of fixed salaries, wages, rentals, etc.

The constant real non–monetary values of salaries, wages, rentals, etc are generally maintained constant on an annual basis, i.e. not eroded, when it is chosen to measure the existing constant values of these constant items in units of constant purchasing power in terms of the annual CPI in most economies with monthly payment in depreciating money during inflation. They are updated on an annual basis during low inflation but then paid on a monthly basis applying the stable measuring unit assumption.

It is not yet generally accepted, but a fact, that the traditional Historical Cost Accounting model unknowingly, unintentionally and unnecessarily erodes the real value of existing constant real value non–monetary items never maintained constant, e.g. equity of companies and banks never maintained constant over time as a result of insufficient revaluable fixed assets, when it is chosen to measure financial capital maintenance in nominal monetary units in terms of the traditional HCA model during low inflation when the stable measuring unit assumption is implemented for an unlimited period of time during indefinite inflation.

As a result of this lack of realizing the erosive nature of the implementation of the stable measuring unit assumption, 1970–style CPPA inflation accounting was also not an accounting system implemented to correct or eliminate the erosion of the constant real value of only constant real value non–monetary items never maintained constant by the use of the stable measuring unit assumption. The split of non-monetary items in variable and constant items has not yet been identified at that time. The split was only identified in 2005.

It was not realized that the HCA model unknowingly erodes real value on a significant scale in all existing constant real value non–monetary items never maintained constant when it is chosen to implement the very erosive stable measuring unit assumption for an unlimited period of time during indefinite inflation. In most cases it is not even known that a choice is made as presented in the original Framework (1989), Par 104 (a). Neither is it realized that the erosion will be stopped automatically by freely choosing to measure financial capital maintenance in units of constant purchasing power by updating only constant items in all entities that at least break even, as approved in IFRS in the Framework (1989).

Prof Geoffrey Whittington in his definitive work on inflation accounting in the beginning of the 1980´s, Inflation Accounting – An Introduction to the Debate, published in 1983, clearly indicated that with 1970–style CPP inflation accounting all non–monetary accounts (with no distinction being made between variable real value non–monetary items and constant real value non–monetary item accounts) were updated by means of the CPI.

"Constant Purchasing Power Accounting (CPP) is a consistent method of indexing accounts by means of a general index which reflects changes in the purchasing power of money. It therefore attempts to deal with the inflation problem in the sense in which this is popularly understood, as a decline in the value of the currency. It attempts to deal with this problem by converting all of the currency unit measurement in accounts into units at a common date by means of the index."

Updated income statement constant real value non–monetary items, for example, salaries, wages, rentals, etc. are – right this very moment – a blessing to users all around the world because they maintain the constant real value or purchasing power of salaries, wages, rentals, etc. constant during low inflation as long as the adjustment is at least equal to inflation over the period in question. Millions of workers, their trade unions, governments, economists and people in general would agree that the practice of updating accounts in a low inflation environment is a blessing to users. In fact, it is one of the basic pillars of a stable economy as has been amply proven by Brazilian accountants, economists and the Brazilian Central Bank during the 30 years of very high and hyperinflation from 1964 to 1994 when they maintained their internal demand in the country relatively stable by updating salaries, wages, rentals and other non–monetary items in their real economy.

Updated balance sheet constant real value non–monetary items, e.g. Issued Share capital, Retained Earnings, Share premiums, Capital Reserves, General Reserves, all other items in Shareholders´ Equity, trade debtors, trade creditors, taxes payable, taxes receivable, salaries payable, salaries receivable, all other non–monetary payables, all other non–monetary receivables, etc in a low inflation economy is a blessing to everyone in that economy when it is simply decided to change from the current implementation of the very erosive stable measuring unit assumption – which is based on a fallacy – and financial capital maintenance in nominal monetary units (the traditional Historical Cost Accounting model) which is impossible during inflation and another fallacy, and it is freely chosen to implement the real value maintaining financial capital maintenance in units of constant purchasing power model during low inflation and deflation ( as applied in the Constant Item Purchasing Power Accounting model) as approved by the IASB in the original Framework (1989), Par 104 (a). Implementing financial capital maintenance in units of constant purchasing power during low inflation knowingly maintains – instead of the generally accepted HCA model currently unknowingly, unnecessarily and unintentionally eroding real value in constant real value non–monetary items never maintained as it also did last year and all the years before and will do next year if the very erosive stable measuring unit assumption is not stopped – all else being equal.


Nicolaas Smith

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