Valuing revaluable fixed assets at HC does not erode their real values

Valuing revaluable fixed assets at HC does not erode their real values

The real values of revaluable fixed assets are not eroded by the stable measuring unit assumption when entities value these items at their original nominal HC values before the date that they are actually sold or exchanged during low inflation and deflation. They would be valued at their current market values on the date of exchange or sale in an open economy. During hyperinflation all non–monetary items (variable and constant real value non–monetary items) are required to be restated in terms of IAS 29 Financial Reporting in Hyperinflationary Economies to make these restated HC or Current Cost period-end financial reports more useful by applying the period-end CPI. A hard currency parallel rate – normally the US Dollar parallel rate – or a Brazilian-style index is applied on a daily basis when a country wishes to stabilize its real economy during hyperinflation.

This is not the case with constant items with real values never maintained constant during low inflation and deflation under the HCA model. The stable measuring unit assumption unknowingly, unintentionally and unnecessarily erodes the real values of constant items never maintained constant at a rate equal to the annual rate of inflation in a low inflationary environment when the HCA model is implemented.

Revaluable fixed assets, e.g., land and buildings´, real values are not being unknowingly eroded by the HCA model as a result of the implementation of IFRS since they exist independently of how we value them. Entities can value land and buildings in the balance sheet at their historical cost 50 years ago, but, when they are sold in the market today they would be transacted at the current market price. The real values of variable items are also not being eroded uniformly at, e.g., a rate equal to the annual inflation rate because of valuing them at original nominal HC. Inflation has no effect on the real values of non–monetary items.

Where real losses are made in dealing with variable items in the economy, these losses are the result of supply and demand or business or private decisions, e.g. selling at a bad price, obsolescence, stock market crashes, credit crunches, etc. They do not result from the implementation of the HC accounting model.

A house is a variable real value non–monetary item. Let us assume a house in Port Elizabeth, South Africa  is fairly valued in the PE market at say R 2 million on 1^st January in year one. With no change in the market a year later but with annual inflation at 6% in SA, the seller would increase his or her price to R2.12 million – all else being equal. The house’s real value remained the same. The depreciating monetary value of the house expressed in the depreciating Rand medium of exchange – all else being equal – was updated to compensate for the erosion of the real value of the depreciating Rand in the internal SA market by 6% annual inflation. It is clear that inflation does not affect the house’s variable non–monetary real value – all else being equal.

However much inflation rises, it can only erode the Rand´s real value at a higher rate and over a shorter period of time. As inflation rises the price of the house would rise to keep pace with inflation or value erosion in the real value of the Rand – all else being equal. The real value of the property will be updated as long as the house is valued as a variable real value non–monetary item at its market price, a measurement base dictated by IFRS and also practiced in all open markets.

The house´s real value is not a constant real value non–monetary item. It is only assumed in this example that only inflation changes with all else being equal. This is not normally the case in the market. The house´s real value is a variable real value non–monetary item.

When a property was valued at Historical Cost in the not so distant past in a company’s balance sheet it may have stayed at its original HC of, for example, R 100 000 for 29 years since January, 1981 in the company’s balance sheet. When it is eventually sold today for R 1.4 million we can see that inflation did not erode the property’s variable real non–monetary value – all else being equal. Inflation only eroded the real value of the depreciating Rand, the depreciating monetary medium of exchange, over the 29 year period – all else being equal. This was taken into account by the buyer and seller at the time of the sale. The selling price in Rand was increased to compensate for the erosion of the real value of the Rand by inflation. R1.4 million today (2010) is the same as R100 000 in January, 1981 – all else being equal.

As the two academics from Turkey state: “Purchasing power of non monetary items does not change in spite of variation in national currency value.”

Nicolaas Smith

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

Historical Cost Debate

Historical Cost Debate

The Historical Cost Debate is the debate over the last 100 years or so about the exclusive use of Historical Cost for all accounting purposes. The accounting profession has realized for a very long time that financial reports based on Historical Cost for all economic items do not fairly represent a company’s results and operations. As a result of this debate the pure Historical Cost Accounting model has been improved and changed dramatically during this time, so much so, that today we have a huge volume of IFRS where under variable real value non–monetary items are not all valued at HC but at, e.g., fair value or the lower of cost and net realizable value or market value or recoverable value or present value, etc. This debate has thus been a very valid and successful debate regarding the valuation of variable real value non–monetary items.

Unfortunately, the stable measuring unit assumption is still an IFRS–approved option that is used for the valuation of most constant real value non–monetary items (excluding annual valuation of salaries, wages, rents, etc.) during low inflation and deflation. Fortunately, the option of measuring financial capital maintenance in units of constant purchasing power during low inflation and deflation (CIPPA) has been approved in IFRS in the original Framework (1989), Par 104 (a).

Entities value variable real value non–monetary items in terms of IFRS when they implement both the traditional HCA model and when they measure financial capital maintenance in units of constant purchasing power during low inflation and deflation applying CIPPA. Inflation has no effect on the real values of variable real value non–monetary items. Inflation can only erode the real value of money and other monetary items: nothing else.

Nicolaas Smith

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

Daily US Dollar parallel rate or daily index required during hyperinflation

Daily US Dollar parallel rate or daily index required during hyperinflation

Hyperinflation is defined as an exceptional circumstance by the IASB. All non–monetary items – variable and constant items – in Historical Cost or Current Costs period-end financial statements are required to be restated in terms of IAS 29 Financial Reporting in Hyperinflationary Economies during hyperinflation by applying the period–end CPI to make the restated HC or CC financial reports more useful. This normally does nothing to the real values of the restated non–monetary items unless they are accepted by the tax authorities as the new real values for these companies.

The only way a country in hyperinflation can stabilize its real or non–monetary economy is by applying the daily US Dollar parallel rate or a Brazilian–style daily index supplied by the government in the valuing of all non–monetary items instead of the period–end CPI.

Nicolaas Smith

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

Measurement bases

Measurement bases

Measurement bases used in the valuation of variable items in terms of IFRS include – but are not limited to – the following:

Market value

Fair value

Historical Cost

Net realisable value

Present value

Recoverable value

Current cost

Carrying value

Residual value

Value in use

Settlement value

Replacement cost

Examples of variable real value non–monetary items

Property

Freehold Land

Buildings

Leasehold Improvements

Plant

Equipment

Equipment under Finance Lease

Investment Property

Other Intangible Assets

Capitalised Development Items

Patents

Trademarks

Licences

Investments in Associates

Joint Ventures  

Foreign currency forward contracts

Available–for–sale investments  

Quoted and Unquoted Shares

Inventories

Raw Materials

Work–in–progress

Finished Goods

Foreign currency

Nicolaas Smith

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

Books to be balanced in real terms

Books to be balanced in real terms

 Constant items would always and everywhere be measured in units of constant purchasing power in terms of a Daily Consumer Price Index or monetized daily indexed unit of account under Constant Item Purchasing Power Accounting; i.e., implementing financial capital maintenance in units of constant purchasing power during inflation and deflation. This would eliminate the total cost of the stable measuring unit assumption (currently hundreds of billions of US Dollars per annum) from the constant item economy only in the unlikely case of complete coordination right from the start of changing over to financial capital maintenance in units of constant purchasing power.

Constant items within an entity with no third parties involved would always and everywhere be measured in units of constant purchasing power. This would include all items in shareholders´ equity, provisions, all items in the income statement, accounts payable, all other non–monetary payables, etc.

A new accounting item, net constant item loss or gain would be calculated and accounted where trade debtors and other third party entities due to pay other non–monetary receivables initially do not agree to measurement in units of constant purchasing power in terms of a Daily Consumer Price Index or monetized daily indexed unit of account. The real value loss is not a net monetary loss because it is not caused by inflation in the real value of a monetary item, but, by the application of the stable measuring unit assumption causing a loss in the real value of a constant real value non-monetary item. The calculation and accounting of the net constant item loss or gain is required because there is no stable measuring unit assumption under financial capital maintenance in units of constant purchasing power: the books would – for the first time – be balanced in real terms.

Nicolaas Smith

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

Variable Items under CIPPA

Variable Items under CIPPA

    Variable items are valued and accounted in terms of IFRS. Variable item revaluation losses and gains are treated in terms of IFRS. Variable items when not valued daily in terms of IFRS would be updated in terms of a Daily Consumer Price Index or a monetized daily indexed unit of account because there is no stable measuring unit assumption under financial capital maintenance in units of constant purchasing power.

Selling prices of items in shops and restaurants, etc. are not updated on a daily basis during low inflation and deflation. They are not historical prices. They are set in a free market.  Keeping them the same during a period is a marketing strategy. Selling prices depend on demand and supply. McDonalds´ prices would not be updated daily in terms of a DCPI or a monetized daily indexed unit of account during low inflation and deflation.

They would be updated daily under financial capital maintenance in units of constant purchasing power during hyperinflation which requires daily updating of all non-monetary items (variable and constant items) in terms of a daily parallel rate (normally the daily US Dollar parallel rate), a Brazilian-style Unidade de Valor Real daily index or a monetized daily indexed unit of account like the UF in Chile. That happened at McDonalds in Harare, Zimbabwe; i.e., the daily updating, not the implementation of financial capital maintenance in units of constant purchasing power during hyperinflation. Implementing IAS 29 Financial Reporting in Hyperinflationary Economies did not result in financial capital maintenance in units of constant purchasing power in Zimbabwe.

IAS 29 simply requires the restatement of period end HC or Current Cost financial statements in terms of the CPI to supposedly make these statements more useful during hyperinflation. The implementation of IAS 29 had no effect on the economic collapse in Zimbabwe.

Nicolaas Smith

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

Monetary items under CIPPA - Part 2

Monetary items under CIPPA - Part 2

The full cost of or gain from inflation – net monetary loss or gain – would be recognized by these entities in their operations. It would be calculated and accounted in financial reports prepared under CIPPA. Under partial inflation–adjustment of monetary items – e.g. in Chile, the US, UK, Canada and all countries issuing inflation–indexed bonds – the net monetary loss or gain would be calculated and accounted for the part not inflation–indexed. This is presently not being done in Chile, the US, UK, Canada, etc. because these countries implement the HCA model under which net monetary losses and gains are not calculated and accounted.

The calculation and accounting of net monetary losses and gains are required under CIPPA because the stable measuring unit assumption is never applied under financial capital maintenance in units of constant purchasing power during inflation and deflation.

The constant purchasing power of capital can automatically be maintained constant by the real value of net assets in entities that at least break even during inflation and deflation – ceteris paribus – whether they own any revaluable fixed assets or not – only when they implement financial capital maintenance in units of constant purchasing power. Capital is equal to the real value of net assets.

Under HCA the cost of inflation in the monetary economy is not calculated and accounted because the books are not being balanced in real terms but in nominal monetary terms with the implementation of the very erosive stable measuring unit assumption under financial capital maintenance in nominal monetary units. The concept of capital being equal to net assets is also applied under HCA, but, in illusionary nominal monetary terms. Historical Cost illusion that it is possible to maintain the real value of capital in nominal monetary units per se during inflation and deflation makes Historical Cost Accounting a very erosive and – in principle – inappropriate accounting policy.

Entities, on the one hand, apply the stable measuring unit assumption under HCA in the valuation of their own shareholders´ equity in their own financial reports in nominal monetary units under which they may not take into account unreported hidden reserves for fixed assets not revalued when they apply the Historical Cost approach to the valuation of fixed assets in terms of IFRS. On the other hand, they always value third parties´ shareholders´ equity taking into account unreported hidden reserves for fixed assets not revalued, e.g. in the share price of listed companies which they value at market value in terms of IFRS, as well as in their valuations of unlisted companies.

This means that under HCA only entities with revaluable fixed assets (revalued or not) with an updated real value equal to 100% of the updated constant real value of shareholders´ equity maintain the real value of their capital under the concept of capital is equal to net assets measured in nominal monetary units during inflation and deflation. This may only be the case in property companies, hotel, hospital and other property–intensive entities. CIPPA maintains the constant purchasing power of capital constant forever in all entities that at least break even during inflation and deflation – ceteris paribus – whether they own any revaluable fixed assets or not. This requires the calculation and accounting of net monetary losses and gains as well as net constant item losses and gains (a new accounting term) because the books are being balanced in real terms; i.e. the stable measuring unit assumption is never applied.

This also means that, under HCA, the portion of shareholders´ equity never covered by sufficient revaluable fixed assets (revalued or not) has always been and is still currently  unnecessarily, unintentionally and unknowingly being eroded at a rate equal to the annual rate of inflation; not by inflation, but, by the implementation of the stable measuring unit assumption during inflation.

The erosion is equal to the annual rate of inflation because economic items are valued in terms of money which is the legal monetary unit of account and inflation erodes the real value of only money and other monetary items. Inflation has no effect on the real value of non–monetary items. Shareholders´ equity is a constant real value non–monetary item. This unnecessary erosion in constant item real value amounts to hundreds of billions of US Dollars per annum in the world´s constant item economy.

Financial capital maintenance in units of constant purchasing power (CIPPA) would stop that forever and would instead maintain hundreds of billions of US Dollars per annum in the world´s shareholders´ equity investment base for an unlimited period of time.

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.

Nicolaas Smith

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

Monetary items under CIPPA

Monetary items under CIPPA

Financial capital maintenance in units of constant purchasing power (CIPPA) never implementing the stable measuring unit assumption during inflation and deflation requires the following:

      All monetary items – historical and current period monetary items – are inflation–adjusted in terms of a Daily Consumer Price Index or monetized daily indexed unit of account like the Unidad de Fomento in Chile. This results in the complete elimination of the cost of inflation (not actual inflation in the monetary unit); i.e. there would be no net monetary loss or gain in the entire economy, only under complete coordination and with all money in the banking system which makes this only a theoretical assumption. There are always bank notes and coins outside the banking system even if all other monetary items in and outside the banking system were inflation–indexed as partially done in Chile since 1967 with the UF. There would thus always be net monetary losses and gains to be calculated and accounted only in the monetary economy. Inflation has no effect on the real value of non–monetary items.

Complete coordination in an economy would most probably not be that easy to achieve right from the start. Banks cannot be forced to inflation–adjust all monetary items in the banking system when entities do not yet understand all the benefits of financial capital maintenance in units of constant purchasing power. Chilean banks operate profitably with inflation–adjusting a portion (currently 20 to 25% of their broad M3 money supply) of deposits from clients since 1967. They inflation–index, for example, mortgages and car loans, which include their profit margins, to clients in terms of the UF.

However, entities may start financial capital maintenance in units of constant purchasing power, as authorized in IFRS, without any inflation–adjustment of monetary items at all. They may be motivated by the invisible hand of self–interest, shareholder pressure or more financial crises caused by continuously undercapitalized banks and companies. They may wish to immediately benefit from automatically maintaining the constant purchasing power of their own shareholders´ equity constant forever as long as they break even during inflation and deflation – ceteris paribus – whether they own any revaluable fixed assets or not. (See CIPPA increases a company´s net asset value.) [Link this to the blog article.]

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

           Prof Rachel Baskerville, Associate Professor of Accounting at the School of Accounting and Commercial Law at the Victoria University of Wellington, New Zealand in her publication 100 Questions(and Answers) about IFRS,  Question 38, 2010 on the Social Science Research Network.

Nicolaas Smith

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

Daily Consumer Price Index - Part 3

Daily Consumer Price Index - Part 3

“The UF is now a lagged daily interpolation of the monthly consumer price

index. The formula for computation of the UF on day t is:                                        

                                UF t = UF t–1 × (1+ π) to the power 1/d

 where π is the inflation rate for the calendar month preceding the calendar month in which t falls if t is between day ten and the last day of the month (and d is the number of days in the calendar month in which t falls), and π is the inflation rate for the second calendar month before the calendar month in which t falls if t is between day one and day nine of the month (and d is the number of days in the calendar month before the calendar month in which t falls).”

Robert J. Shiller, Indexed Units of Account: Theory and Assessment of Historical Experience, Cowles Foundation Discussion Paper No 1171, 1998, p3.
The above formula applies to the UF in Chile where the CPI for the current calendar month used to be available on the 10th of the next calendar month. The general case formula can be stated as follows:
On day t
                            DI t = DI t–1 X (1 + π) to the power 1/d

where π is the monthly inflation rate for the second calendar month before the calendar month in which t falls if t is on or between day one and the day of publication of the CPI of the previous calendar month (and d is the number of days in the calendar month before the calendar month in which t falls), and π is the monthly inflation rate for the calendar month preceding the calendar month in which t falls if t is on or between the day the CPI for the previous calendar month is published and the last day of the month (and d is the number of days in the calendar month in which t falls).

The monthly inflation rate for a calendar month is calculated using the CPI for that month and for the preceding month. The DCPIs within a given calendar month thus depend on the CPI for each of the three preceding months. For example, the July DCPIs depend before the day the June CPI is published on the CPI for April and May, and starting with the day the June CPI is published on the CPI for May and June.

A DCPI is very similar to, but, not exactly the same as a monetized daily indexed unit of account, e.g. the UF in Chile. The UF is monetized; i.e. it is stated in terms of the Chilean peso. That is not the case with a DCPI. A DCPI is not automatically monetized.
“The UF was and is an amount of currency related to the Indice de Precios al Consumidor (IPC), the consumer price index for Chile.” (Shiller, 1998, p3)

A DCPI is, like the monthly CPI on which it is based, a non–monetary index value. Monetization depends on generally accepted monetary practices in an economy: see the UF in Chile. A DCPI can be monetized and used as a monetized daily indexed unit of account with payments being made in the national monetary unit depending on users in an economy. Monetization is not a necessity.
“An exchange rate between the unit (the UF) and the true money or legal tender, in Chile the peso, is defined using an index number (such as the consumer price index), and payments are executed in money. Thus, the indexed units of account facilitate payments that are tied to the index number, without being a means of payment.” (Shiller, 1998, p2)

A DCPI is not a unit of account just like the CPI is not a unit of account for accounting purposes. The US Dollar, Euro, Yen, Yuan, etc are the nominally fixed monetary units of account, unstable in real value, used in their respective countries as the national monetary unit of account for accounting purposes during inflation, deflation and hyperinflation. The US, EU, Japanese and Chinese CPIs are not units of account for accounting purposes. They are non–monetary general price level indices. So are their DCPIs. Prices are not quoted in CPIs or in DCPIs – although they can be.

DCPIs based on the UF formula for Portugal and South Africa are available on this blog as from 1st July, 2011.


Nicolaas Smith

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

Daily Consumer Price Index - Part 2

Daily Consumer Price Index - Part 2

Daily inflation–indexing monetary items is thus not a new concept. Chile is the country which is closest to inflation–indexing its money supply. 30–Day deposits are not inflation–indexed. 20 to 25% of Chile´s broad M3 money supply is inflation–indexed on a daily basis in terms of the UF according to the Banco Central de Chile.


The Consumer Price Index is an example of a non–monetary general price level index. The annual percentage change in the CPI indicates the annual rate of inflation. The CPI for a particular calendar month is normally published in the second or third week of the next month.

A daily instead of a monthly general price level index is required to implement financial capital maintenance in units of constant purchasing power during inflation and deflation (Constant Item Purchasing Power Accounting). Using the CPI published monthly may result in sudden increases or decreases in values on the date the new CPI is published. A Daily CPI which is a lagged daily interpolation of the CPI solves this problem. The UF is a very successful monetized daily indexed unit of account used in Chile during the last 44 years and was copied by Ecuador, Mexico and Columbia. (See Shiller, 1998, p6.)

Constant Purchasing Power Accounting (CPPA) during hyperinflation requires either a daily parallel hard currency exchange rate – normally the daily US Dollar parallel rate – or a Brazilian style Unidade Real de Valor daily index primarily based on a daily parallel hard currency rate. The URV was an excellent daily index published by the government during hyperinflation in Brazil because it was mainly based on the US Dollar parallel rate (a hard currency parallel rate is essential during hyperinflation which is an exceptional circumstance), but, the CPI was also included in the formula.

The CPI is the weighted average index value of a typical basket of consumer goods purchased by a typical consumer statistically stated as a non–monetary initial index value of 100 at the start date. The CPI is thus fixed in real terms – not in nominal terms. It changes monthly in nominal terms, but, it stays fixed in real terms.

An example is the harmonized consumer price index of the Euro Area stated as the non–monetary index value of 100 in 2005. This fixed internal unit of real value is then compared to the weighted average price of the typical basket of consumer goods and services a year later in order to determine the annual rate at which inflation is eroding the real value of only money and other monetary items in only the monetary economy or deflation is creating real value in only money and other monetary items in only the monetary economy. Inflation and deflation have no effect on the real value of non–monetary items. The same is true for hyperinflation.

The stable measuring unit assumption (not inflation and hyperinflation) erodes the real value of constant items never maintained constant (never measured in units of constant purchasing power in a double–entry accounting model where the real value of capital is equal to the real value of net assets) during inflation and hyperinflation under the Historical Cost paradigm. Similarly, it is not deflation, but, the stable measuring unit assumption that creates real value in constant items never maintained constant (qualified as per the previous sentence) during deflation under HCA.

The annual percentage change in the CPI indicates the annual rate at which only the real value of the national (or monetary union, e.g. the European Monetary Union) monetary unit and other monetary items is being eroded by the economic processes of inflation and hyperinflation or being increased by the economic process of deflation.

A Daily Consumer Price Index is a lagged daily interpolation of the CPI based on the formula to calculate the daily price of a government inflation-indexed bond in a particular country, e.g., the formula used to calculate the Unidad de Fomento in Chile or the formula to calculate the daily price of TIPS in the US.



Every country which issues inflation-indexed government bonds has a Daily Consumer Price Index based on the respective CPI. In practice, a DCPI is used to inflation–adjust monetary items, to update historical variable items and to measure constant items in units of constant purchasing power under Constant Item Purchasing Power Accounting; i.e. financial capital maintenance in units of constant purchasing power during inflation and deflation as authorized in International Financial Reporting Standards (IFRS) in the original Framework (1989), Par 104 (a).

The Unidad de Fomento in Chile is the most successful monetized daily indexed unit of account to date.

A DCPI is calculated and published daily, for example, the UF published daily by the Banco Central de Chile. The monthly published CPI for the first day of any month is only available – at the earliest – round–about the tenth of the next month: up to 41 days later. The SA CPI for the first of the month can become available up to the 24th of the next month: i.e. up to 55 days later. This is very impractical for daily financial capital maintenance in units of constant purchasing power.

The Daily Consumer Price Index - Part 3

Nicolaas Smith

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

Daily Consumer Price Index - Part 1

Daily Consumer Price Index  - Part 1

      Unstable money is the unstable medium of exchange, unstable store of value and unstable unit of account in the economy. Pre–monetary economies had units of account without money being available in the economy. (See Shiller, 1998)

      Today the economic values of all economic items are stated in terms of unstable money. Prices are expressed in unstable monetary units. Unstable money is the generally accepted unstable monetary unit of account used to value and account all economic activity by entities applying the stable measuring unit assumption as part of the traditional Historical Cost Accounting model under which they implement financial capital maintenance in fixed nominal monetary units with unstable real values in the world economy during inflation, deflation and hyperinflation.

      Unstable money is not fixed in constant real value. Unstable money is fixed in nominal value in economies subject to inflation, deflation and hyperinflation. Unstable money is a fixed nominal unit of account with a daily changing real value (purchasing power).  Financial capital maintenance in nominal monetary units, although approved in International Financial Reporting Standards (IFRS) and by the United States Financial Accounting Standards Board (FASB) and implemented worldwide, is a very popular accounting fallacy not yet extinct since it is impossible to maintain the real value of capital in nominal monetary units per se during inflation, deflation and hyperinflation.

      Bank notes and bank coins cannot currently be inflation–indexed which makes it impossible for money or the monetary unit of account to be a constant indexed unit of account or a perfectly stable unit of constant real value during inflation, deflation and hyperinflation.

      Notwithstanding or despite the above, monetary items in the form of certain time deposits  – not the actual bank notes and coins – and other monetary items, e.g. government and commercial capital market bonds, have been inflation–indexed in Chile since 1967 by means of the Unidad de Fomento which is now a monetized daily indexed unit of account. Inflation-indexed government and commercial bonds are issued in many economies, e.g. the UK, Canada, the US, SA, India, Australia, Portugal, France, and many other countries.

      The Central Bank of Chile translates the “Unidad de Fomento” on their website to An Inflation–Indexed Accounting Unit  and CPI–Indexed Unit of Account (UF).

      The UF´s value in Chilean escudos was originally (1967) updated every quarter which would be the official rate for the following quarter. The UF´s original value of 100 has never been rebased like most CPIs. It was updated monthly from October 1975, with the currency changeover to pesos, till 1977. Since July 1977 it was calculated daily by interpolation between the 10th of each month and the 9th of the following month, according to the monthly variation of the Indice de Precios al Consumidor (IPC), the Chilean Consumer Price Index. The Banco Central de Chile has calculated and published the UF´s value daily since 1990. The UF is a lagged daily interpolation of the Chilean CPI. The IPC is independently calculated and published monthly by the Chilean National Statistical Institute.

      The UF daily rate is available on the Chilean Central Bank´s website.

Most bank deposits in Chile are 30–day non–indexed deposits or 90–day indexed deposits whose rates are expressed in terms of the UFs. Interest rates on the indexed deposits are expressed as a premium over the UFs. On maturity, the deposits are converted back to pesos at the current UF rate. Shiller, 1998, p3

Daily Consumer Price Index - Part 2

Nicolaas Smith

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

Inflation

Inflation

Inflation is always and everywhere a monetary phenomenon – per Milton Friedman.

Inflation – being the economic process which erodes only the real value of money and other monetary items (not inflation simply meaning any price increase) – is a sustained rise in the general price level of goods and services inside a national economy or monetary union measured over a period of time. Prices and the values of all economic items are normally expressed in terms of unstable money (the unstable monetary unit of account).

The unstable monetary unit of measure is fixed in nominal value but unstable in real value during inflation, deflation and hyperinflation because it is currently impossible to inflation–adjust the nominal values of physical bank notes and coins.

All non–cash monetary items can be inflation–indexed or deflation–indexed on a daily basis during inflation and deflation. The entire money supply excluding actual bank notes and coins can be inflation–adjusted on a daily basis in terms of a Daily Consumer Price Index or a monetized daily indexed unit of account during inflation. Chile has been inflation–adjusting a portion of the country´s money supply since 1967 by means of the Unidad de Fomento which is now a monetized daily indexed unit of account. According to the Banco Central de Chile 20 to 25% of the broad M3 money supply in Chile is inflation–indexed on a daily basis in terms of the Unidad de Fomento.


Nicolaas Smith

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

The three different basic economic items

The three fundamentally different basic economic items

They are defined and described in the order that they appeared in the economy.

Variable real value non–monetary items

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

Examples of variable items are property, plant, equipment, inventories, quoted and unquoted shares, raw material stock, finished goods stock, patents, trademarks, foreign exchange, etc. Variable items are everything you see around you generally bought/sold/traded in markets and shops excluding money and anything to do with money, e.g. bank statements, loan statements, etc.

The first economic items were variable items. Their values were not yet expressed in terms of money because money has not yet been invented at that time.

Monetary items

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

Examples of monetary items are bank notes and coins, bank loans, bank savings, other monetary savings, other monetary loans, bank account balances, treasury bills, commercial bonds, government bonds, mortgage bonds, student loans, car loans, consumer loans, credit card loans, notes payable, notes receivable, etc. Under Historical Cost Accounting monetary items are fixed in nominal terms while their real values change inversely with the rate of inflation, deflation and hyperinflation. The net monetary loss or gain from holding monetary items is not calculated and accounted under HCA. It is required to be calculated in terms of IAS 29 Financial Reporting in Hyperinflationary Economies. It is also required to be calculated under financial capital maintenance in unit of constant purchasing power accounting as authorized in IFRS in the original Framework (1989), Par 104 (a) which states:

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

The entire money supply (excluding bank notes and coins) can be inflation–adjusted on a daily basis. According to the Banco Central de Chile 20 to 25% of the Chile´s broad M3 money supply is currently inflation–indexed daily in terms of the Unidad de Fomento which is a monetized daily indexed unit of account.

Money has the following three attributes during inflation and deflation:

a. Unstable medium of exchange
b. Unstable store of value
c. Unstable unit of account

Only unstable money and other unstable monetary items´ real values are continuously being eroded by inflation and hyperinflation over time. Inflation and hyperinflation have no effect on the real value of non–monetary items. Deflation increases the real value of only unstable money and other unstable monetary items over time. Deflation also has no effect on the real value of non–monetary items.

Non–monetary items are all items that are not monetary items.

Non–monetary items in today’s economy are divided into two sub–groups:

a) Variable real value non–monetary items

b) Constant real value non–monetary items


Nicolaas Smith

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

The three different parts of the economy

The three different parts of the economy

What advantages does the Merchant derive from Book–keeping by double–entry? It is amongst the finest inventions of the human mind.  

Goethe

          The economy consists of economic entities and economic items. Economic items have economic value. Accounting does not simply record what happened in the past. Financial reporting is not simply a scorekeeping exercise. Economic items are valued every time they are accounted. Accounting is a measurement instrument – per David Mosso. Utility, scarcity and exchangeability are the three basic attributes of an economic item which, in combination, give it economic value.

       It is generally accepted that there are only two basic, fundamentally different, economic items in the economy; namely, monetary and non–monetary items and that the economy is divided in the monetary and non–monetary or real economy. However, non–monetary items are not all fundamentally the same.

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 three parts:

1.            Monetary economy

2.            Variable item economy

            3.            Constant item economy

1.   Monetary economy

          The monetary economy within a national economy or monetary union like the European Monetary Union (EMU) consists of the broad money supply (M3) of which about 7% is made up of actual bank notes and bank coins -  based on the US money supply figures. The monetary economy is made up of money and other monetary items, e.g. bank notes, bank coins, bank loans, bank savings, credit card loans, car loans, home loans, student loans, consumer loans, commercial and government bonds, Treasury Bills, all capital market items, all monetary investments, etc. The monetary economy is the fiat money supply created in the banking system by means of fractional reserve banking.  It is notable that Swedish commercial banks are not required to keep reserves with the Riks Bank, the Swedish Central Bank, like commercial banks in the rest of the world.

             Bank notes and coins (cash) generally make up only about 7% of the money supply.  The other 93% of the money supply is made up of bank money (loan / overdraft / monetary application values in bank accounts) and other monetary items. They are non–cash monetary items. They have exactly the same attributes as physical bank notes and coins except that they are not present as cash. Their real values are being eroded by inflation and hyperinflation and increased by deflation in exactly the same way as with bank notes and coins.

            2. Variable item economy

The variable item economy is made up of non–monetary items with variable real values over time; for example, cars, groceries, houses, factories, books, property, plant, equipment, inventory, mobile phones, quoted and unquoted shares, computers, foreign exchange, TV´s, finished goods, raw material, etc.

           3. Constant item economy

The constant item economy consists of non–monetary items with constant real values over time, e.g. salaries, wages, rentals, all other income statement items, balance sheet constant items, e.g. issued share capital, share premiums, share discounts, capital reserves, revaluation reserves, retained earnings, all other items in shareholders´ equity, provisions, trade debtors, trade creditors, taxes payable, taxes receivable, all other non–monetary payables, all other non–monetary receivables, etc.

The variable item economy and the constant item economy make up the non–monetary. The monetary economy and the non–monetary economy constitute the economy.

Nicolaas Smith

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

TIPS

TIPS

      Treasury Inflation–Protected Securities (TIPS) are inflation–adjusted or inflation–indexed money loans to the US government. The U.S. Treasury started issuing TIPS in January 1997. The United Kingdom has been issuing inflation-indexed bonds since 1981 and Canada since 1991. The United States of America has thus been a relatively late starter in the inflation-indexed government bond market. Unlike normal nominal Treasury Bonds, these TIPS offer investors protection against inflation as well as the opportunity to gain from deflation, but, only as far as the capital amount of the loan is concerned. Both the semi-annual coupons (interest payments) and the capital repayments of TIPS are adjusted for changes in the Consumer Price Index during inflation. Only the capital amount of the loan is maintained fixed in nominal value during deflation allowing the investor to automatically gain from the creation of real value in money during a deflationary period. This is not possible with the interest paid on the loan. The interest paid is maintained constant in real value during inflation and deflation. There is thus no automatic gain in the real value of TIPS interest during deflation.

       

       

If at maturity the inflation-indexed capital amount is less than the par amount of the security (due to deflation), the final payment of the principal will not be less than the par amount of the security at issuance. In such a circumstance, the Treasury will pay an additional amount at maturity so that the additional amount plus the inflation-indexed capital amount will equal the par amount of the security on the date of original issuance.

Nominal Treasury Bonds would gain from the fact that deflation creates real value in nominal monetary items in both the principal and in interest payments.

      The coupon paid out is the fixed rate coupon times the compounded rate of inflation from the date of issue. The capital amount repaid is the par amount or the par amount times the compounded rate of inflation from the date of the issue, whichever is greater.

      TIPS are inflation-indexed in terms of the US non-seasonally adjusted Consumer Price Index for All Urban Consumers (NSA CPI-U). The CPI-U for a particular calendar month is only published during the following calendar month. The inflation-indexed coupon and capital repayments are thus paid in terms of a TIPS Daily Consumer Price Index which is a lagged daily interpolation of the CPI-U with a two month lag. The CPI-U index value used for the calculation of the DCPI on the first day of a calendar month is the CPI-U of three months before.

       The TIPS DCPI value calculated for any given day in a calendar month is the daily interpolation of the CPI-U index value (of three months before) used at the beginning of the calendar month and the CPI-U index value (of three months before) used at the beginning of the following calendar month.

       A country which issues inflation-indexed government bonds and uses a one or two month lagged interpolated Daily Consumer Price Index to determine the daily price of these bonds can use the DCPI for the implementation of financial capital maintenance in units of constant purchasing power during inflation and deflation (CIPPA). A DCPI is not automatically a monetized daily indexed unit of account like the Unidad de Fomento in Chile. A DCPI is simply a lagged daily interpolation of the CPI.

See A TIPS Valuation Framework, Lehman Brothers, Fixed Income Research, US Interest Rate Strategy, 2006.

Nicolaas Smith

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

Historical Cost illusion

Historical Cost illusion

The illusion that it is possible to measure financial capital maintenance in nominal monetary units per se during inflation and deflation.

The illusion that it is possible to maintain the real value of capital in nominal monetary units per se during inflation and deflation.

Financial capital maintenance in nominal monetary units per se during inflation and deflation is a fallacy. It is impossible to maintain the real value of capital in nominal monetary units per se during inflation and deflation. That is only possible

(1)  under sustainable zero annual inflation which has never been achieved in the past and is not likely soon to be achieved in the future and

(2)  in entities which always invest 100% of the updated original constant real value of shareholders ´ equity in revaluable fixed assets with an equivalent updated fair value (revalued or not). This mostly only applies to property companies, hotel, hospital and other property–intensive entities.

 Financial capital maintenance in nominal monetary units was authorized in IFRS in the original Framework (1989), Par 104 (a). It was unnecessarily implemented by Chile when that country started compliance with IFRS in 2008.

Chilean companies maintained the real value of their capital constant in units of constant purchasing power in terms of the Unidad de Fomento which is a monetized daily indexed unit of account under the “correción monetaria” regime before 2008, and then stopped doing that to comply with IFRS.

FRS compliance very unfortunately stopped financial capital maintenance in units of constant purchasing power in Chile. Fortunately, IFRS compliance did not stop the Unidad de Fomento.

Financial capital maintenance in units of constant purchasing power is also authorized in IFRS in the exact same original Framework (1989), Par 104 (a) which states:

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

Chilean companies can thus go back to maintaining the real value of their capital in units of constant purchasing power as they did before 2008 and they will still comply with IFRS.

Financial capital maintenance in units of constant purchasing power (CIPPA) automatically maintains the constant purchasing power of capital constant forever in all entities that at least break even in real value during inflation and deflation – ceteris paribus – 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.