Basic objective of accounting not realized

Basic objective of accounting not realized

Many people still see financial reporting as simply providing historic economic information. It is not realized that it is a basic objective of general purpose financial reporting to maintain the constant purchasing power of capital.

The reasons for this are:

(1) The Three Popular Accounting Fallacies.

(a)   The stable measuring unit assumption based on the fallacy that changes in the purchasing power of money are not sufficiently important to require financial capital maintenance inunits of constant purchasing power during low inflation and deflation. Changes in the purchasing power of unstable money logically require financial capital maintenance in units of constant purchasing power at all levels of inflation and deflation in terms of a daily rate.

(b)   Financial capital maintenance in nominal monetary units per se during low inflation and deflation originally authorized in IFRS in the Framework (1989), Par 104 (a) and in the FASB´s Concepts Statement No. 5. It is impossible to maintain the real value of capital in nominal monetary units per se during inflation and deflation.

(c) The generally accepted belief that the erosion of companies´ profits and capital is caused by inflation fully supported in IFRS and specifically stated by the FASB. Inflation has no effect on the real value of non-monetary items. Companies´ profits and capital are constant real value non-monetary items. The implementation of the stable measuring unit assumption during inflation erodes the constant purchasing power of owners´ equity that is not being maintained constant by the real value of net assets.

(1)   It is not realized that the stable measuring unit assumption and not inflation erodes the real value of constant items never maintained constant when financial capital maintenance in nominal monetary units (the traditional HCA model) is implemented during low inflationary periods.

(2)   It is not realized that continuous measurement of financial capital maintenance in units of constant purchasing power (CIPPA) in terms of a daily index rate automatically remedies this erosion by the stable measuring unit assumption in all entities that at least break even in real value during low inflation – ceteris paribus- whether they own any revaluable fixed assets or not.

The stable measuring unit assumption as implemented under financial capital maintenance in nominal monetary units, i.e., the HCA model, would already have been stopped by now, if the above were realized.

(3)   Although the principle of financial capital maintenance in units of constant purchasing power during inflation and deflation was authorized in IFRS in 1989, it is not generally implemented during low inflation and deflation because the very erosive effect of the stable measuring unit assumption on the real value of constant items never maintained constant is not recognized as such. It is generally believed that it is inflation doing the eroding in, for example, companies´ invested capital and profits – as  specifically stated in FAS 89 – when this erosion in constant item real value is, in fact, caused by the stable measuring unit assumption. Inflation has no effect on the real value of non–monetary items. Capital and profits are constant real value non–monetary items.

Nicolaas Smith


Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.

IAS 29 made no difference in Zimbabwe

IAS 29 made no difference in Zimbabwe

The implementation of IAS 29 by Zimbabwean listed companies as required by the Zimbabwean Stock Exchange made no difference to the collapse of the Zimbabwean constant item economy during hyperinflationary. Valuing all non–monetary items in restated HC or CC financial statement as required by IAS 29 in terms of the period–end CPI which was published a month or more after the month to which it related when the real value of the Zimbabwe Dollar sometimes halved every day, obviously, made no difference to the collapse of the economy.

Massive increases in the local currency money supply hyper–eroded the real value of only the ZimDollar and ZimDollar monetary items in the Zimbabwean monetary economy during hyperinflation.

Most variable items in Zimbabwe´s variable item economy, especially in the private sector, were valued in terms of the daily unofficial US Dollar parallel rate. The real values of most variable items in the private sector were thus maintained while the unofficial US Dollar parallel rate and finally the Old Mutual Implied Rate (OMIR) were available.

The real values of variable items in the public sector were not maintained in terms of the daily US Dollar parallel rate. The government attempted various periods of price freezes in the private and public sector.

The continued use of the HCA model in the Zimbabwean economy during the financial year unknowingly, unintentionally and unnecessarily eroded Zimbabwe´s constant item economy with the use of the stable measuring unit assumption during hyperinflation, as approved by the IASB and supported by PricewaterhouseCoopers (amongst others). HC financial statements of Zimbabwean companies were then restated in terms of the period–end CPI (while the CPI was still made available in Zimbabwe) to make these restated HC financial statements ‘more useful’. That made no difference to the collapse of the constant item economy.

Brazil rejected the HCA model and the stable measuring unit assumption during 30 years of very high and hyperinflation from 1964 to 1994. Brazil introduced the Historical Cost Accounting model again in 1994. The Brazilian real or non–monetary economy was kept relatively stable with daily indexing of most non–monetary items (variable and constant items) in terms of a daily index supplied by the various governments during that period while they had hyperinflation of up to 2000 per cen per annum in only their monetary unit.  Hyperinflation has no effect on the real value of non–monetary items.

How anyone can use or accept the use of the HCA model during hyperinflation is completely incomprehensible. The use of the HCA model during hyperinflation should specifically be banned by law.

Nicolaas Smith

Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.

HCA should be banned during hyperinflation

HCA should be banned during hyperinflation

IAS 29 Financial Reporting in Hyperinflationary Economies is not a departure from, but an extension to Historical Cost Accounting.

The only way a country with a hyperinflationary economy can maintain its variable item and constant item economies relatively stable during hyperinflation is by continuously measuring all non–monetary items (variable and constant items) in units of constant purchasing power. The real economy would still be affected by the stable measuring unit assumption in constant items never maintained constant at a rate of real value erosion equal to the annual rate of inflation of the hard currency used for determining the parallel rate, normally the US Dollar.

The real economy can be maintained relatively stable during hyperinflation in the local currency monetary unit not by restating Historical Cost or Current Cost financial statements at the end of the reporting period in terms of the period–end monthly published CPI to make them ‘more useful’ as required by IAS 29, but, by applying the daily parallel US Dollar or other hard currency exchange rate, or – as was done in Brazil during the 30 years of very high and hyperinflation from 1964 to 1994 – with daily indexation.

Daily indexation is, in principle, better than applying the daily US Dollar parallel rate. Daily indexation in terms of a Brazilian-style Unidade Real de Valor daily index would keep the real economy more stable: the erosion of the real value of constant items never maintained constant caused by the stable measuring unit assumption as applied to the US Dollar parallel rate is eliminated in the formulation of the index value when the CPI is included in the formula as it was in the case of the URV.

Nicolaas Smith

Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Valuing constant real value non–monetary items

Valuing constant real value non–monetary items

All constant items have always and everywhere (historic and current period constant items) to be measured in units of constant purchasing power in terms of a Daily CPI or other daily rate under financial capital maintenance in units of constant purchasing power (CIPPA) in order to automatically maintain the constant purchasing power of capital constant in all entities that at least break even in real value at all levels of inflation and deflation – ceteris paribus – whether they own any revaluable fixed assets or not in a double-entry accounting model under which the real value of owners´ equity is equal to the real value of net assets. This is not always the case, hence the necessity to calculate the net constant item loss or gain during the current financial period when constant items are not measured in units of constant purchasing power, e.g., in the case of trade debtors and trade creditors as well as other non-monetary payables and receivables treated incorrectly as monetary items by third parties who still implement HCA.

The constant real values of constant items in the constant item economy are automatically maintained constant under Constant Item Purchasing Power Accounting during low inflation and deflation by means of continuous financial capital maintenance in units of constant purchasing power

Annual measurement in units of constant purchasing power is only currently implemented under the HCA model in the case of certain (not all) income statement items, e.g., salaries, wages, rentals, etc. in non–hyperinflationary economies. Once updated annually, these items are normally paid at the same monthly value; i.e., the stable measuring unit assumption is applied in their monthly payments during the financial year.

Financial reporting has to take all three scenarios – occurring simultaneously – into account over time when an entity´s economic activities are accounted daily and financial reports are prepared and presented periodically and accessed or viewed today at the current Daily CPI or other daily rate.

Harvey Kapnick was correct when he stated in the Saxe Lecture in 1976:

‘In the long run both value accounting and price–level accounting should prevail.’

Nicolaas Smith

Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Valuing variable items

Valuing variable items

Variable real value non–monetary items are valued and accounted in terms of IFRS at, for example, fair value, market value, the lower of cost or net realizable value, recoverable value, present value, etc. excluding the stable measuring unit assumption under financial capital maintenance in units of constant purchasing power (CIPPA). These prices change all the time: even minute by minute in many markets, e.g., the prices of foreign currencies, commodities, precious metals, quoted shares, properties, finished goods, services, raw materials, etc. Their historic prices (e.g., of the day before) are updated on a daily basis to the current (today´s) rate in terms of a Daily CPI or other daily rate when they are not valued at the current date (today) in terms of IFRS as qualified.

Under the stable measuring unit assumption it is assumed that changes in the purchasing power of money are not sufficiently important to require capital maintenance in units of constant purchasing power on a daily basis. Another way to state the stable measuring unit assumption is to state that it is assumed that the real value of money is perfectly stable over time. The stable measuring unit assumption is applied to the measurement of certain non-monetary items under HCA. It is never applied under financial capital maintenance in units of constant purchasing power (CIPPA).

Inflation and deflation have no effect on the real value of non-monetary items. Historic variable items are thus not inflation-adjusted or deflation-adjusted daily. Historic variable items are updated daily in terms of a daily index or other daily rate when they are not valued daily in terms of IFRS as qualified.

Nicolaas Smith

Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.

A fact will eventually prevail over an assumption of that fact

A fact will eventually prevail over an assumption of that fact

Under the stable measuring unit assumption it is assumed that changes in the purchasing power of money are not sufficiently important to require capital maintenance in units of constant purchasing power during inflation and deflation.

The 3000-year-old, generally accepted, globally implemented, traditional Historical Cost Accounting model is based on the stable measuring unit assumption.

The fact is that changes in the purchasing power of money are sufficiently important to require capital maintenance in units of constant purchasing during inflation and deflation as authorized in IFRS and implemented under Constant Item Purchasing Power Accounting.

Just as the double-entry accounting model drove out weaker accounting models in the past, so will capital maintenance in units of constant purchasing power (CIPPA) drive out HCA in the future. Financial capital maintenance in units of constant purchasing power (CIPPA) will eventually prevail over financial capital maintenance in nominal monetary units (HCA).

Nicolaas Smith

Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Valuing monetary items

Valuing monetary items

Financial reporting values and accounts unstable monetary items on recognition at their nominal values in nominal monetary units under all accounting models. Monetary items are then valued daily in fixed nominal monetary units (unstable in real value) only during the current financial period under financial capital maintenance in units of constant purchasing power (CIPPA) and the net monetary loss or gain is, logically and necessarily, calculated and accounted

All historical monetary items are inflation-adjusted daily in terms of the current (today´s) Daily CPI thereafter, i.e., once they are reported in historical financial reports, whether for comparison purposes or not. The historical net monetary loss or gain (a constant real value non-monetary item once accounted) is thereafter measured in units of constant purchasing power in terms of the current (today´s) Daily CPI or other daily rate over time.

Low inflation, high inflation, deflation and hyperinflation determine the always current generally unstable real value of the unstable monetary unit (US Dollar, Euro, British Pound, Bolívar, Yen, Yuan, etc.) and other unstable monetary items within each country´s monetary economy.

The real value of money held and other unstable monetary items changes equally (all unstable monetary items are affected evenly) on a daily basis at all levels of inflation and deflation. The change is quantified with the daily publication of the Daily CPI or monetized daily indexed unit of account value during low inflation, high inflation and deflation and the daily US Dollar or other hard currency parallel rate or Brazilian-style daily Unidade Real de Valor during hyperinflation. The daily black market or parallel US Dollar exchange rate or street rate is generally constantly (24/7, 365 days a year) available in a hyperinflationary economy.

The Daily CPI is an internal non-monetary index rate between the unstable real value of a fixed nominal monetary unit and a unit of constant real value within an economy. The daily parallel US Dollar (or other hard currency) exchange rate or a Brazilian–style Unidade Real de Valor daily index rate fulfills this role in a hyperinflationary economy.

The nominal values of bank notes and coins currently (2012) cannot be changed daily on the notes and coins. Inflation and deflation always affect the real value of bank notes and coins and all other monetary items. Inflation-adjusting the total money supply would eliminate the entire cost of inflation or hyperinflation (not actual inflation or hyperinflation) from the monetary economy. This would require complete co-ordination. 20 to 25 per cent of the broad M3 money supply in Chile is inflation-adjusted daily in terms of the Unidad de Fomento according to the Banco Central de Chile. $ 2.68 trillion (2009) of sovereign inflation-linked bonds are inflation-adjusted daily worldwide in terms of country specific Daily Consumer Price Indices.

Months of zero annual inflation are rare and generally not sustained for more than a month of two. During hyperinflation the real value of the very unstable monetary unit and all other very unstable monetary items often changes once per day. Prices can double every 24.7 hours during hyperinflation as happened during severe hyperinflation in Zimbabwe. (Hanke, 2010)

The real values of monetary items inflation-adjusted daily are still affected by inflation and deflation, but by inflation-adjusting or deflation-adjusting them their real values are maintained constant by contract. The capital amounts of inflation-indexed bonds have constant real values over time during inflation. They are, however, not constant real value monetary items in principle. That would only be the case at permanently sustainable zero inflation. Inflation and deflation thus always affect the real values of all monetary items within an economy. The real values of monetary items inflation-adjusted daily are maintained constant by contract.

Nicolaas Smith

Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Accounting is a measurement instrument per David Mosso

Accounting is a measurement instrument per David Mosso

Economic items are valued or measured whenever economic transactions and events are accounted. Financial reporting does not simply report on what took place in the past in nominal historical cost terms. Accounting is not just a scorekeeping exercise of what happened in the past. Financial reporting values everything that happens in the economy on a daily basis.

The three fundamentally different, basic economic items in the economy, namely, monetary items, variable items and constant items, have economic values expressed in terms of unstable money which is also the unstable monetary unit of account. Economic transactions and events involving these three basic economic items are valued and accounted in an organized manner when a double entry accounting model is implemented: journal entries, general ledger accounts, trial balances, cash flow statements, income and expenses in the income statement, assets and liabilities in the balance sheet plus other financial, management and costing reports.

Accounting entries are valuations of the economic items (the debit items and the credit items) accounted.

Financial reporting is the valuing, classifying, recording, summarizing and reporting of economic transactions and events in an entity in terms of the three basic economic items measured in an unstable functional currency at all levels of inflation and deflation. It is the daily valuation and recording of an entity´s economic activities in terms of an unstable functional currency. Under Constant Item Purchasing Power Accounting financial reporting deals with economic values on a daily basis when an entity´s daily economic activities are accounted.

Financial capital maintenance in units of constant purchasing power (CIPPA) is a real net asset valuation of an entity in terms of a Daily Consumer Price Index or daily monetized indexed unit of account, e.g. the Unidad de Fomento, during low inflation, high inflation and deflation or a daily rate, for example the US Dollar parallel rate or a Brazilian-style Unidade Real de Valor daily index rate, during hyperinflation. The real net asset value of an entity is reported in financial terms by means of valuation of the three basic economic items in terms of IFRS, excluding the stable measuring unit assumption, implementing financial capital maintenance in units of constant purchasing power in terms of a daily rate (CIPPA).

Nicolaas Smith

Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.

A financial report relates to one day

A financial report relates to one day

A balance sheet is prepared periodically reporting the real net asset value (not the real market value or the real intrinsic value) of an entity on a specific day, e.g. the end of a month, the end of a quarter, the end of six months, the end of a financial year or sometimes a longer financial period.

A balance sheet under financial capital maintenance in units of constant purchasing power (CIPPA) is a financial report relating to an instant in an entity´s economic life: a report about the real net asset value of an entity on a specific day; i.e., the date of the financial report in terms of the Daily Consumer Price Index or other daily rate on that day when the financial report is accessed or viewed on that day.

The next day and every day thereafter, the real net asset value of an entity is generally different because the daily valuations of variable real value non-monetary items have changed, the entity has created more constant real value in the form of constant real value non-monetary after tax net income or has suffered a constant real value non-monetary net loss or extra capital or other resources have been contributed by shareholders or other third parties. The entity is a going concern and its real net asset value generally changes day after day.

In the event of the real net asset value remaining the same from the one day to the next, the nominal net asset value would generally change during inflation and deflation under financial capital maintenance in units of constant purchasing power (CIPPA) because the stable measuring unit assumption is not implemented under this accounting model. Inflation and deflation change the real value of money, the monetary unit of account, over time.

The real net asset value of the entity as reported in the balance sheet on the date of the balance sheet stays constant in real value (not in nominal value during inflation and deflation) for an indefinite period of time with reference to the date of the financial report. But, the real value of the functional currency (the unstable monetary unit of account) generally changes daily as indicated by the change in the Daily CPI or monetized daily indexed unit of account in a non-dollarized economy at all levels of inflation and deflation. Thus, all items in a historic balance sheet and all historic financial reports have to be valued at the current, i.e. today´s, Daily CPI or other daily rate under financial capital maintenance in units of constant purchasing power (CIPPA).

Nicolaas Smith

Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Valuation of constant items during hyperinflation

Valuation of constant items during hyperinflation

The stable measuring unit assumption is applied in the valuation of constant real value non–monetary items, e.g., salaries, wages, rentals, equity, trade debtors, trade creditors, taxes payable, etc. during hyperinflation when these items are not updated at all or not fully updated during hyperinflation; i.e., when the HCA model is implemented during hyperinflation as mistakenly approved in IAS 29 and mistakenly supported by Big Four accounting firms like PricewaterhouseCoopers.

PricewaterhouseCoopers state the following regarding the use of the HCA model during hyperinflation:

‘Inflation–adjusted financial statements are an extension to, not a departure from, historic cost accounting. IAS 29 seeks to overcome the limitations of historic cost financial reporting in hyperinflationary conditions.’

Financial Reporting in Hyperinflationary Economies – Understanding IAS 29, PricewaterhouseCoopers, 2002, p 5.

IAS 29 states:

‘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.

It is absolutely clear from the above quotes that IFRS approve and PricewaterhouseCoopers support the implementation of the Historical Cost Accounting model and the very erosive stable measuring unit assumption during hyperinflation. That is a fundamental mistake during hyperinflation. HCA should be banned by law during hyperinflation.

Certain (not all) income statement items, e.g., salaries, wages, rentals, etc. are measured as a generally accepted accounting practice in units of constant purchasing power on an annual basis (they are updated annually – not monthly) as part of the traditional Historical Cost Accounting model during low inflation. The Framework states that various measurement bases are used in conjunction in the HCA model during inflation, hyperinflation and deflation.

A constant real value non–monetary item´s legal existence is determined by contract or statute (company law, commercial law, etc.). However, these constant real value non–monetary items are – in practice – treated as monetary items (cash) during the period that they are not measured in units of constant purchasing power in terms of the daily US Dollar or other daily hard currency parallel rate or a daily index rate during hyperinflation.

Salaries, wages, rentals, trade debtors, trade creditors, all other non–monetary payables, all other non–monetary receivables, etc. are not required in IAS 29 to be valued or measured or updated at the date of payment in terms of the period–end monthly published CPI. That is, obviously, not practically possible when the period–end monthly CPI is normally only available one or two months after the month to which it relates during hyperinflation. What is required in IAS 29 is that these constant real value non–monetary items´ nominal Historical Cost or Current Cost values – after payment or after the liability for the payment have been accounted – in HC or CC financial statements at the end of the accounting period be restated in terms of the period–end monthly CPI in order – simply – to make the HC or CC financial statements more useful during hyperinflation. The practical implementation of IAS 29 thus does not generally result in financial capital maintenance in units of constant purchasing power during hyperinflation. That clearly explains the failure of IAS 29, for example, when it was implemented during hyperinflation in Zimbabwe. It did not manage to keep the Zimbabwe real economy relatively stable like daily updating in terms of the daily index supplied by various governments during 30 years of very high and hyperinflation in Brazil did. The complete failure of IAS 29 in Zimbabwe seems to make absolutely no difference to the IASB´s confidence in this failed standard.

When there is no CPI published as happened towards the end of severe hyperinflation in Zimbabwe, constant real value non–monetary item values cannot be determined. It was impossible to implement IAS 29 during severe hyperinflation in Zimbabwe. See reference below. However, these constant items´ real legal or contractual values do not disappear even when they – temporarily – cannot be valued in the local currency. Their legal or contractual constant real non–monetary values still exist even after monetary meltdown of only the local currency. Constant real value non–monetary items are measured at fair value (in nominal monetary units or units of constant purchasing power depending on whether the entity chooses the HCA or CIPPA model) in the opening balance sheet after monetary meltdown in terms of IAS 1.

The IASB authorized an addition to IAS 1 in 2011 to allow for the fair value valuation of all non–monetary items (constant and variable items) in the opening balance sheet of companies applying IFRS after severe hyperinflation and a monetary meltdown. Inflation and hyperinflation have no effect on the real value of non–monetary items. All non–monetary items (constant and variable items) were still there to be fair–valued and included in the opening balance sheet of companies after the monetary meltdown in Zimbabwe in 2008.

No exchangeability with all relatively stable foreign currencies means no exchange rates which means no hyperinflation (no prices being set in the local currency) and vice versa: no exchange rate with any relatively stable foreign currency means no exchangeability which means no hyperinflation (no prices being set in the local currency). No prices being set in the local currency means monetary meltdown: the total money supply (all local currency money and other monetary items stated in the local currency) has no value.

Trade debtors and trade creditors are constant real value non–monetary items and not monetary items as incorrectly stated by the US Financial Accounting Standards Board, the International Accounting Standards Board, PricewaterhouseCoopers and most others except 180 million Brazilians and 10 million Angolans during hyperinflation.

Nicolaas Smith

Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Valuing monetary items during deflation

Valuing monetary items during deflation

The whole money supply would be deflation-adjusted daily under complete coordination and perfect financial capital maintenance in units of constant purchasing power during deflation. It is highly unlikely that this would happen right from the start in any economy which decides to abandon the HCA model while it is in deflation and adopt financial capital maintenance in units of constant purchasing power (CIPPA). Monetary items not deflation-adjusted daily in bank and ledger accounts would continue to be valued in nominal monetary units and the net monetary gain or loss would be calculated and accounted under financial capital maintenance in units of constant purchasing power (CIPPA).

Monetary items not deflation-adjusted daily are valued in nominal monetary units under the HCA model during deflation. Their real values thus increase daily. The net monetary gain or loss is not calculated under HCA during deflation.

Not all inflation-indexed government bonds become deflation-indexed bonds during deflation. US Treasury Inflation-Protected Securities (TIPS) and most euro-denominated sovereign inflation-indexed bonds, for example, contain a clause that states that when the nominal value of the capital amount adjusted for deflation is less than the original nominal amount, the original amount would be repaid. These bonds would thus be nominal bonds and the capital amounts would gain in real value during deflation.

‘The presence of this guarantee, which is beneficial for the investor in the event of deflation, is mainly due to accounting considerations: in a lot of countries, bonds must have a minimum redemption price:’

CNO Inflation-linked bonds, p. 15

This does not apply to the coupon payments. They stay the same in real value during inflation and deflation, i.e., they would be lower in nominal value during deflation, but the same in real value.

 Some countries´ government inflation-indexed bonds do not contain the above clause and thus become deflation-indexed bonds during deflation, i.e., they are real constant value bonds. Their capital amounts and their coupon payments would be constant in real value during inflation and deflation.

 ‘The UK, Canada and Japan, do not guarantee a minimum redemption price for their indexed issues.’

CNO Inflation-linked bonds, p. 15.

Nicolaas Smith

Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Objectives of general purpose financial reporting

Objectives of general purpose financial reporting

It is clear from the above that the objectives of general purpose financial reporting are:

(a)                Maintaining the constant purchasing power of capital.

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

‘It is the overall objective of reporting for price changes to ensure the maintenance of the business as an entity.’

(Coenenberg and Macharzina, 1976)

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

(Framework, 2010)

‘It is essential to the credibility of financial reporting to recognize that the recovery of the real cost of investment is not earnings — that there can be no earnings unless and until the purchasing power of capital is maintained.’

(FAS 33, 1979)

Only existing constant real non-monetary value capital can be maintained. Double–entry accounting does not and cannot create real value out of nothing as a result of simply passing update entries when no real value actually exists.

Financial capital maintenance in units of constant purchasing power at all levels of inflation and deflation (CIPPA) automatically maintains the constant purchasing power of (existing) capital constant for an indefinite period of time in all entities that at least break even in real value at all levels of inflation and deflation – ceteris paribus. Maintaining the constant purchasing power of capital at all levels of inflation and deflation is a basic objective of financial reporting.

An entity has maintained the existing constant purchasing power of its capital if it has as much equity – expressed in units of constant purchasing power – at the end of the reporting period as it had at the beginning of the period, after excluding any distributions to, and contributions from, owners during the period. Consequently, a profit is earned only if the constant purchasing power of equity at the end of the period exceeds the constant purchasing power of equity at the beginning of the period, after excluding any distributions to, and contributions from, owners during the period.

The German economist Werner Sombart (1863–1941) wrote in Medieval and Modern Commercial Enterprise:

‘The very concept of capital is derived from this way of looking at things; one can say that capital, as a category, did not exist before double entry bookkeeping.’

(Sombart, 1953)

The objectives of general purpose financial reporting are supposed to answer the question, what is financial reporting supposed to do? The only accounting model an entity can use to implement a capital concept is double–entry accounting. Every fundament concept of capital logically gives rise to its respective fundamental capital maintenance concept.

Nicolaas Smith

Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Stable measuring unit assumption based on a fallacy

Stable measuring unit assumption based on a fallacy

Under the stable measuring unit assumption it is assumed that changes in the purchasing power of money are not sufficiently important to require financial capital maintenance in units of constant purchasing power during low inflation and deflation.

In practice the stable measuring unit assumption means that the real value of money is assumed to be perfectly stable during low inflation and deflation.

The stable measuring unit assumption is an assumption made in economics and accounting. The fact is that the real value of money is never perfectly stable under inflation and deflation.

The stable measuring unit assumption is thus based on a fallacy, namely the fallacy that money is stable in real value during low inflation and deflation.

Nicolaas Smith

Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Financial capital maintenance in nominal monetary units per se is a very popular accounting fallacy

Financial capital maintenance in nominal monetary units per se is a very popular accounting fallacy

 Capital is a constant real value non-monetary item.

Maintaining the constant purchasing power of capital is a fundamental objective of financial reporting.

Financial capital maintenance in nominal monetary units per se as implemented under traditional Historical Cost Accounting is a very popular accounting fallacy because it is impossible to maintain the constant purchasing power of capital in nominal monetary units per se during inflation.

 It is only possible per se in entities that at least break even in real value – ceteris paribus – during indefinite zero inflation which has never been achieved in the past and is not soon to be achieved in the future.

 It is only possible to maintain the constant purchasing power of capital in nominal monetary units during inflation in entities that it least break even in real value – ceteris paribus – when they continuously invest 100 per cent of the constant purchasing power of all to contributions to capital in revaluable net assets (revalued or not) with an equivalent fair value, i.e., when the constant purchasing power of capital is always equal to the real value of net assets.

 It is possible to maintain the real value of capital with financial capital maintenance in nominal monetary units in entities that at least break even in real value – ceteris paribus – during indefinite deflation because the real value of capital would increase continuously during deflation as qualified.

 The constant purchasing power of capital would thus not be kept constant (which is what is required) in real value during deflation under financial capital maintenance in nominal monetary units.

Capital would be maintained constant in real value in all entities which at least break even in real value – ceteris paribus – in terms of a Daily CPI or other daily rate per se at all levels of inflation and deflation under financial capital maintenance in units of constant purchasing power (Constant Item Purchasing Power Accounting) as authorized in the original Framework (1989), Par. 104 (a) [now Conceptual Framework (2010), Par. 4.59 (a)] which states:

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

It is most probably safe to state that very few companies in the world economy would be able to claim with 100 per cent certainty that they have maintained the constant purchasing power of their owners´ equity over the lifetime of the company. It is most probably safe to state that hardly any company knows whether it has or has not. It is also most probably safe to state that very few companies in the world economy are 100 per cent sure that they are currently (2012) maintaining the constant purchasing power of their owners´ equity in nominal monetary units under traditional Historical Cost Accounting.

 All companies that would at least break even in real value – ceteris paribus – implementing financial capital maintenance in units of constant purchasing in terms of a Daily CPI or other daily rate (CIPPA) would be able to claim that at all levels of inflation and deflation.

Nicolaas Smith

Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Do you think Argentina should end Historical Cost Accounting?

Do you think Argentina should end Historical Cost Accounting?

Annual inflation in Argentina is currently (February, 2012) at 9.7 per cent. There are some people who think it is closer to 26 per cent per annum according to reports in the press. These people also think the official inflation numbers are being tampered with.

The Argentinean Accounting Federation submitted a research paper to the IASB in 2010 in the form of a proposed new IFRS named IFRS 'X' INFLATION in which they proposed that entities should perform restatements of their financial statements when:

(a) the cumulative inflation rate of its functional currency for the last 12 months
is higher or equal to 10%; or

(b) the cumulative inflation rate of its functional currency for the last 36 months
is higher or equal to 26%; or

(c) the preceding financial statements were restated and the cumulative inflation
rate of its functional currency has not been lower than 15% for the last 36
months.

The Argentinean Federation thus wants the IASB to do what the Federation thinks it cannot do on its own.

The IASB and the Argentinean Federation made the proposal available to me and I amended it (via an unsolicited comment letter to the IASB) to IFRS ‘X’ CAPITAL MAINTENANCE IN UNITS OF CONSTANT PURCHASING POWER. The amended version would require an end to HCA: a fundamental change from HCA to financial capital maintenance in units of constant purchasing power (Constant Item Purchasing Power Accounting) as originally authorized in IFRS in the Framework (1989), Par. 104 (a) at annual inflation equal to or higher than 10 per cent or cumulative inflation equal to or higher than 26 per cent over three years with no return to HCA afterwards at any level of inflation or deflation.

Afterwards I realized that all Argentinean companies could right now freely choose to implement financial capital maintenance in units of constant purchasing power because it was authorized in IFRS in 1989.

I then suggested to the Argentinean Accounting Federation (Federación Argentina de Consejos Profesionales de Ciencias Económicas) that they should simply authorize a national accounting standard in Argentina requiring Argentinean companies to implement financial capital maintenance in units of constant purchasing power in terms of their amended proposal at annual inflation equal to or greater than 10 per cent per annum or cumulative inflation equal to or greater than 26 per cent over three years with no future return to HCA.
Implementation is not required in IFRS, but it is authorized. Argentina should simple require it.

They would be requiring something that was authorized in IFRS in 1989.

In my opinion Argentina should end HCA in this manner when it is taken into account that financial capital maintenance in units of constant purchasing power would automatically maintain the constant purchasing power of capital constant for an indefinite period of time in all Argentinean entities that at least break even in real value at all levels of inflation and deflation – ceteris paribus- whether they own any revaluable fixed assets or not.

What is your opinion?

Nicolaas Smith

Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Hurdles to financial capital maintenance in units of constant purchasing power

Hurdles to financial capital maintenance in units of constant purchasing power
Financial capital maintenance in units of constant purchasing power (CIPPA) which automatically maintains the constant purchasing power of capital constant for an indefinite period of time in all entities that break even in real value during inflation and deflation – ceteris paribus – is not yet generally accepted by companies for the following reasons:

1        The CIPPA due process is not yet complete in 2012; it is an on–going process although authorization of the principle of financial capital maintenance in units of constant purchasing power at all levels of inflation and deflation in IFRS in 1989 was a major milestone.

2        It is still (2012) initially assumed that any price–level accounting model refers to either (a) the inflation accounting model authorized in IAS 29 to be used only during hyperinflation or (b)  to the CPPA inflation accounting model used during the high inflation 1970s and 80s.

3        It is not yet generally understood 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 understood that this massive annual erosion of existing constant real value in existing constant items never maintained constant can be stopped by simply selecting the alternative approved in IFRS in 1989.

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

6        The HCA model that includes the stable measuring unit assumption is implemented by most entities world–wide.

7        The fallacy that the erosion of business profits and invested capital is caused by inflation is still (2012) generally accepted.

8        The cost of the stable measuring unit assumption (the net constant item loss in constant items not maintained constant over time under HCA) is mistakenly still (2012) generally accepted to be the same as the cost of inflation (the net monetary loss from holding a net balance of monetary item assets over time) and needs to be limited by central banks´ monetary policies because 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.

9        The concept of a constant item with a constant real non-monetary value to be maintained constant over time by means of financial capital maintenance in units of constant purchasing power in terms of a daily rate is still a very new accounting concept in 2012.

Nicolaas Smith

Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.