Introduction
Historical
Cost Accounting is the globally implemented, generally accepted, traditional, basic
accounting model used by entities to prepare their financial reporting. It was originally
authorized in IFRS in 1989 as an optional (not required) accounting model at
all levels of inflation and deflation (including during high inflation and
hyperinflation) in the original Framework for the Preparation and Presentation
of Financial Statements, Par. 104 (a) which states:
‘Financial
capital maintenance can be measured in either nominal monetary units or in units
of constant purchasing power.’
HCA
is thus not required by IFRS. It is an optional nominal financial capital
maintenance basic accounting model. The other optional financial capital maintenance concept authorised in IFRS at all
levels of inflation and deflation (including during high inflation AND HYPERINFLATION) is financial
capital maintenance in units of constant purchasing power.
The
exact wording of the original Framework (1989), Par. 104 (a) is maintained in
the current Conceptual Framework (2010), Par. 4.59 (a).
Three concepts of capital
maintenance authorised in IFRS
There
are thus three concepts of capital and three concepts of capital maintenance
authorised in IFRS since 1989 although both the original Framework (Par. 107)
and the Conceptual Framework (Par. 4.62) mistakenly state:
‘The
principle difference between the two
capital maintenance concepts is the treatment of the effect of changes in the
prices of assets and liabilities of the entity.’
the
exact same wording maintained here too between the Framework (1989) and the
Conceptual Framework (2010).
Capital concepts authorised in IFRS
since 1989
The
following three concepts of capital can be identified in the Conceptual
Framework, Par. 4.57:
- Physical capital.
See Par. 4.57 and 4.58
- Nominal
financial capital. See Par. 4.59 (a)
- Constant purchasing
power financial capital. See Par. 4.59 (a)
Capital maintenance concepts
authorised in IFRS since 1989
The
three concepts of capital identified in Par. 4.57 give rise to the following three concepts of capital maintenance
during all levels of inflation and deflation, including during high inflation and hyperinflation:
- Physical capital maintenance concept. Optional at all
levels of inflation and deflation. The Current Cost Accounting model is
prescribed in IFRS when the physical capital maintenance concept is
implemented. See Par. 4.56
- Financial capital maintenance in nominal monetary
units.
(HCA) Authorised in IFRS, but not prescribed. Optional at all levels of
inflation and deflation, including during high inflation and
hyperinflation. See Par. 4.59 (a)
- Financial capital maintenance in units of constant
purchasing power. Authorised
in IFRS, but not prescribed. Optional at all levels of inflation and
deflation, including during high inflation and hyperinflation. See Par. 4.59 (a)
Constant real value non-monetary
items inferred in IFRS
In
terms of the Conceptual Framework (2010), Par. 4.59 (a), financial capital
maintenance can be measured in units of constant purchasing power. There are
thus actual economic items with constant real values over time.
Inflation
erodes the real value of only monetary items over time.
‘Inflation
is always and everywhere a monetary phenomenon.’
Milton Friedman
´The
purchasing power of non monetary items does not change in spite of variation in
national currency value.’
Gucenme U and Arsoy A P 2005 Changes in financial reporting in Turkey, Historical development of inflation
accounting 1960 – 2005 Academy of Accounting Historians 2005 Research
Conference 6-8 Oct 2005 Ohio State University Columbus Ohio USA
Low
inflation, high inflation, hyperinflation and deflation thus affect the real
value of only monetary items over
time. Low inflation, high inflation, hyperinflation and deflation have, consequently,
no effect on the real value of non-monetary items over time (and never had in
the past and never will have in the future).
The
above-mentioned economic items with constant real values over time are thus not
monetary items. Consequently, they are non-monetary items with constant real
values over time. They are thus constant real value non-monetary items or
constant items.
When
the stable measuring unit assumption is never
implemented, i.e., under capital maintenance in units of constant purchasing
power, these constant items have permanently fixed constant real values over time at all levels of
inflation and deflation, including during high inflation and hyperinflation.
When,
however, the stable measuring unit assumption is implemented, i.e., under
traditional Historical Cost Accounting, and these constant items are not
maintained constant in real value over time (because of the implementation of
the stable measuring unit assumption – HCA - , not inflation), then the
constant real non-monetary values of these constant items are eroded by the
stable measuring unit assumption – HCA - (not by low inflation, high inflation
or hyperinflation) over time at a rate equal to the annual rate of low
inflation, high inflation or hyperinflation (because they are measured in terms
of depreciating money, i.e., the depreciating monetary unit of account - and low
inflation, high inflation and hyperinflation erode the real value of only money
over time) and increased at a rate equal to the annual rate of deflation by the
stable measuring unit assumption (not by deflation).
Examples of constant items are salaries, wages, rentals, pensions, borrowing
costs, fees, royalties, employment benefits, interest received, interest paid,
bank charges, issued share capital, retained income, retained losses, reserves,
all other items in shareholders´ equity, provisions, trade debtors, trade
creditors, taxes payable, taxes receivable, all other non-monetary payables and
all other non-monetary receivables, all items in the income statement, etc.
Definition: Constant real value
non-monetary items are non-monetary items with constant real values over time.
Variable real value non-monetary
items inferred in IFRS
Consequently,
non-monetary items that are not constant real value non-monetary items are
variable real value non-monetary items or variable items. They have variable
real values over time generally determined by supply and demand in free
markets.
Definition: Variable items are
non-monetary items with variable real values over time generally determined in
terms of demand and supply.
Examples of variable items are property, plant,
equipment, inventories, foreign exchange, quoted and unquoted shares, goodwill,
patents, copy right, trade marks, intellectual property rights, etc.
Non-monetary items
Definition: Non-monetary items are
all items that are not monetary items.
Non-monetary
items are sub-divided in:
- Variable real value
non-monetary items
- Constant real value
non-monetary items
Monetary Items
The
definition of monetary items thus determines whether an item is a monetary or
non-monetary item. When the definitions of monetary items need improvement as
they currently do in IFRS in IAS 29, Par. 12:
‘Monetary items are money held and items to be
received or paid in money,’
and
IAS 21, Par. 8:
´Monetary
items are units of currency held and assets and liabilities to be paid in a
fixed or determinable number of units of currency.’
then
some monetary and non-monetary items would be mis-classified. This would result
in the doubtful calculation and accounting of the net monetary item loss or
gain and the net constant item loss or
gain only under capital maintenance in units of constant purchasing power
if the current definitions of monetary items in IFRS were to be followed. The
overall net effect of such mis-classification on the financial statements would
be nil: the net loss or gain would in any case be calculated and accounted, as
either a net monetary item loss or gain, or a net constant item loss or gain only
under capital maintenance in units of constant purchasing power since it is
normally constant items (e.g., trade debtors and trade creditors) that are incorrectly
treated as monetary items. It is, however, necessary to classify items correctly
as monetary, constant or variable items.
Net
monetary item losses and gains and net constant item losses and gains are not
required (net constant item losses and gains are not even identified under HCA)
to be calculated and accounted (although net monetary losses and gains can be
calculated and accounted under HCA according to Harvey Kapnick in the 1976 Sax
Lecture by the ex-Chairman of Arthur Andersen) under the Historical Cost
Accounting model as a result of the implementation of the stable measuring unit
assumption. It is assumed, in practice, that money is perfectly stable for the purpose
of the measurement of constant items and constant items treated as monetary
items (e.g., trade debtors and trade creditors, etc.) under HCA during low
inflation, high inflation and deflation while under hyperinflation the measures
in IAS 29 are required, but Pricewaterhousecoopers very correctly states:
‘Inflation-adjusted
financial statements are an extension to, not a departure from, historic cost accounting.’
PricewaterhouseCoopers 2006 Understanding IAS 29 p 5
IAS
29 simply requires the restatement of Historical Cost or Current Cost financial
statements in terms of the measuring unit current at the end of the reporting
period to make them more meaningful. IAS is not a departure from Historical
Cost Accounting, even during hyperinflation of hundreds of billions percent per
annum.
‘The Measuring Unit Principle:
The unit of
measure in accounting shall be the base monetary unit of the most relevant
currency. This principle also assumes the unit of measure is stable, that is, changes
in its general purchasing power are not considered sufficiently important to
require adjustments to the basic financial statements.’
Walgenbach,
Dittrich and Hanson 1973 p 429
The
implementation of the stable measuring unit assumption under the Historical
Cost Accounting model, consequently leads to the erosion of the real value of constant
real value non-monetary items never maintained constant during low inflation,
high inflation, hyperinflation and deflation; e.g., that portion of an entity´s
equity never maintained constant by the real
value of its net assets over time - probably amounting to the unnecessary
erosion of real value in the world’s capital investment base amounting to
hundreds of billions of US Dollar per
annum in the world economy. Replacing the Historical Cost Accounting
model by adopting constant real value maintaining capital maintenance in units
of constant purchasing power in terms of a daily index would automatically maintain
the constant purchasing power of equity constant for an indefinite period of
time in all entities that at least break even in real value – all else being
equal – at all levels of inflation and deflation, including during high
inflation and hyperinflation, whether these entities own any revaluable fixed
assets or not. This would maintain hundreds of billions of US Dollar per annum in the world economy for as
long as the current level of world inflation maintains.
Definition of Monetary items
Monetary
items constitute the money supply.
Examples are local currency bank notes and
coins and the local currency capital amounts of home loans, car loans,
commercial loans, business loans, student loans, government bonds, commercial
bonds, capital market investments, money market investments, notes payable,
notes receivable, etc.
Three economic items
From
the above it is absolutely clear that there are not just the generally accepted
two economic items in the economy, namely monetary and non-monetary items, but
three basic, fundamentally different economic items in the economy and that the
economy is made up of three basic, fundamentally different parts as follows:
Three basic, fundamentally different
economic items
- Monetary
items
- Variable real value
non-monetary items (variable items)
- Constant real value
non-monetary items (constant items)
Three parts of
the economy
- Monetary
economy
- Variable
item economy
- Constant
item economy
Measurement under capital
maintenance in units of constant purchasing power
Daily measurement required
Daily
measurement of all items are required under capital maintenance in units of
constant purchasing power since constant items like trade debtors and trade
creditors can pay or be paid on any day of the month. The Daily Consumer Price
Index is used for this purpose during low inflation, high inflation and
deflation and the daily US Dollar parallel rate during hyperinflation. Most
countries (representing about 95 percent, or more, of the world economy) issue
capital inflation-indexed government bonds. These bonds trade on a daily basis
and are priced in terms of a Daily
CPI which is a one or two month lagged daily interpolation of the monthly
published CPI available in all these countries.
Chile
has been using an index, the Unidad
de Fomento (UF), to index non-monetary and some monetary items since
1967. It has been published daily since 1977. Chile currently inflation-indexes
25 per cent of its money supply daily.
During
hyperinflation, populations spontaneously start using the daily US Dollar parallel rate to index variable items.
Value date
The
value date under capital maintenance in units of constant purchasing power is the
current value of the daily index, that is, today´s value. Everything in a
company and economy is always presented, accessed, valued, measured, treated,
shown and printed in terms of the current, that is, today´s Daily CPI or daily
US Dollar parallel rate (during hyperinflation). It changes every day.
Financial statements are not printed on hard copy: they are kept in digital
format and updated daily: they change every day in nominal value, but they stay
the same in real value.
A
person quickly learns during hyperinflation that the value date is today:
everybody uses the current, today´s, value of the US Dollar parallel rate to
price variable items: it changes every day during hyperinflation. On some days
it changes more than once a day.
Financial
statements are thus stated at the measuring unit current at the end of the
accounting period, only at the end of the accounting period: on that day. The
next day (and at all future dates) all items in the financial statements are
updated in terms of the new Daily CPI or the new daily USD parallel rate
(during hyperinflation). The real values in the financial statements stay the
same, but their daily nominal values change daily- the same for all values in
the economy.
Constant items
Constant
items are the easiest to measure under capital maintenance in units of constant
purchasing power in terms of a daily index. They are always and everywhere (current
period and historical constant items) measured in terms of the Daily CPI at
today´s rate. When they are not measured daily as decribed – during the current financial period, then the
net constant item loss or gain is calculated and accounted in the income
statement. Net constant item losses and gains are constant items once accounted
and measured in units of constant purchasing power daily thereafter - like all
constant items.
Variable items
Variable
items are valued daily in terms of IFRS, e.g., at fair value, net realisable
value, recoverable value, present value, etc., excluding the stable measuring unit assumption, i.e., excluding
nominal historical cost. Nominal historical cost is only valid during zero
inflation – an economic environment never achieved on a sustainable basis in
the past and aparently not soon to be achieved in the future. When variable
items are not valued daily in terms of IFRS, as qualified, they are updated (only
monetary items can be inflation-adjusted – inflation only
affects monetary items) daily in terms of the Daily CPI till they are again
measured daily in terms of IFRS, as qualified. Impairment, losses and gains in
variable items are treated in terms of IFRS, as qualified.
Monetary items
Monetary
items are always and everywhere (historical and current period monetary items)
inflation-adjusted on a daily basis. When they are not inflation-adjusted during the current accounting period,
then the net monetary loss or gain is calculated and accounted.
Inflation-adjusting
the entire money supply on a daily basis in terms of the Daily CPI compensates
for (nullifies) the effect of low
inflation, high inflation and deflation, and in terms of the Daily USD parallel
rate, nullifies the effect of
hyperinflation. However, this does not remove actual low inflation, high inflation,
hyperinflation and deflation. This means that the monetary economy and constant
item economy can be maintained stable with an IFRS. Normally it is seen that
the stability of the monetary economy is the responsibility of the Central
Bank. In fact it is not. It is the responsibility of the accounting profession
to implement capital maintenance in units of constant purchasing power in terms
of a daily index correctly under complete co-ordination (everyone doing it). No
central bank intervention is actually required to stop the effect of the erosion of the real value of monetary
items from the monetary economy. It can be done by accountants with an IFRS: with
capital maintenance in units of constant purchasing power in terms of a daily
index. Central bank intervention is only required to eliminate actual inflation
and deflation. Correct accounting can compensate for (nullify) its effect in
the economy.
Nicolaas Smith
Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.
