Monetary meltdown

Monetary meltdown

A monetary meltdown takes place when a hyperinflationary local currency monetary unit stops having exchangeability with all foreign currencies, normally after first a period of hyperinflation and then a period of severe hyperinflation. It happened in Zimbabwe on 20 November 2008.

The monetary economy (the total real value of the fiat money supply) can disappear completely from one day to the next. It happened three times during three months towards the end of hyperinflation in Yugoslavia. It happened at the end of hyperinflation in Zimbabwe in 2008, terminating severe hyperinflation in that country. Zimbabwe did not try hyperinflation again like Yugoslavia which has the distinction of having wiped out the real value of its entire monetary economy three times in three months. In Zimbabwe the economy dollarized spontaneously after a decision by the Reserve Bank of Zimbabwe to close the Zimbabwe Stock Exchange. That stopped the Old Mutual Implied Rate being the final exchange rate of the Zimbabwe Dollar with a foreign currency: the British Pound.

The Zimbabwean economy dollarized spontaneously after that because it was a sufficiently open economy right next to the stable South African, Botswana and other stable economies in the Southern Africa region. Those stable economies supplied the Zimbabwean economy with essential goods and services during and after hyperinflation.  Zimbabwe then had the opportunity to slowly recover from total monetary meltdown and the devastating effect of implementing the very erosive stable measuring unit assumption – the Historical Cost Accounting model – during hyperinflation as supported by the IASB and Big Four accounting firms like PricewaterhouseCoopers.. The implementation of the HCA model during hyperinflation is mistakenly accepted in International Financial Reporting Standards and mistakenly supported by Big Four accounting firms like PricewaterhouseCoopers. Zimbabwe spontaneously adopted a multi–currency dollarization model using the US Dollar, the Euro, the South African Rand, the British Pound and the Botswana Pula as relatively stable foreign currencies in the Zimbabwean economy in 2008.

The variable real value non–monetary item economy (fixed assets, land, property, plant, equipment, inventory, etc.) cannot disappear completely from the one day to the next because of wrong monetary policies. ‘Inflation is always and everywhere a monetary phenomenon.’ Inflation and hyperinflation have no effect on the real value of non–monetary items. After monetary meltdown in Zimbabwe the fixed assets, land, properties, plant, equipment, raw materials, finished goods, etc., were still there. The variable item economy can be destroyed by natural disasters like earth quakes and tsunamis and by man–made events like war, but not by hyperinflation.

The constant item economy (owners´ equity, trade debtors, trade creditors, salaries, wages, rentals, etc.) also cannot be eroded by inflation and hyperinflation because inflation and hyperinflation have no effect on the real value of non–monetary items – both variable and constant real value non–monetary items. However, the very erosive stable measuring unit assumption (i.e., the HCA model or financial capital maintenance in nominal monetary units during inflation and hyperinflation) erodes the constant real non–monetary value of constant items not maintained constant during inflation and hyperinflation, e.g., trade debtors, trade creditors, salaries, wages, rentals, that portion of shareholder´s equity never maintained constant by the real value of net assets under HCA, all other non–monetary payables and receivables, etc., at a rate equal to the annual rate of inflation or hyperinflation.

Severe hyperinflation is the final stage of a devastating hyperinflationary spiral only in the local currency monetary unit with a continuously super–increasing rate of hyperinflation reaching millions per cent per annum when exchangeability of the hyperinflationary monetary unit becomes limited to very few or just one single relatively stable foreign currency.

Hyperinflation and severe hyperinflation need exchangeability with at least on foreign currency. With no exchangeability there is no local currency and no hyperinflation, in this case, no severe hyperinflation.

The real value of the entire money supply can be eliminated like in the case of the Zimbabwe Dollar on 20 November, 2008, not as a result of hyperinflation, but as a result of a monetary meltdown after a period of severe hyperinflation.

As of 14 November 2008, Zimbabwe’s annual inflation rate was 89.7 Sextillion per cent (89,700,000,000,000,000,000,000%).

Hanke 2010

In Zimbabwe the Zimbabwe Dollar finally had exchangeability only with the British Pound via the Old Mutual Implied Rate (OMIR) as derived from continued trade in Old Mutual shares on the Zimbabwe Stock Exchange even during severe hyperinflation. A monetary meltdown took place in Zimbabwe on 20 November, 2008 when the ZSE was closed by government regulation and the Zimbabwe Dollar stopped having exchangeability with the British Pound (the last foreign currency it had exchangeability with) via the OMIR.

Nicolaas Smith

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

Valuing monetary items during hyperinflation

Valuing monetary items during hyperinflation

Monetary items are valued at their nominal monetary HC values during the current accounting period under HCA during hyperinflation too. The real value of money and other monetary items is eroded at the rate of hyperinflation which can be anything from 100 per cent per over three years (i.e., 26 per cent per annum for three years in a row) to 89.7 Sextillion per cent (89,700,000,000,000,000,000,000 per cent) in the case of Zimbabwe in 2008. (Hanke 2010)

Net monetary losses and gains have to be calculated and accounted during hyperinflation as required by IAS 29 Financial Reporting in Hyperinflationary Economies under HCA. IAS 29 is an extension to and not a departure from HCA. This is in total contradiction to what is done during low inflation under HCA.

The net monetary loss or gain from holding net monetary item assets or net monetary item liabilities has to be calculated and accounted during hyperinflation under HCA in terms of IAS 29, but not during low inflation of up to, for example, 15 per cent per annum.

Hyperinflation is defined by the IASB as 100 per cent cumulative inflation over three years. That is 26 per cent annual inflation for three years in a row. At 26 per cent annual inflation for three years in a row companies have to calculate and account the cost of hyperinflation and write it off against profit, but, not at 15 per cent or 6 per cent inflation. At 22 per cent annual inflation for three years or 81.6 per cent cumulative inflation over three years an economy would not be in hyperinflation. However, 81.6 per cent of the real value of the monetary unit, all other monetary items as well as the real value of all constant items not maintained constant (treated as monetary items) of  listed and unlisted companies would be wiped out over the short period of three years. The economy would not be in hyperinflation and the HCA model would be implemented.

SA, for example, had been going along at 12 per cent average annual inflation or 40 per cent cumulative inflation over three years for at least the last 15 years before 2000, continuously implementing the HCA model.

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 when the economy changes over from inflation to 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:

Comité de Normalisation Obligataire 2011: 15  CNO_Indexed_Bonds_-Final_15.7.2011-2-2.pdf

This normally 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 capital deflation-indexed bonds during deflation, i.e., they are real constant real 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.

Comité de Normalisation Obligataire 2011: 15   CNO_Indexed_Bonds_-Final_15.7.2011-2-2.pdf

     

Nicolaas Smith

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

Measurement during low inflation

Measurement during low inflation

Monetary items are normally not inflation–adjusted daily under HCA during low inflation although Chile inflation-adjusts between 20 and 25 per cent of its broad M3 money supply daily (2011) and most countries issue government inflation-indexed bonds which totalled about USD 2.9 trillion at the end of 2009. Inflation thus erodes the real value of most money and other monetary items evenly throughout the world´s monetary economy under the HC paradigm. Money and other monetary items would only maintain their real values perfectly stable, excluding complete daily indexation of the total money supply, under permanently sustainable zero per cent annual inflation. This has never been achieved on a sustainable basis over an extended period of time.

The South African Reserve Bank conducts monetary policy within an inflation targeting framework. The current target is for CPI inflation to be within the target range of 3 to 6 per cent on a continuous basis.

SARB

The SARB´s definition of price stability results in the erosion of the real value of the Rand at a rate of three to six per cent per annum. That is the erosion of about R66 to R132 billion in real value in the SA monetary economy per annum (March 2012). Real value is eroded evenly in Rand bank notes and coins and other monetary items (loans, deposits, consumer credit, mortgage credit, monetary investments, car loans, nominal government bonds, etc.) throughout the SA monetary economy. Inflation has no effect on any non–monetary item in the SA or any other economy.

Monetary items not inflation-indexed daily are valued at their current depreciated generally lower real values by being accounted during the current accounting period at their original nominal HC values during inflation. Monetary items´ real values are eroded by inflation over time. Being valued at their original nominal values during inflation means that monetary items are automatically being valued by the continuous economic process of inflation over time. Monetary items´ real values thus change daily in the internal economy as indicated by the Daily CPI or a monetized daily indexed unit of account, but their nominal values stay the same over time under HCA. Under HCA this change in real value is not calculated and not accounted. The net monetary loss or gain is not calculated and accounted during low inflation.

This obviously means that monetary items are always correctly valued during the current financial period in any current account: at its current real value as determined by the Daily CPI or monetized daily indexed unit of account. Money and other monetary items´ real values consequently generally decrease to a lower real value daily as indicated by the Daily CPI in low inflationary economies. Their nominal values stay the same under HCA when they are not inflation-adjusted daily.

There are net monetary losses and gains whenever the entire or any part of the money supply is not inflation–indexed on a daily basis. It is however a Generally Accepted Accounting Practice compliant with IFRS not to calculate net monetary losses and gains under HCA except during hyperinflation as required by IAS 29.  By implementing the stable measuring unit assumption it is considered that changes in the purchasing power of money are not sufficiently important to require financial capital maintenance in units of constant purchasing power during low and high inflation and deflation. It is thus generally assumed under HCA that money is, in practice, perfectly stable for the purpose of valuing current period monetary items during low inflation in the accounting records. Daily infltion-indexed monetary items are valued and accounted at the values as determined in the contracts under which they are being inflation-adjusted daily, i.e. their nominal values increase daily while their real values stay the same during inflation.

There is no stable measuring unit assumption under financial capital maintenance in units of constant purchasing power (CIPPA). All monetary items (the whole money supply) would be inflation–indexed on a daily basis in terms of the Daily CPI with complete coordination in a perfect implementation of financial capital maintenance in units of constant purchasing power which is highly unlikely in the near future (2012). It would be the best solution, but it is doubtful that any country would have an accounting authority and a central bank with the necessary understanding of the implementation and benefits of financial capital maintenance in units of constant purchasing power in terms of a Daily CPI to implement the best solution right from the start.  This would remove the entire cost of inflation (not actual inflation in money and other monetary items) from the economy.

The concept of net monetary losses and gains would be extinct under inflation-adjusting the entire money supply and complete coordination.

Chile is the country closest to achieving this, still implementing the HCA model. Chile inflation-indexes 20 to 25 per cent of its broad M3 money supply (2011) on a daily basis by means of the Unidad de Fomento. The rest of Chile´s money supply is subject to the erosion of the real value monetary items by inflation. All constant items in Chile´s constant item economy economy never maintained constant are also still subject to the erosion of their real values by the implementation of the stable measuring unit assumption.

The stable measuring unit assumption does not erode the about R132 billion (March 2012) in real value of the Rand and other monetary items in the SA monetary economy: six per cent annual inflation does that.

Net monetary gains and losses are constant real value non–monetary items (income statement gains and losses) once they are accounted and have to be inflation–adjusted – measured in units of constant purchasing power – thereafter 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.

Valuing monetary items

Valuing monetary items

Measurement is determining the particular basis on which monetary items are to be valued and accounted on a daily basis in the functional currency – the legal unit of account for accounting purposes – in an economy under all levels of inflation and deflation. The functional currency is the currency of the primary economic environment in which an entity operates. The functional currency is normally the national (or monetary union) monetary unit which is legal tender in the economy. In dollarized economies the adopted hard currency is the functional currency for accounting purposes.

Entities implement financial capital maintenance in nominal monetary units when they prepare their financial reports in terms of the HCA model. The stable measuring unit assumption is applied to some – not all – items under HCA.  It is applied to all monetary items not inflation-adjusted on a daily basis under HCA.

Monetary items are thus generally not inflation–adjusted under HCA. The Chilean banking system is partially indexed daily using the Unidad de Fomento. Some monetary items are also inflation–adjusted daily in other economies, e.g., TIPS in the US economy, where HCA is the generally accepted accounting model.

Under CIPPA, i.e., financial capital maintenance in units of constant purchasing power in terms of a Daily CPI during inflation and deflation, there is no stable measuring unit assumption. All monetary items would thus be inflation–adjusted on a daily basis in terms of the Daily CPI or monetized daily indexed unit of account. Historical monetary items as well as current financial period monetary items would be inflation–adjusted daily. This would require inflation–indexing of all monetary items in the banking system. Complete coordination in the economy would eliminate the total cost of inflation (not actual inflation) from the monetary economy. Chile is the country closest to achieving this. HCA is the generally accepted accounting model in Chile (2012).

Chile may be closer than all other economies to eliminating the cost of inflation (not inflation) from the country´s monetary economy with the generally accepted monetary practice of inflation–adjusting a significant part of their money supply in terms of the Unidad de Fomento which is a monetized daily indexed unit of account, but the stable measuring unit assumption (not inflation) is still eroding the real values of constant items never maintained constant in the country´s constant item economy because Chile is still implementing the HCA model in 2012. Chile is thus still bearing the full cost of the stable measuring unit assumption in its constant item economy. Fully coordinated financial capital maintenance in units of constant purchasing power (CIPPA) in terms of the UF on a daily basis would eliminate this cost completely from their economy too.

Nicolaas Smith

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

Functions of money

Functions of money

Money performs the following three functions:

1        Unstable medium of exchange

2        Unstable store of value

3        Unstable unit of account

Unstable medium of exchange

Money has the basic function that it is an unstable medium of exchange. It overcomes the inconveniences of a barter economy where there must be a double coincidence of wants before a trade can take place. For a trade to take place in a barter economy one person must want exactly what the other person has to offer, at the exact time and place where it is offered.

In a monetary economy the real value of goods and services are measured in terms of unstable money, the unstable monetary medium of exchange, which is generally accepted to buy any other good or service. Without this function or attribute the invention cannot be money.

We use payment with unstable money instead of barter to exchange real values in our economies in the transactions we enter into when we buy and sell goods, services, ideas, rights and any kind of property whether physical, virtual or intellectual. Unstable money is the lifeblood of an economy even though it is continuously changing in real value. The creation and exchange of real value in an economy would be severely restricted without unstable money since it would be a barter economy.

Unstable store of value

Unstable money is an unstable store of real value. Unstable money is a depreciating store of value during inflation and an appreciating store of value during deflation.

Unstable money has to maintain most of its real value over the short term in order to be accepted as an unstable medium of exchange. It would not solve barter’s double coincidence of wants problem if it could not be stored over time and still remain valuable in exchange.

The fact that inflation is eroding the real value of unstable money means it is a store of depreciating real value during inflation. Money was a store of value right from the start. The first types of money consisted of gold and silver coins. The metals from which the coins were made had an actual real value in themselves and these coins could be melted down and the metal could be sold in its bullion form when the bullion price was above the coin price. Next money was not made of precious metals but money consisted of bank notes, the real value of which was fully backed by gold. Today depreciating or appreciating fiat money´s real value is backed by all the underlying value systems in an economy while the actual bank notes and coins are simply physical tokens of money since the materials the notes and coins are made of have almost no intrinsic value. Although the store of value function (legal tender) and permanently fixed nominal values of depreciating or appreciating bank notes and bank coins are legally defined, fiat money´s real value is in fact determined by all the underlying values systems in an economy. The daily change in fiat money´s depreciating or appreciating real value is indicated by the change in the Daily CPI.

The abuse of money’s store of value function led to inflation.

Money in the form of bank notes and coins and in the form of virtual real values in bank and credit card accounts are liquid media of exchange; i.e., they are readily available. It is normally easy to obtain cash on demand in banks in most economies under normal economic conditions. A property, e.g., a well–located plot of land with a well–maintained and well–equipped building, which is a variable real value non–monetary item, is also a store of value. It is however quite an illiquid store of value. The real value is not immediately available in easily transportable and divisible cash. Money’s high liquidity makes it more desirable as a store of value in comparison with other stores of value like gold, property, marketable securities, bonds, etc. Money is obviously not the best store of value in an inflationary economy where its real value is continuously being eroded by inflation. Money is normally available in convenient small denominations which facilitate everyday small purchases. As such, money is very user friendly. It is easily transportable especially with electronic transfer facilities (2012).

Inflation actually manifests itself in money’s store of value function since inflation always and everywhere erodes the real value of only money and other monetary items. Inflation does not manifest itself in money’s medium of exchange function in the case of spot transactions since (a) the exchange is made between money and the other item considered to be equal in real value to the money amount at the moment of exchange and also since (b) inflation only happens over time. Inflation also does not manifest itself in money’s unit of account function (the stable measuring unit assumption manifests itself in money´s unit of account function) which vindicates the fact that inflation can only erode the real value of money and other monetary items; i.e., inflation has no effect on the real value of non–monetary items. Money is always a medium of exchange of equal real value at the moment of exchange. Free market prices are adjusted in the market in a price setting process that takes the decreasing real value of money during inflation or the increasing real value of money during deflation into account (amongst many other factors) so that economic items - the product or service or right and the amount of money- of equal real value are exchanged at the moment of exchange.

Depreciating money has a constantly decreasing real value during inflation.  Depreciating ‘bank money’ deposits have the same attributes as depreciating money with the single exception that they are not physical depreciating bank notes and bank coins but accounted depreciating monetary items. The depreciating money represented by depreciating bank money also has a depreciating store of value function during inflation. Money and other monetary items appreciate in real value during deflation.

Unstable unit of account

Unstable money’s third function is that it is the unstable unit of account in the economy. It is a monetary standard of measure of the real value of economic items to facilitate exchange without barter in order to overcome the double coincidence of wants problem. Inflation erodes the real value of money and deflation increases the real value of money. Money has never been perfectly stable in real value over an extended period of time. However, money illusion makes people believe that money maintains its real value stable over the short to medium term. Money is the only standard unit of measure that is not a fundamentally stable or fixed unit of account. All other standards of measure are perfectly stable units.

Accounting transformed money illusion into a Generally Accepted Accounting Practice with the very destructive stable measuring unit assumption, also called the Measuring Unit Principle.

‘The unit of measure in accounting shall be the base money unit of the most relevant currency. This principle also assumes the unit of measure is stable; that is, changes in its general purchasing power are not considered sufficiently important to require adjustments to the basic financial reports.’

Walgenbach, Dittrich and Hanson 1973: 429

The very erosive stable measuring unit assumption is based on the fallacy that changes in the general purchasing power (real value) of unstable money are not sufficiently important to require adjustments to the basic financial reports; i.e., not sufficiently important to require financial capital maintenance in units of constant purchasing power during inflation and deflation.

In an inflationary economy depreciating money is used as a depreciating monetary unit of account to value and account economic activity. It is very tempting to state that it is very clear that you cannot have a unit of account in the economy that is not stable – not fixed – in real value for accounting purposes. However, we have been doing exactly that since the start of inflation in the economy; i.e., for about the last 3000 years. Accounting has been trying to overcome this problem for the last 3000 years by simply assuming money is perfectly stable in real value duirng inflation and deflation. However, a fact will eventually prevail over an assumption regarding it. The assumption in Historical Cost Accounting is that changes in the purchasing power of money are not sufficiently important to require financial capital maintenance in units of constant purchasing power during inflation and deflation. In practice that means that unstable money is assumed to be perfectly stable in real value during inflation and deflation. The fact is that money is not perfectly stable in real value during inflation and deflation. Financial capital maintenance in units of constant purchasign power during inflation and deflation implements this fact instead of the stable measuring unit assumption under Historical Cost Accounting. The stable measuring unit assumption is not implemented under financial capital maintenance in units of constant purchasing power (CIPPA). The problem stems from the difficulty in achieving zero inflation on a permanently sustainable basis - never achieved to date (2012) - and the difficulty in defining a universal unit of real value - also never achieved to date.

The only remedy to eliminate the erosion of real value in constant real value non-monetary items never maintained constant during inflation and deflation under HCA – besides permanently sustainable zero inflation – would be to change over to financial capital maintenance in units of constant purchasing power; i.e., the measurement of all constant items in units of constant purchasing power in terms of a Daily Index during inflation and deflation (CIPPA).

The only remedy to eliminate the erosion of real value in money and other monetary items – besides permanently sustainable zero inflation – would be inflation-adjusting the entire money supply on a daily basis under complete co-ordination. Chile is already 20 to 25 per cent (2011) of the way there according to the Banco Central de Chile.

Nicolaas Smith

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

Consumer Price Index

 Consumer Price Index

‘The consumer price index was first used in 1707. In 1925 it became institutionalized when the Second International Conference of Labour Statisticians, convened by the International Labour Organization, promulgated the first international standards of measurement.’

(Vink, Kirsten and Woerman, 2004)

The CPI is a non–monetary index value measuring changes in the weighted average of prices quoted in the unstable monetary unit of a typical basket of consumer goods and services. The annual per centage change in the CPI is used to measure inflation. It is a price index determined by measuring the price of a standard group of goods and services representing a typical market basket of a typical urban consumer. It measures the change in the weighted average price for a constant market basket of goods and services from one period to the next within the same area (city, region, or nation). It can be used to measure changes in the cost of living. It is a measure estimating the average price of consumer goods and services purchased by a typical urban household.

The daily change in the CPI would be used as a measure to calculate and account the erosion of real value caused by inflation in only monetary items under financial capital maintenance in units of constant purchasing power (CIPPA). The net monetary loss or gain resulting from holding either a net weighted average excess of monetary item assets or a net weighted average excess of monetary items liabilities during a specific period is not calculated and accounted under the traditional HCA model during low inflation and deflation. It is also calculated and accounted during hyperinflation as required by IAS 29.

The daily change in the CPI would be used to calculate the net constant item loss from holding an excess of constant item assets not maintained constant over constant item liabilities not maintained constant at all levels of inflation and deflation under financial capital maintenance in units of constant purchasing power (CIPPA). Likewise it would be used to calculate the net constant item gain from holding an excess of constant item liabilities not maintained constant over constant items assets not maintained constant at all levels of inflation and deflation under CIPPA.

The cost of the stable measuring unit assumption is – like the cost of inflation – not calculated and accounted under HCA during inflation and deflation. Most people mistakenly believe the erosion in, for example, companies´ capital and profits - in fact, never maintained constant by the real value of net assets because of the implementation of stable measuring unit assumption - is caused by inflation. However, inflation has no effect on the real value of non-monetary items and capital and retained profits are constant real value non-monetary items. Thus, the cost of the stable measuring unit assumption is mistakenly believed by most people to be the same as the cost of inflation. They do not know that it is caused by the stable measuring unit assumption. They are taught that the erosion of companies´ capital and retained profits is caused by inflation. Since the cost of inflation is not calculated and accounted under the HCA model, entities – mistakenly treating constant items like monetary items, e.g., in the case of trade debtors and trade creditors as well as mistakenly believing that the erosion of companies’ capital and retained profits is caused by inflation - are satisfied to do nothing about it because net monetary losses and gains are not calculated and accounted under HCA during low inflation and deflation. They see it as the central bank´s duty to lower inflation and lower this erosion. They believe it has nothing to do with the accounting profession.

There is no CPI in a barter economy since there is no money in such an economy. The Daily CPI is essential in practice to index the real value of constant items in the economy with continuous measurement of financial capital maintenance in units of constant purchasing power (CIPPA) being used as the fundamental model of accounting during inflation and deflation.

The nominal value of money stays the same over time while the change in the real value of money is indicated by the rate of inflation and deflation. The nominal value of a constant item changes inversely with the rate of daily inflation or deflation with measurement in units of constant purchasing power under CIPPA resulting in its real value remaining constant during inflation and deflation. The real value of money changes inversely with the rate of inflation and deflation.

The Daily CPI is the sine qua non under financial capital maintenance in units of constant purchasing power (CIPPA) in an inflationary and deflationary economy to correctly fix the problem created by the fact that money is the only global unit of account that is not a stable unit of measure: the monetary unit of account has no fundamental constant. Under the Historical Cost paradigm it is assumed that money was, is and will always be perfectly stable in all cases where the stable measuring unit assumption is applied.

It would be difficult to measure the erosion and creation of real value in monetary items correctly during inflation and deflation, respectively, and to correctly implement financial capital maintenance in units of constant purchasing power without the CPI. The CPI is calculated during hyperinflation, but, it is impossible to maintain the constant purchasing power of constant items constant in terms of the CPI that becomes available a month or more after a transaction or event during hyperinflation of hundreds of millions or more per cent per annum. The daily change in a parallel or daily index rate is used for that purpose during hyperinflation. See Brazil´s use of daily indexing during very high and hyperinflation from 1964 to 1994.

Financial capital maintenance in units of constant purchasing power in terms of the Daily CPI makes it relatively easy to fix this problem and to stop the erosion of hundreds of billions of US Dollars in real value in the world´s constant item economy each and every year during inflation.

Nicolaas Smith

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

CIPPA removes the entire cost of erosion from the economy

CIPPA removes the entire cost of erosion from the economy

Inflation–adjusting all monetary items (all money and all monetary item assets and all monetary item liabilities) in the economy daily in terms of a Daily CPI or monetized daily indexed unit of account would eliminate the cost of or gain from inflation completely from the economy during low and high inflation and deflation. Chile inflation-adjusts 20 to 25 per cent (2011) of its broad M3 money supply daily in terms of the Unidad de Fomento. USD 2.9 trillion (2009) of government inflation-indexed bonds are inflation-indexed daily worldwide in terms of the Daily CPI.

This has been authorized in International Financial Reporting Standards in the original Framework, Par 104 (a) which states ‘Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power’ since 1989 because financial capital maintenance in units of constant purchasing power means there is no stable measuring unit assumption at all in the economy under Constant Item Purchasing Power Accounting. All monetary items, constant items and historical variable items would, in principle, be inflation–adjusted, measured in units of constant purchasing power or updated, respectively, daily in terms of a Daily CPI under financial capital maintenance in units of constant purchasing power (CIPPA). The net monetary loss or gain would be calculated and accounted when monetary items are not inflation-adjusted daily. The constant item loss or gain would be calculated and accounted when constant items are not measured in units of constant purchasing power daily. Losses and gains in variable items would be treated in terms of IFRS, excluding the stable measuring unit assumption.

All three basic economic items would thus be free from the stable measuring unit assumption under financial capital maintenance in units of constant purchasing power (CIPPA):

1. Historic and current period monetary items would be inflation–adjusted on a daily basis in terms of the current (today´s) Daily CPI (UF in Chile): no stable measuring unit assumption. The net monetary loss or gain would be calculated when monetary items are not inflation-adjusted daily during the current accounting period.

2. Historic and current period constant items would be measured in units of constant purchasing power on a daily basis in terms of the current (today´s) Daily CPI (UF in Chile): no stable measuring unit assumption. The net constant item loss or gain would be calculated when constant items are not measured in units of constant purchasing power daily during the current accounting period.

3. Current period variable items would be valued daily in terms of IFRS excluding the stable measuring unit assumption. Historical variable items (e.g., yesterday´s value) would be updated daily in terms of the current (today´s) Daily CPI during inflation and deflation: no stable measuring unit assumption. Variable item losses and gains would be treated in terms of IFRS, excluding the stable measuring unit assumption.

Inflation–adjusting all monetary items daily does not stop inflation since inflation is always and everywhere a monetary phenomenon (Friedman). However, it would eliminate the entire cost of or gain from inflation and deflation from the economy under complete co-ordination.

Measuring all constant items in units of constant purchasing in terms of a Daily CPI or other daily index would eliminate the complete cost of the stable measuring unit assumption from the economy under complete co-ordination.

Financial capital maintenance in units of constant purchasing power in terms of a Daily CPI or other daily index (CIPPA) would thus remove the entire cost of erosion from the economy under complete co-ordination. The cost of inflation in only the real value of monetary items in the monetary economy and the cost of the stable measuring unit assumption in only constant items never maintained constant in the constant item economy.

Nicolaas Smith

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

Inflation accounting

Inflation accounting

Financial capital maintenance in units of constant purchasing power as authorized in the original Framework (1989), Par. 104 (a) as an alternative to financial capital maintenance in nominal monetary units during low inflation and deflation is not an inflation accounting model. The IASB´s inflation accounting model is specifically defined in IAS 29 Financial Reporting in Hyperinflationary Economies.

An inflation accounting model is generaly understood to be an accounting model specifically implemented only during very high inflation and hyperinflation. According to the IASB hyperinflation is cumulative inflation over three years approaching or exceeding 100 per cent, i.e., 26 per cent annual inflation for three years in a row. Under CIPPA financial capital maintenance in units of constant purchasing power is implemented at all levels of inflation and deflation, including during hyperinflation. Financial capital maintenance in units of constant purchasing power is the IASB-authorized alternative to financial capital maintenance in nominal monetary units at all non-hyperinflationary levels, i.e., the alternative to the traditional HCA model which is not an inflation accounting model.

The IASB´s inflation accounting model defined in IAS 29 is a failed inflation accounting model. The IASB even admitted that it was impossible to implement IAS 29 during the final severe hyperinflation in Zimbabwe. It was implemented during hyperinflation in Zimbabwe and had absolutely no effect on the economic conditions in that country during hyperinflation.

Brazil, on the other hand, very successfully implemented inflation accounting during 30 years from 1964 to 1994 by indexing non-monetary items in the economy in terms of a daily index supplied by the various governments during that period. This very successful use of inflation accounting in terms of a daily index was apparently completely ignored by the IASB in the formulation of IAS 29 in 1989. IAS 29 simply requires the restatement of HC or CC period-end financial statements in terms of the monthly published CPI.

Constant Purchasing Power Accounting (CPPA) is an inflation accounting model.

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

(Whittington, 1983: )

The CIPPA model under which only constant items (not variable items) are measured in units of constant purchasing power by applying the Daily Consumer Price Index at all levels of inflation and deflation is not an inflation accounting model although it is also to be implemented during hyperinflation. Variable items are not simply indexed daily in terms of a Daily CPI during non-hyperinflationary periods under CIPPA. They are valued daily in terms of IFRS, excluding the stable measuring unit assumption, and only updated daily in terms of the Daily CPI when they are not valued daily in terms of IFRS.

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

Most entities in low inflationary and deflationary economies implement the Historical Cost Accounting model under which the stable measuring unit assumption is implemented. This means that all balance sheet constant items (e.g., owners´ equity, trade debtors, trade creditors, provisions, other non–monetary payables, other non–monetary receivables, etc.) and most (not all) income statement items are measured at their historical cost, i.e., financial capital maintenance is measured in nominal monetary units as authorized in IFRS. Some income statement items, e.g., salaries, wages, rentals, etc. are measured annually in units of constant purchasing power in terms of the annual CPI, but, are then paid on a monthly basis implementing the stable measuring unit assumption under HCA. It is impossible to maintain the real value of financial capital constant with financial capital maintenance in nominal monetary units per se during low and high inflation, deflation and hyperinflation. Financial capital maintenance in nominal monetary units during inflation and deflation, although authorized in IFRS, is still a popular accounting fallacy not yet extinct.

Valid inflation accounting, i.e., the use of an accounting model to automatically stop the erosion of real value in all non–monetary items (variable and constant items) in all entities that at least break even in real value during hyperinflation – ceteris paribus, is only possible with financial capital maintenance in units of constant purchasing power in terms of a daily non–monetary index or relatively stable daily hard currency parallel rate (not the monthly published CPI) to the valuation of (not the ‘restatement of’ period–end Historical Cost or Current Cost financial statements) all non–monetary items during hyperinflation.

This can be stated differently as follows: Only inflation accounting based on daily indexing of all non–monetary items in terms of a daily index or daily parallel rate automatically maintains the real value of all non–monetary items in all entities that at least break even in real value during hyperinflation – ceteris paribus; i.e., maintains the real or non–monetary economy stable during hyperinflation in the monetary unit.

The best example of successful inflation accounting was the use in Brazil of a daily government–supplied non–monetary index to index all non–monetary items daily during the 30 years of very high and hyperinflation in that country from 1964 to 1994.

The IFRS response to the erosion of real value in non–monetary items caused by the implementation of the HCA model, i.e., the implementation of the stable measuring unit assumption, during hyperinflation is IAS 29. IAS 29 requires entities operating in hyperinflationary economies, not to value or measure all non–monetary items in terms of a daily non–monetary index or a daily parallel rate, but to simply restate Historical Cost or Current Cost period–end financial statements in terms of the period–end monthly published CPI.

‘The financial statements of an entity whose functional currency is the currency of a hyperinflationary economy, whether they are based on a historical cost approach or a current cost approach, shall be stated in terms of the measuring unit current at the end of the reporting period.’

(IAS 29, Par. 8)

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

‘Inflation–adjusted financial statements are an extension to, not a departure from, historic cost accounting.’

(PricewaterhouseCoopers, 2006: 5)

The best example of the failure of the implementation of IAS 29 to have any effect at all on a hyperinflationary economy was its application, as required by the IASB, by listed companies on the Zimbabwean Stock Exchange during hyperinflation. The Zimbabwean real or non–monetary economy imploded in tandem with Zimbabwe´s monetary unit and monetary economy despite the implementation of IAS 29. The IASB actually officially admitted that it was impossible to implement IAS 29 during severe hyperinflation in Zimbabwe.

However, a daily relatively stable parallel rate was available till the last day of hyperinflation in Zimbabwe, which officially ended on 20 November 2008, when Gideon Gono, the governor of the Reserve Bank of Zimbabwe issued regulations that closed down the ZSE which stopped the daily Old Mutual Implied Rate (OMIR) being available in Zimbabwe. The (normally unofficial) parallel rate – usually the US Dollar parallel rate – is an excellent, not a perfect, substitute for a daily non–monetary index in a hyperinflationary economy. The US Dollar parallel rate was available 24/7, 365 days a year during Zimbabwe´s hyperinflation. Right at the end, during severe hyperinflation when the CPI was not being published any more and it was impossible to implement IAS 29, the OMIR was still available on a daily basis.

IAS 29 is fundamentally flawed by simply requiring the restatement of HC or CC period–end financial statements in terms of the period–end CPI instead of daily valuation / measurement of all non–monetary items in terms of a daily Brazilian–style Unidade Real de Valor index or parallel rate.

A number of entities are requesting a fundamental review of IAS 29 (2011). See  IFRS ´X’ Capital Maintenance in Units of Constant Purchasing Power.

Nicolaas Smith

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

Money versus real value

Money versus real value

In practice, money has a specific real value for one day at a time in an internal economy or monetary union during low inflation and deflation. It changes every time the Daily CPI changes. A monetary note or monetary coin has its nominal value permanently printed on it. Its nominal value does not and now (2012) cannot change.

National monetary units are mostly created in economies subject to inflation. The Japanese economy is sometimes in a state of deflation. The Japanese Yen, all monetary items and all constant items measured in fixed nominal monetary units (all items in owners´ equity, trade debtors, trade creditors, all non-monetary payables, all non-monetary receivables, provisions, fixed salaries, fixed pensions, fixed rentals, fixed wages, etc.) increase in real value inside the Japanese economy during deflation.

Money refers to a monetary unit used within the economy or monetary union in which it is created. This does not refer to the foreign exchange value of a monetary unit which is not the subject of this book. The foreign exchange value of a monetary unit refers to its exchange value in relation to another monetary unit normally the monetary unit of another country or monetary union.

The real value of a monetary unit would remain the same over time only at sustainable zero per cent annual inflation. Money would thus have an absolutely stable real value only at sustainable zero per cent annual inflation. This has never happened on a permanent basis in any economy in the past. Now and then countries achieve zero annual inflation for a month or two at a time. But never for a sustainable period of a year or more.

Real value is the most important fundamental economic concept although it is the lesser studied and understood compared to the study of money. Money and real value are, unfortunately, not one and the same thing during inflation and deflation. Money and other monetary items generally have lower real values during inflation and higher real values during deflation. Money and other monetary items inflation-adjusted daily have constant real values over time. Chile inflation-adjusts 20 to 25 per cent of its broad M3 money supply daily in terms of the Unidad de Fomento which is a monetized daily indexed unit of account (2011).

Money is an invention. Its existence can be terminated while real value is a fundamental economic concept, which exists, while we exist. The Zimbabwe Dollar´s existence was terminated on 20 November, 2008 when Gideon Gono, the Governor of the Reserve Bank of Zimbabwe issued instructions to shut down the activities of the Zimbabwe Stock Exchange which resulted in the end of trading in Old Mutual shares on the ZSE. This stopped the last exchangeability of the ZimDollar with the British Pound since the Old Mutual Implied Rate (OMIR) was being used as an implied exchange rate between the two currencies. That stopped the existence of the ZimDollar. No exchangeability with any foreign currency means no value for a monetary unit.

Economies have already functioned without money. Barter economies operated without a medium of exchange. Cuba in the past bought oil from Venezuela and paid part in money and part by the provision of the services of sports coaches and medical doctors. Corn farmers in Argentina stored their corn in silos and paid for new pick–up trucks and other expensive mechanized farm implements with quantities of corn – the unit of real value Adam Smith described as a very stable unit of real value.

There will always be real value while the human race exists. The need for a medium of exchange, which is money’s first and basic function, is equally true. Money is one of the greatest human inventions of all time. It ranks on par with the invention of the wheel and the Gutenberg press in terms of importance to human development. Without money modern human development would have been slower. 

Nicolaas Smith

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