Capital Maintenance in Units of Constant Purchasing Power in terms of the Daily CPI

Saturday 17 April 2010

Accountants´ unknowing destruction of entities´ capital and profits with Historical Cost Accounting during low inflation as well as its only remedy authorized in IFRS in the same statement 21 years ago.

ACCOUNTANTS´ UNKNOWING DESTRUCTION OF ENTITIES´ CAPITAL AND PROFITS WITH HISTORICAL COST ACCOUNTING DURING LOW INFLATION AS WELL AS ITS ONLY REMEDY AUTHORIZED IN IFRS IN THE SAME STATEMENT 21 YEARS AGO.

Nicolaas Johannes SMITH

Thematic Area: IFRS 2nd April 2010

Accountant, Lisbon, Portugal, +351 911 925 778, realvalueaccounting@yahoo.com

ABSTRACT

Accountants unknowingly, unnecessarily and unintentionally destroy the real value of banks´ and companies´ shareholders´ equity never maintained constant as a result of insufficient revaluable fixed assets under the HCA model during low inflation with their free choice of implementing the stable measuring unit assumption (which is based on a fallacy) as part of financial capital maintenance in nominal monetary units per se (another popular accounting fallacy) authorized in IFRS in the Framework, Par 104 (a) in 1989. This amounts to hundreds of billions of US Dollars of unnecessary real value destruction in the world economy each and every year. The IASB, FASB and accountants mistakenly blame this on inflation and act as if they are powerless to do anything about it. They are wrong. Inflation has no effect on the real value on non-monetary items.

Accountants would maintain the real value of all constant real value non-monetary items – e.g. banks´ and companies´ capital and retained profits – constant for an unlimited period of time – ceteris paribus – thus boosting the world economy with hundreds of billions of US Dollars every year in all entities that at least break even when they freely choose the other financial capital maintenance option also authorized in IFRS in exactly the same Framework, Par 104 (a) twenty one years ago, namely, continuous financial capital maintenance in units of constant purchasing power during low inflation and deflation. This would happen whether these entities own revaluable fixed assets or not and without the requirement of more capital or additional retained profits to simply maintain the existing constant real value of existing shareholders´ equity constant.

The critical difference in this change of basic accounting model compared to previous attempts to replace the HCA model is that it is clearly and undeniably proven that accountants unknowingly and unnecessarily destroy a significant amount of real value in the world economy with traditional HCA during low inflation each and every year. They know and admit that real value is being destroyed in companies’ capital and profits: they mistakenly blame inflation. Fortunately, the only and perfect remedy was authorized in IFRS in the same Framework, Par 104 (a) twenty one years ago for implementation during low inflation and deflation.

Keywords: constant real value non-monetary items, variable real value non-monetary items, continuous financial capital maintenance in units of constant purchasing power, the Framework Par 104 (a), Constant Item Purchasing Power Accounting.

1) Introduction

The three fundamentally different basic economic items in the economy are:

1) Monetary items

2) Variable real value non-monetary items

3) Constant real value non-monetary items

“Non-monetary items include variable real value non-monetary items valued, for example, at fair value, market value, present value, net realizable value or recoverable value.” 1

“Retained Income is a constant real value non-monetary item.” 2

Monetary items are money held and items with an underlying monetary nature. Examples are bank notes, bank coins, money loans, government bonds, commercial bonds, home loans, car loans, student loans, consumer loans, credit card loans, notes payable, etc. Monetary items are always valued in nominal monetary units during the current accounting period under all accounting models and under all economic models.

Variable items are non-monetary items with variable real values over time. Examples are property, plant, equipment, inventory, foreign exchange, listed and unlisted shares, etc, valued during low inflation and deflation in terms of specific IFRS at, for example, fair value, market value, present value, net realizable value, recoverable value, etc. Variable items, being non-monetary items, are required in terms of IAS 29 to be restated in terms of the measuring unit current at the balance sheet date by applying the period-end Consumer Price Index during hyperinflation.

Constant items are non-monetary items with constant real values over time. Examples are all income statement items, retained income, all other shareholders´ equity items, trade debtors, trade creditors, taxes payable, taxes receivable, provisions, all other non-monetary payables, all other non-monetary receivables, etc. Constant items have to be continuously valued in units of constant purchasing power by applying the monthly change in the annual CPI in terms of continuous financial capital maintenance in units of constant purchasing power as authorized in IFRS in the Framework, Par 104 (a) during low inflation and deflation and the daily parallel rate in terms of IAS 29 Financial Reporting in Hyperinflationary Economies during hyperinflation.

Certain income statement constant items, e.g. salaries, wages, rentals, etc, are generally inflation-adjusted under HCA during low inflation. Other income statement constant items and all balance sheet constant items are valued in nominal monetary units, i.e. at Historical Cost, by accountants implementing the stable measuring unit assumption under HCA during low inflation and deflation.

International Financial Reporting Standards (IFRS) is the single term used to designate Standards, Interpretations and the Framework for the Interpretation and Presentation of Financial Statements adopted and issued by the International Accounting Standards Board (IASB).

“In the absence of a Standard or an Interpretation that specifically applies to a transaction, management must use its judgement in developing and applying an accounting policy that results in information that is relevant and reliable. In making that judgement, IAS 8.11 requires management to consider the definitions, recognition criteria, and measurement concepts for assets, liabilities, income, and expenses in the Framework. This elevation of the importance of the Framework was added in the 2003 revisions to IAS 8.” ³

There are no specific Standards or Interpretations applicable to the concepts of capital, the concepts of capital maintenance and the valuation of constant items. The definitions and concepts in the Framework (1989) are thus applicable.

“Concepts of Capital

Par. 102. A financial concept of capital is adopted by most entities in preparing their financial statements. Under a financial concept of capital, such as invested money or invested purchasing power, capital is synonymous with the net assets or equity of the entity. Under a physical concept of capital, such as operating capability, capital is regarded as the productive capacity of the entity based on, for example, units of output per day.

Concepts of Capital Maintenance and the Determination of Profit

Par 104 The concepts o capital in paragraph 102 give rise to the following concepts of capital maintenance:

(a) Financial capital maintenance. Under this concept a profit is earned only if the financial (or money) amount of the net assets at the end of the period exceeds the financial (or money) amount of net assets at the beginning of the period, after excluding any distributions to, and contributions from, owners during the period. Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power.

(b) Physical capital maintenance. Under this concept a profit is earned only if the physical productive capacity (or operating capability) of the entity (or the resources or funds needed to achieve that capacity) at the end of the period exceeds the physical productive capacity at the beginning of the period, after excluding any distributions to, and contributions from, owners during the period.

Par 108 When the concept of financial capital maintenance is defined in terms of constant purchasing power units, profit represents the increase in invested purchasing power over the period. Thus, only that part of the increase in the prices of assets that exceeds the increase in the general level of prices is regarded as profit.” 4

The three concepts of capital defined in IFRS during low inflation and deflation are:

•(1) Physical capital. Par 102.

•(2) Nominal financial capital. Par 104 (a).

•(3) Constant purchasing power financial capital. Par 104 (a) and 108.

The three concepts of capital maintenance authorized in IFRS during low inflation and deflation are:

•(a) Physical capital maintenance: optional during low inflation and deflation. The Current Cost basis of measurement is prescribed in the Framework, Par 106 when the physical capital maintenance concept is chosen.

•(b) Financial capital maintenance in nominal monetary units (traditional Historical Cost Accounting): authorized in IFRS but not prescribed - optional during low inflation and deflation. Par 104 (a). It is adopted by most entities in preparing their financial statements. It is a popular accounting fallacy: it is impossible to maintain the real value of financial capital constant during inflation and deflation with measurement in nominal monetary units per se. It requires the implementation of the stable measuring unit assumption which is also based on a fallacy.

•(c) Financial capital maintenance in units of constant purchasing power: authorized in IFRS but not prescribed - optional during low inflation and deflation. Par 104 (a) and 108. Only constant real value non-monetary items are continuously measured in units of constant purchasing power by applying the monthly change in the annual CPI during low inflation and deflation. Variable items are measured in terms of specific IFRS during low inflation and deflation. Monetary items are and can only be measured in nominal monetary units during the current accounting period under all economic environments and under all accounting models. The net monetary loss or gain from holding net monetary assets or net monetary liabilities would be calculated and accounted in the income statement. The stable measuring unit assumption is rejected under this concept. Constant Item Purchasing Power Accounting (CIPPA), namely continuous financial capital maintenance in units of constant purchasing power during low inflation and deflation as authorized in IFRS in the Framework, Par 104 (a) is the only basic accounting model that can automatically maintain the real value of all constant items constant for an unlimited period of time in all entities that at least break even – ceteris paribus – whether they own revaluable fixed assets or not and without the need for extra capital or extra retained profits simply to maintain the existing constant real value of existing shareholders´ equity constant during low inflation and deflation.

“Having decided on what concept of capital is to be adopted, the company then decides on which type of capital maintenance is most appropriate to report. It can report on the basis of Financial Capital Maintenance (and this can be in Nominal Monetary Units or in Constant Purchasing Power units) or it can report in terms of Physical Capital Maintenance. There is much to be gained from moving away from reporting on the basis of Financial Capital Maintenance in Nominal Monetary Units.” 5

Constant Purchasing Power Accounting (CPPA) is the IASB´s inflation accounting model defined in IAS 29 which requires the restatement of all non-monetary items – constant and variable items – in Historical Cost or Current Cost financial statements by applying a price index at the period-end during hyperinflation. This paper is not about CPPA inflation accounting during hyperinflation as required in IAS 29.

2. Basis for Historical Cost Accounting

IFRS only define two economic items: monetary items in IAS 29 Par 12 and IAS 21 Par 8 and non-monetary items in IAS 29 Par 14. There are, however, three fundamentally different basic economic items in the economy as defined above. Constant real value non-monetary items and variable real value non-monetary items are defined indirectly in IFRS. According to the Framework, Par 104 (a) financial capital maintenance can be measured in units of constant purchasing power during low inflation and deflation. Although IAS 29 is only to be applied during hyperinflation, it defines monetary and non-monetary items in general. According to IAS 29 Par 12: “Monetary items are not restated because they are already expressed in terms of the monetary unit current at the balance sheet date.” IAS 29 Par 14 defines non-monetary items as all items that are not monetary items. Since monetary items are not restated only non-monetary items can thus be measured in units of constant purchasing power or inflation-adjusted or restated or updated or maintained constant. As such, non-monetary items measured in units of constant purchasing power during low inflation and deflation in terms of the Framework, Par 104 (a) are thus constant real value non-monetary items; e.g. all income statement items, all items in shareholders´ equity, trade debtors, trade creditors, taxes payable and receivable, etc. Consequently, non-monetary items that are not measured in units of constant purchasing power during low inflation and deflation are thus variable real value non-monetary items since they have variable real values over time valued in terms of specific IFRS.

IFRS do not split non-monetary items in constant and variable items as a result of the stable measuring unit assumption. One of the basic principles in accounting is “The Measuring Unit principle: The unit of measure in accounting shall be the base money unit of the most relevant currency. This principle also assumes the unit of measure is stable; that is, changes in its general purchasing power are not considered sufficiently important to require adjustments to the basic financial statements.” 7

Non-monetary items under the HCA model include Historical Cost items based on the stable measuring unit assumption. Accountants value both variable real value non-monetary items (e.g. inventory and fixed property) stated at HC in terms of IFRS, as well as constant real value non-monetary items (e.g. shareholders´ equity items) also stated at HC in terms of the HCA model as authorized in IFRS, in nominal monetary units applying the stable measuring unit assumption during non-hyperinflationary periods. Both HC variable and HC constant items are thus considered by accountants to be simply HC non-monetary items.

It is a generally accepted accounting practice for accountants not to apply the stable measuring unit assumption to the valuing of certain income statement constant items, namely salaries, wages, rentals, etc which they generally inflation-adjust annually. Accountants value all other income statement items and all balance sheet constant items in nominal monetary units when they implement financial capital maintenance in nominal monetary units during low inflation and deflation.

However, it is impossible to maintain the real value of financial capital constant with financial capital maintenance in nominal monetary units per se applying the stable measuring unit assumption during inflation and deflation. The measuring unit (money) is not perfectly stable during inflation and deflation. Inflation destroys the real value of money and other monetary items while deflation creates more real value in money and other monetary items over time. Sustainable zero annual inflation has never been achieved in the past and is not likely to be achieved any time soon in the future. Financial capital maintenance in nominal monetary units per se during inflation and deflation as authorized in IFRS in the Framework, Par 104 (a) is a popular accounting fallacy. IFRS should not be based on popular accounting fallacies as they currently are.

“Under a financial concept of capital, such as invested money or invested purchasing power, capital is synonymous with the net assets or equity of the entity.” 8

Shareholders´ equity’s real value can only be maintained constant (excluding continuous additions of fresh capital or additional retained profits at the rate of inflation) with financial capital maintenance in nominal monetary units (traditional HCA) during low inflation when 100% of the updated original real value of all contributions to the shareholders´ equity balance are invested in revaluable fixed assets with an equivalent updated fair value – revalued or not. Valuing a revaluable fixed asset at HC (in nominal monetary units applying the stable measuring unit assumption) does not destroy its real value. It would normally be revalued when it is eventually sold or exchanged. It can also be revalued via the revaluation reserve before it is finally sold.

However, the portion of shareholders´ equity’s real value, under HCA, that is never maintained constant with sufficient revaluable fixed assets during low inflation, is unknowingly and unnecessarily being treated by accountants the same as a monetary item (e.g. cash). Accountants unknowingly, unnecessarily and unintentionally destroy its real value at a rate equal to the annual rate of inflation because they freely choose in terms of the Framework, Par 104 (a) - as authorized in IFRS - to implement financial capital maintenance in nominal monetary units and apply the stable measuring unit assumption during low inflation. This amounts to hundreds of billions of US Dollars of unnecessary real value destruction in the world economy each and every year.

Shareholders´ equity’s value is expressed in terms of a monetary unit of account (the functional currency or money) and inflation destroys the real value of money. It is not inflation doing the destroying of the real value of the constant real value non-monetary item shareholders´ equity: it is accountants´ free choice of financial capital maintenance in nominal monetary units when they implement their very destructive stable measuring unit assumption as authorized in IFRS in the Framework, Par 104 (a) during low inflation.

Inflation can only destroy the real value of money and other monetary items – nothing else. Inflation is always and everywhere a monetary phenomenon. Inflation has no effect on the real value of non-monetary items. Shareholders´ equity is a constant real value non-monetary item.

“Purchasing power of non monetary items does not change in spite of variation in national currency value.” 9

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

Everybody suddenly then agrees to destroy hundreds of billions of Dollars in real value in all companies´ Retained Income balances all around the world.” 10

3. The basis for continuous financial capital maintenance in units of constant purchasing power

When accountants freely choose the other option also authorized in IFRS in the Framework, Par 104 (a), namely continuous financial capital maintenance in units of constant purchasing power, they would maintain the real value of all constant real value non-monetary items constant for an unlimited period of time – ceteris paribus – in all entities that at least break even whether these entities own revaluable fixed assets or not and without the requirement of additional capital or additional retained profits simply to maintain the existing constant real value of existing shareholders´ equity constant at all levels of inflation and deflation. It is thus not inflation doing the destroying, but accountants´ free choice of financial capital maintenance in nominal monetary units during low inflation.

The stable measuring unit assumption is based on the fallacy that changes in the purchasing power of money are not sufficiently important for entities to choose to continuously measure financial capital maintenance in units of constant purchasing power during low inflation and deflation as authorized in IFRS in the Framework, Par 104(a). Hyperinflation is defined in IFRS as a cumulative inflation rate approaching or equal to 100% over three years, i.e. 26% annual inflation for 3 years in a row. Financial capital maintenance in units of constant purchasing power is required in IFRS in IAS 29 during hyperinflation: it is thus required at 26% annual inflation for 3 years in a row. It is, however, left as an option at 20% or 15% or 6% or 2% for three years in a row or any number of years. Real value destruction in constant items never maintained constant by the implementation of the stable measuring unit assumption at continuous 20% inflation (which would wipe out 100% of the real value of shareholders´ equity never maintained constant in 4 years) is currently considered as not sufficiently important for the implementation of continuous financial capital maintenance in units of constant purchasing power. Accountants currently unknowingly, unnecessarily and unintentionally destroy 51% of the real value of shareholders´ equity and all other constant items never maintained constant over 35 years in all economies with continuous 2% annual inflation implementing financial capital maintenance in nominal monetary units per se as authorized in IFRS in the Framework, Par 104 (a).

“The erosion of business profits and invested capital caused by inflation” is generally accepted as stated in the US Financial Accounting Standard FAS 33: “In Mr. Mosso's view, conventional accounting measurements fail to capture the erosion of business profits and invested capital caused by inflation.” 11

There is absolutely no doubt in the accounting profession that real value is being destroyed in entities´ capital and profits and there is equally absolutely no doubt in the accounting profession that it is caused by inflation. In fact, “the erosion of business profits and invested capital caused by inflation” is a fallacy. Inflation is always and everywhere a monetary phenomenon as per the late American Nobel Laureate Milton Friedman. Inflation destroys the real value of money and other monetary items – nothing else. Inflation has no effect on the real value of non-monetary items. It is impossible for inflation per se to destroy the real value of non-monetary items. See Gucenme and Arsoy above.

Continuous financial capital maintenance in units of constant purchasing power only results in zero destruction of real value in constant items for an unlimited period of time at any level of inflation or deflation in entities that at least break even – ceteris paribus. It has no direct effect on the rate of inflation or deflation.

4. Examples

Example: Sufficient fixed assets revalued by HC accountant

Historical Cost Accounting

Company started in Jan 1981 CPI = 7.3 (2008 = 100 Source: Statistics South Africa) Monetary unit: South African Rand

Opening Accounts

Dr Issued Share Capital Cr

~~. .~~

| Jan 81 O Bal R 1 000 000

Dr Land Cr

~~. .~~

Jan 81 O Bal R 1 000 000 |

Closing Accounts

Dec 2009 CPI = 109.2 (Source: Statistics SA)

Cumulative inflation from Jan 1981 to Dec 2009 1 395.9 %

Update factor from Jan 1981 to Dec 2009 109.2 / 7.3 = 14.959

Dr Issued Share Capital Cr

~~. .~~

                                                 | Dec 09 C Bal         R 1 000 000

Dr                                      Land                                             Cr
~~.                                                                                                .~~
Jan 81 O Bal          R 1 000 000 |
Dec 09 Reval. Res   13 959 000 |
                            ~~.                 .~~
Dec 09 C Bal           14 959 000 |

Dr                           Revaluation Reserve                                Cr
~~.                                                                                               .~~
                                               | Dec 09 Land            R 13 959 000

In the above example it is assumed that the Land was revalued at a rate equal to the cumulative inflation rate over the period. This is only the assumption made for this example. It is not normally the case in practice. In practice, properties are revalued by experts in this field or at the actual market rate, where possible.

Statement of Changes in Equity for the year ended 31 Dec 2009

Issued Share Revaluation Total

Capital Reserve

R´000 R´000 R´000

Bal at 31 Dec 2008 1 000 --- 1 000

Reval Land Dec 2009 - 13 959 13 959

~~. .~~ ~~. .~~ ~~. .~~

Bal 31 Dec 2009 1 000 13 959 14 959

It can be seen from the above Statement of Changes in Equity that the revaluation of fixed assets can be used under the HCA model to maintain the real value of Shareholders Equity. This is obviously only possible for companies with sufficient revaluable fixed assets to revalue in this manner. Very few companies are in this position: mainly hotel groups and property companies.

If the board of directors in 1981 had decided to measure financial capital maintenance in units of constant purchasing power and this was continued till 31 Dec, 2009, the closing accounts would be as follows:

Example: Constant Item Purchasing Power Accounting

Closing accounts

Dec 2009 CPI = 109.2

Dr Issued Share Capital Cr

~~. .~~

| Dec 09 Cl Bal R 14 959 000

Dr Land Cr

~~. .~~

Dec 09 C Bal R 14 959 000 |

Statement of Changes in Equity for the year ended 31 Dec 2009

Dec 2009 CPI 109.2

Issued Share Total

Capital

R´000 R´000

Balance at 31 Dec 2008 14 959 14 959

Profit for the year - -

Balance at 31 Dec 2009 14 959 14 959

There is no Revaluation Reserve - in this particular example - because of the assumption that the Land’s revaluation is equal to the cumulative rate of inflation over the period. See above. Capital is valued monthly in units of constant purchasing power every time the value of the CPI changes. Land is revalued monthly too applying the change in the CPI (only for this example).

When the revaluation of the Land is a value higher than the value at the beginning of the period times the change in the CPI over the period, then the difference would be shown in the revaluation reserve account.

If a company during the period from Jan 1981 to December 2009 had R 1 000 000 in Land – with no revaluation till the end of 2009 - and there were an extra R 1 000 000 in retained earnings and R1 000 000 in trade debtors account in Jan 1981 with the same items remaining in the company till 31 Dec 2009 then the opening and closing accounts would be as follows:

Example: Insufficient fixed assets to revalue by HC accountant

Historical Cost Accounting

Jan 1981 CPI = 7.3

Dr Issued Share Capital Cr

~~. .~~

| Jan 81 O Bal R 1 000 000

Dr Retained Earnings Cr

~~. .~~

| Jan 81 O Bal R 1 000 000

Dr Trade Debtors Cr

~~. .~~

Jan 81 O Bal R 1 000 000 |

Dr Land Cr

~~. .~~

Jan 81 O Bal R 1 000 000 |

Statement of Changes in Equity for the year ended 31st Dec 1981

Issued Share Retained Total

Capital Earnings

R´000 R´000 R´000

Balance 1 Jan 1981 1 000 1 000 2 000

Profit for the year - - -

Balance 31 Dec 1981 1 000 1 000 2 000

Equity can be increased in Dec 2009 by R13 959 000 to reflect the revaluation of the Land. At the same time we can see that R13 959 000 was unknowingly destroyed by the company accountants in the real value of the Retained Earnings balance from Jan 1981 to Dec 2009 – which can not be updated under HCA during low inflation - because they implemented the stable measuring unit assumption as part of the Historical Cost Accounting model during low annual inflation.

Historical Cost Accounting

Dec 2009 CPI = 109.2

Dr Issued Share Capital Cr

~~. .~~

| Dec 09 C Bal R 1 000 000

Dr Retained Earnings Cr

~~. .~~

| Dec 09 C Bal R 1 000 000

Dr Trade Debtors Cr

~~. .~~

Dec 09 C Bal R 1 000 000 |

Dr Land Cr

~~. .~~

Jan 81 O Bal R 1 000 000 |

Dec 09 Reval Res 13 959 000 |

Dec 09 C Bal 14 959 000 |

Dr Revaluation Reserve Cr

~~. .~~

| Dec 09 Land R 13 959 000

Statement of Changes in Equity for the year ended Dec 2009

Retained Issued Share Revaluation Total

Earnings Capital Reserve

R´000 R´000 R´000 R´000

Bal 31 Dec 08 1 000 1 000 --- 2 000

Reval Land - - 13 959 13 959

Bal 31 Dec 09 1 000 1 000 13 959 15 959

If the board of directors in January, 1981 had decided to measure financial capital maintenance in units of constant purchasing power and this was continued till Dec, 2009, the closing accounts would be as follows:

Constant Item Purchasing Power Accounting

Dec 2009 CPI = 109.2

Dr                               Issued Share Capital                          Cr
~~.                                                                                                .~~
                                                  | Dec 09 C Bal       R 14 959 000

Dr                               Retained Earnings                              Cr
~~.                                                                                                .~~
                                                  | Dec 09 C Bal       R 14 959 000

Dr                                    Trade Debtors                               Cr
~~.                                                                                                .~~
Dec 09 C Bal         R 14 959 000 |

Dr                                          Land                                         Cr
~~.                                                                                                .~~
Dec 09 C Bal         R 14 959 000 |

Statement of Changes in Equity for the year ended 31 Dec 2009

Issued Share Retained Total

Capital Earnings

R´000 R´000 R´000

Bal 31 Dec 2008 14 959 14 959 29 918

Profit for the year - - -

Bal at 31 Aug 2009 14 959 14 959 29 918

It can be seen from the above that there is no extra capital or extra profits required to maintain the real value of existing shareholders´ equity. It is simply a matter of maintaining the real value of existing constant real value non-monetary items constant (trade debtors, retained earnings and issued share capital in this case) in a double entry accounting model while variable real value non-monetary items (Land in this case) are valued in terms of specific IFRS. Net monetary losses and gains would be calculated and accounted in the income statement. This is Constant Item Purchasing Power Accounting or continuous financial capital maintenance in units of constant purchasing power during low inflation and deflation as authorized in IFRS in the Framework, Par 104 (a). It can also be seen from the above that continuously maintaining the constant purchasing power of capital is a fundamental basic function or objective of accounting / general purpose financial reporting during inflation and deflation.

Accountants unknowingly and unnecessarily, in this manner, destroy hundreds of billions of US Dollars each and every year in the real values of banks´ and companies´ reported constant items never maintained constant, e.g. retained earnings, implementing their very destructive stable measuring unit assumption as a result of their free choice to measure financial capital maintenance in nominal monetary units – which is a fallacy – as authorized in IFRS in the Framework, Par 104 (a).

5. The Inflation Mistake

Accountants clearly know and admit that there is real value being destroyed in non-monetary items, namely in companies´ profits and capital: “the erosion of business profits and capital caused by inflation” as it is so generally accepted. Accountants just do not realize that they are actually unknowingly doing the destroying when they freely choose to implement the stable measuring unit assumption during low inflation. They think it is inflation doing the destroying. It is impossible for inflation per se to destroy the real value of any non-monetary item.

Accountants mistakenly think the erosion (which is the same as destruction) of business profits and invested capital is caused by inflation. Everybody knows the actual cost of inflation – the net monetary loss from holding a net monetary balance of monetary assets during the accounting period – is not accounted under HCA during low inflation and deflation. Accounting authorities and accountants think it is the monetary authorities´ task to reduce inflation which would reduce the cost of inflation and “the erosion of business profits and invested capital caused by inflation”. First of all, the erosion (destruction) of business profits and invested capital is not caused by inflation but by accountants´ free choice of implementing financial capital maintenance in nominal monetary units during low inflation.

Yes, reducing inflation reduces the actual cost of inflation (the net monetary loss) and it also reduces the cost of the stable measuring unit assumption. However, sustained zero annual inflation - required to eliminate the cost of the stable measuring unit assumption completely in this manner - has never been achieved in the past in any economy using money and is not likely to be achieved any time soon in the future. So, central bankers will, most probably, never eliminate the cost of the stable measuring unit assumption completely in the world’s constant item economy, namely, the hundreds of billions of US Dollars unnecessarily, unknowingly and unintentionally being destroyed by accountants´ free choice of financial capital maintenance in nominal monetary units during low inflation. However, continuous financial capital maintenance in units of constant purchasing power which accountants can freely implement any time they want and which has been authorized in IFRS in the Framework, Par 104 (a) twenty one years ago will permanently eliminate the entire cost of the stable measuring unit assumption forever at any level of inflation and would prevent economic instability during deflation caused by the appreciation in the real value of constant items under HCA. Accountants would then knowingly maintain hundreds of billions of US Dollars per annum in the world’s real economy for an unlimited period of time during indefinite low inflation – all else being equal.

It is no use repeating the third not yet extinct accounting fallacy, namely that “the erosion of business profits and invested capital is caused by inflation” (which is not true since inflation per se can only destroy the real value of money and other monetary items) and that lowering inflation would lower the cost of the stable measuring unit assumption when sustainable zero inflation is not an option (and most probably never will be an option) while IFRS-authorized continuous financial capital maintenance in units of constant purchasing power would result in zero inflation (zero destruction of real value) in all constant items forever – ceteris paribus – at any rate of inflation: 2% or 2 000% or 2 million per cent per annum in all entities that at least break even whether they own revaluable fixed assets or not and without the requirement of more capital or additional retained profits to simply maintain the real value of existing constant items constant.

Accountants mistakenly regard the unnecessary destruction caused by their choice to implement the stable measuring unit assumption as “the erosion of business profits and invested capital caused by inflation” as it was described by a member of the US Financial Accounting Standards Board in FAS 33 in 1979.

They and accounting authorities thus consider it to be the same as the cost of inflation which is not calculated and accounted under HCA during low inflation. They are consequently satisfied that they “correctly” follow a generally accepted accounting practice of not accounting the net monetary loss or gain from inflation during low inflation when they refer to “the erosion of business profits and invested capital caused by inflation” which is in fact the cost of their very destructive stable measuring unit assumption. They do not see the destruction of the real value of companies´ profits and capital (the destruction of the real value of constant items never maintained constant under HCA) as separate from the destruction of the real value of money and other monetary items actually caused by inflation. To them the net monetary loss from holding a net balance of monetary assets and the “erosion of business profits and invested capital caused by inflation” are both the same thing – both caused by inflation. They are mistaken. Inflation has no effect on the real value of non-monetary items. Inflation can only destroy the real value of money and other monetary items which are items with an underlying monetary nature. All items in shareholders´ equity are constant real value non-monetary items.
The IASB authorized an alternative basic accounting model - financial capital maintenance in units of constant purchasing power - in the Framework, Par 104 (a) which accountants are free to choose which would allow them to stop their unknowing destruction caused by their choice of the stable measuring unit assumption during low inflation.

Unfortunately, accountants do not realize they are destroying hundreds of billions of US Dollars in real value each and every year when they freely choose, also in terms of the Framework, Par 104 (a), an IASB-authorized 700 year old traditional, generally accepted accounting model complaint with IFRS; consequently, they do not look for a solution in IFRS: they ignore the IFRS-authorized option in the Framework, Par 104 (a), namely, continuous financial capital maintenance in units of constant purchasing power during low inflation and deflation.

The cost of inflation, i.e., the net weighted average monetary loss from holding a net weighted average balance of monetary assets during the accounting period is not required to be accounted under HCA during low inflation although it is specifically required in IFRS in IAS 29 during hyperinflation in a generally accepted contradiction of accounting and economic logic in IFRS. The cost of inflation is not the same as the cost of the stable measuring unit assumption; i.e. the cost of the unknowing and unnecessary destruction of the real value of constant items never maintained by accountants´ free choice of measuring them in nominal monetary units during low inflation when it is a fact that inflation can only destroy the real value of money (the functional currency) which is the monetary unit of account in the economy. The cost of the stable measuring unit assumption is the unnecessary cost of a destructive accounting practice by accountants which is authorized in IFRS.

IAS 29 requires the calculation of the net monetary gain or loss from holding monetary items during hyperinflation. Theoretically, IAS 29 rejects the stable measuring unit assumption, but, actually only in restatement of HC or Current Cost financial statement in a hyperinflationary economy; i.e. in presentation or restatement of period-end HC or Current Cost financial statements to make them more useful after the period-end. As PricewaterhouseCoopers states: “Inflation adjusted financial statements are an extension to and not a departure from historic cost accounting.” 12 IAS 29 clearly states that historical cost or current cost financial statements have to be restated in terms of the period-end CPI. The IASB does not require the complete rejection of the highly destructive HCA model during hyperinflation when, in fact, it should specifically be banned by law during hyperinflation.

The destruction of the real values of constant items never maintained caused by accountants´ implementation of the stable measuring unit assumption during low inflation and hyperinflation is eliminated completely and the real values of constant items are maintained constant in all entities that at least break even whether they own revaluable fixed assets or not for an unlimited period of time when accountants reject the stable measuring unit assumption and constant real value non-monetary items are continuously valued or measured in units of constant purchasing power over time during the accounting period. This only happens to a limited extent during hyperinflation when IAS 29 is implemented and when a country’s tax authorities accept the year-end HC or CC financial statement restated values for the purpose of calculating taxes as in the case of Turkey in 2004.

Constant items´ real values are still hyper-destroyed by accountants´ implementation of the stable measuring unit assumption during hyperinflation even with the implementation of IAS 29 in hyperinflationary economies when they do not implement continuous financial capital maintenance in units of constant purchasing power by applying the daily parallel rate or index the non-monetary economy daily in terms of normally the US Dollar parallel rate. When accountants restate their HC or CC financial statements after they have unknowingly hyper-destroyed their constant item economy with their very destructive stable measuring unit assumption (during hyperinflation) and the restated values are not accepted by the tax authorities as the real values of items for tax calculation purposes, for example Turkey in 2003, then IAS 29 has a limited effect in the economy. It had no effect in Zimbabwe’s hyperinflationary economy. This normally happens in hyperinflationary economies which do not follow the Brazilian example by indexing non-monetary items daily in terms of a US Dollar based rate, which Brazil did – in principle – for 30 years from 1964 to 1994.

As per the Banco Central do Brasil:

Prezado Senhor

Não temos como fornecer, conforme solicitado, os detalhes exatos do indexador utilizado durante o período de alta inflação no Brasil. Vale esclarecer que, desde 1964, quando foi implementado o Programa de Ação Econômica do Governo - PAEG, vários mecanismos de indexação foram introduzidos na economia brasileira objetivando reduzir os efeitos da inflação não antecipada sobre o lado real da economia. Podemos destacar os mecanismos destinados à taxa de câmbio, aos salários e e à correção monetária de ativos financeiros. Ao longo da existência das ORTNs e de seus sucedâneos, por exemplo, os governos mudaram em diversas oportunidades as fórmulas de cálculo da correção monetária e trocaram várias vezes os índices de preços que eram utilizados no cálculo da mesma.
Assim sendo, sugerimos uma consulta ao Ministério da Fazenda, que talvez possa fornecer o histórico dos indexadores utilizados no País.
Atenciosamente,

DEPEP/RJ”

Accountants´ application of the stable measuring unit assumption during the accounting period in a hyperinflationary economy hyper-destroys the real value of the constant real value non-monetary item part of the real or non-monetary economy while hyperinflation hyper-destroys the real value of money and other monetary items in the monetary economy. That is what happened in Zimbabwe but it did not happen in Brazil during 30 years of high and hyperinflation. Hyperinflation only hyper-destroyed the real value of the Brazilian monetary unit during those 30 years. They maintained the real value of their real economy more or less stable with indexation, which – in broad principle – is the same as continuous financial capital maintenance in units of constant purchasing power as authorized in the Framework, Par 104 (a). The results of the two different approaches (in Brazil and in Zimbabwe) are very clear in 2010 in those two countries.

It appears that it is not the IASB´s IAS 29´s intention to stop accountants´ unknowing hyper-destruction of real value in constant items never maintained by continuously implementing the stable measuring unit assumption during hyperinflation. IAS 29 appears simply to be intended to make hyper-destroyed HC or CC financial reports more meaningful by restating them in terms of the period-end CPI at the end of the accounting period after accountants have already unknowingly hyper-destroyed the constant item economy in a hyperinflationary economy by implementing the stable measuring unit assumption – during hyperinflation - as accepted by the IASB in IAS 29.

The two enemies in the economy: the one very well known; the other a stealth enemy camouflaged by authorization in IFRS. The one – inflation - seen as an enemy in most instances; the other – accountants´ free choice of the stable measuring unit assumption - wreaking possibly even more damage in the real economy than inflation in the monetary economy. The stable measuring unit assumption is a very destructive stealth enemy very effectively camouflaged by IFRS authorization during low inflation and IFRS acceptance during hyperinflation as supported by Big Four accounting firms like PricewaterhouseCoopers. See above.

The net monetary loss or gain from inflation is required by IFRS to be accounted under the two circumstances when the stable measuring unit assumption is rejected in terms of IFRS: (1) during hyperinflation in terms of IAS 29 and (2) when accountants would choose to measure financial capital maintenance in units of constant purchasing power during low inflation and deflation in terms of the Framework, Par 104 (a). The cost of inflation has to be debited to the Profit and Loss Account as a net monetary loss.

There would obviously be no destruction in constant items´ real values at permanently sustainable zero inflation – an economic model never achieved in the past and not likely to be achieved any time soon in the future.

The cost of low inflation, although not calculated and accounted under HCA, is experienced by everyone in a low inflationary economy holding money and other monetary items over time: the money and the original real values of other monetary items are worth less because inflation destroys their real values over time. Take for example South Africa: The cost of inflation amounts to R119 billion per annum at 6.2% annual inflation in SA´s monetary base M3 of R1 923.538 billion while the cost of real value destroyed in SA constant item economy unknowingly caused by SA accountants´ implementation of the stable measuring unit assumption amounts to about R200 billion per annum at the same time. The full R200 billion per annum can be maintained instead of destroyed at 6% annual inflation with continuous financial capital maintenance in units of constant purchasing power for an unlimited period of time. SA will still suffer the destruction of R119 billion per annum in the real value of the Rand money supply as long as inflation stays at 6.2% per annum – all else being equal, but, SA accountants would knowingly boost the SA real economy with about R200 billion per annum for an unlimited period of time as long as they would implement financial capital maintenance in units of constant purchasing power. This applies to all accountants in low inflationary economies.

In most companies in which the above situation applies, this annual destruction would be at least equal to the weighted average annual value of Retained Earnings times the average annual inflation rate. This cost can be calculated to know its constant real value and the magnitude of real value destroyed like this (or to be gained per annum in all entities at least breaking even for an unlimited period of time – all else being equal - from freely changing over to financial capital maintenance in units of constant purchasing power), but, it is never accounted as a loss in the Profit and Loss account at any time under the HCA model – similar to the non-accounting of the cost of inflation during low inflation. Because Retained Profits never maintained are, in principle, in this manner treated the same as monetary items under HCA during low inflation, this destruction of real value operates similar to – but it is not the same as - the cost of inflation in monetary items, but in Retained Profits and other constant items never maintained. Most people mistakenly think it is also caused by inflation.

In the case of companies with no revaluable fixed assets at all implementing HCA during low inflation this results in their total equity being valued in nominal monetary units thus being destroyed by accountants´ choice of the stable measuring unit assumption over time at a rate equal to the annual rate of inflation

6. Conclusions

HC accountants unknowingly, unnecessarily and unintentionally destroy hundreds of billions of US Dollars each and every year in the world economy in the real value of banks´ and companies´ shareholders´ equity never maintained constant with sufficient revaluable fixed assets under Historical Cost Accounting because they freely choose financial capital maintenance in nominal monetary units per se as authorized in IFRS in the Framework, Par 104 (a) twenty one years ago during low inflation implementing their very destructive stable measuring unit assumption. They mistakenly blame this on inflation. However, inflation is always and everywhere a monetary phenomenon. It has no effect on the real value of non-monetary items.

Accountants would knowingly stop this destruction and instead boost the world economy with hundreds of billions of US Dollars for an unlimited period of time – ceteris paribus – in all entities which at least break even whether these entities own revaluable fixed assets or not and without the requirement of additional capital or additional retained profits to simply maintain the existing constant real value of existing shareholders´ equity constant during low inflation when they freely choose continuous financial capital maintenance in units of constant purchasing power as authorized in IFRS in the exact same Framework, Par 104 (a) during low inflation and deflation.

References

1, 2, 10 Nicolaas Smith, Financial Statements, Inflation & The Audit Report (Johannesburg: Accountancy SA, Sept 2007) 38.
http://www.accountancysa.org.za/resources/ShowItemArticle.asp?ArticleId=1235&issue=857

3 Deloitte, Summaries of International Financial Reporting Standards (IAS Plus, Deloitte, 28th March, 2010) http://www.iasplus.com/standard/framewk.htm

4, 8 International Accounting Standards Board, Framework for the Preparation and Presentation of Financial Statements (London: IASB, 1989) 96-97.
http://www.iasb.org/IFRSs/IFRs.htm

5 Rachel F. Baskerville, 100 Questions (and Answers) about IFRS (Wellington: Victoria University, 15th March 2010) 19.

6 International Accounting Standards Board, International Accounting Standard IAS 29 Financial Reporting in Hyperinflationary Economies (London: IASB, 1989) Par 6.
http://www.iasb.org/IFRSs/IFRs.htm

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

9 Ümit GUCENME, Aylin P. ARSOY, Changes in financial reporting in Turkey, Historical Development of Inflation Accounting 1960 – 2005 (Bursa: Uludag University, 2005) 9.
http://www.mufad.org/index2.php?option=com_docman&task=doc_view&gid=9&Itemid=100

11 Financial Accounting Standards Board, Financial Accounting Standard 33, Financial Reporting and Changing Prices (Norwalk: FASB, 1979) 24.

12 PricewaterhouseCoopers, Financial Reporting in Hyperinflationary Economies, Understanding IAS 29 (London: PricewaterhouseCoopers, 2002) 5.

Bibliography

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Blanchard, O., Dell´Ariccia G. and Mauro, P., Rethinking Macroeconomic Policy, IMF Staff Position Note, Feb. 2010.

Zeff, Stephen A., The SEC Rules Historical Cost Accounting: 1934 to 1970s. Accounting and Business Research, 2006.

Arteta, Gustavo, Dollarization in Equador: Experiences, Challenges and Lessons, Institute of the Americas, 2001.

Vélez-Pareja, Ignacio, Merlo, Mariono G., Londoño, David A., and Sarmiento, Julio:
Potential Dividends and Actual Cash Flows. A Regional Latin American Analysis, Social Science Research Network, 2009

Carruthers, Bruce G., Nelson Espeland, Wendy, Accounting for Rationality: Double-Entry Bookkeeping and the Rhetoric of Economic Rationality, The American Journal of Sociology, Vol. 97, No. 1. (Jul., 1991), 31-69.

Salvary, Stanley C. W., Price Level Changes and Financial Accounting Measurement, Research Papers in Economics, RePEc:wpa:wuwpot:0410009, 2004.

Aly, Ibrahim, Simyar, Farhad, Capital Maintenance Concepts and Income Measurement, Indian Journal of Accounting, Vol XXXIII, 1992, 111-124.

Cassim, F. H. I., Cassim, Rehana, The Capital Maintenance Concept and Share Repurchases in South African Law, Johannesburg, Attorneys: Bowman and Gilfillan, 2004.

Parker, P. W. and Gibbs, P. M. D., Accounting for Inflation – Recent Proposals and their Effects, Institute of Actuaries, 1974.

Mallik, Girijasankar and Anis Chowdhury, Anis, Inflation and Economic Growth: Evidence from four South Asian Countries, Asia-Pacific Development Journal, Vol. 8, No. 1, June 2001.

Salvary, Stanley C. W., Accounting: A General Commentary on an Empirical Science, Munich Personal RePEc Archive, 2007.

The Company Law Review Steering Group, Consultation Document, Modern Company Law for a Competitive Economy, Capital Maintenance: Other Issues, Financial Services and the Treasury Bureau, Hong Kong, June 2000.

Financial Accounting Standards Board, Statement of Financial Accounting Concepts No. 5, Recognition and Measurement in Financial Statements of Business Enterprises, Norwalk: FASB, 1984.

Canadian Accounting Standards Board, Discussion Paper – Measurement Bases for Financial Accounting, Toronto, ACSB, 2006.

Chopping, David and Skerratt, Len, Applying GAAP 1995/1996. Manchester: University of Manchester, 1995.

Einzig, Paul, Monetary Policy: Ends and Means. London: Pelican, 1967.

Mcconnell, Campbell R. and Brue, Stanley L., Economics – Principles, Problems and Policies. Columbus: McGraw-Hill, 2005.

Emerson, Michael, Gros, Daniel, Italianer, Alexander, One Market, One Money. Oxford: Oxford University Press, 1992.

Nazmi, Nader, Economic Policy and Stabilization in Latin America. Armonk: M.E. Sharpe, 1996.

Deutsche Bundesbank, The Deutsche Bundesbank Annual Report 1996. Frankfurt: Deutsche Bundesbank, 1996.

Greenspan, Alan, Regulating Electronic Money. Cato Policy Report March/April 1997.

Jordan, Jerry L., Governments and Money, The Cato Journal, Vol 15 no 2-3.

Gavin, W. T. and Stockman, A. C., The case for zero inflation. Economic Commentary, Federal Reserve Bank of Cleveland, Sept 15, 1998.

Schuler, Kurt and Selgin, George. A Proposal for Reforming Lithuania´s Monetary System. Direct copy of the Submission to the President and Prime Minister of the Republic of Lithuania.

Dowd, Kevin, A Rule to Stabilize the Price Level. Cato Journal, Vol 15 (1), 1995.

Hanke, Steve H. and Schuler, Kurt, A Self-help Blueprint for the Commonwealth of Independent States. Cato Institute, Foreign Policy Briefing Paper No 17, 1992.

White, L. H., Inflation and the Federal Reserve: The Consequences of Political Money Supply. Policy Analysis No 8, April 15, 1982.

Kapnick, Harvey, Value-based accounting: Evolution or Revolution? Saxe Lecture, Newman Library Digital Collection, Feb 17th, 1976.

Schuler, Kurt, Selgin, George, Sinkey Jr., Joseph, Replacing the Ruble in Lithuania: Real Change versus Pseudo Reform. Policy Analysis no 163, Oct 28, 1991.

Dowd, Kevin, The cost of inflation and disinflation, The Cato Journal, Vol. 14, No. 2, Fall 1994.

Heikensten, Lars, The Intellectual Framework for Monetary Policy, Monetary Policy Forum, Swedish Central Bank, May 26, 1997.

Copyright © 2010 Nicolaas J Smith All Rights Reserved

World Institute for Research and Publication

Friday 16 April 2010

Money illusion and the E-Type Jag

Definition: Money illusion is the mistaken belief that money is stable – as in fixed – in real value over time.

Money illusion is primarily evident in low inflation countries. In hyperinflationary countries there is absolutely no money illusion as far as the hyperinflationary national currency is concerned. Everyone knows as a fact that the local hyperinflationary currency loses value day by day and even hour by hour. In low inflationary countries people are vaguely aware that money loses value over a long period of time. Money in a low inflationary economy is used as if its real value is completely stable over the short term. That is money illusion.

Money illusion is evident everywhere in low inflationary economies. TV presenters reporting on historical events regularly quote Historical Cost values as the most natural thing to do. “Marble Arch was built for 10 000 Pounds” the TV reporter states with sincere knowledge that his audience is being well entertained with correct facts and figures. It is a figure very difficult to instantaneously value today. 10 000 British Pounds was the original cost in historical terms but we live today and absolutely no-one can immediately imagine what the construction cost of Marble Arch is in current terms. It is the same as saying that something cost one Pound 300 years ago. It is impossible to immediately value it now. We live now and not 300 years in the past. We don’t know what some-one could have bought for a Pound 300 years ago. People in the United Kingdom know what a person can buy for one Pound now – and the Pound’s value changes month after month.

Companies report an unending stream of information about their performance and results. Sales increased by 5 per cent over last year’s figures, for example. Are these historical cost comparisons or real value comparisons? It is more never than hardly ever stated.

Money illusion is very, very common in our low inflationary economies. Another example: The BBC ran a program about the fantastic E-Type Jag. The presenter stated that one of the many reasons why the E-type Jag - the best car ever, according to the presenter - was such a success, was its original nominal price of 2 500 Pounds at the time of its first introduction into the market. Towards the end of the program it is then stated that a number of years later these same original E-Type Jags sold at a nominal price at that time of 25 000 Pounds. It is thus implied to be 10 times more than the original price of 2 500 Pounds. In nominal terms, yes. We all agree. Certainly not in real terms and we are interested in real values. Nominal profits - however fantastic they may look - are misleading the longer the time period and the higher the rate of inflation or hyperinflation in the transaction currency during the time period involved.

In this example we are all led to believe that the E-Type Jag was sold at a real value 10 times its original real value. It is the notorious money illusion at work. The real value in a sale like that certainly would not be 10 times the original real value once the original nominal price is adjusted for inflation in the British Pound over the years in question.

Kindest regards

Nicolaas Smith
realvalueaccounting@yahoo.com

Copyright © 2010 Nicolaas J Smith

Thursday 15 April 2010

The net monetary gains and losses puzzle

Entities with net monetary assets (weighted average of monetary assets greater than weighted average of monetary liabilities) over a period of time, e.g. a year, will suffer a net monetary loss (less real value owned/more real value – real assets – destroyed) during inflation – all else being equal. Companies with net monetary liabilities (weighted average of monetary liabilities greater than the weighted average of monetary assets) will experience a net monetary gain (less real value owed/more real liabilities destroyed) during inflation – ceteris paribus.

Buy the ebook for $2.99 or £1.53 or €2.68

Net monetary gains and losses are calculated and accounted during hyperinflation as required by IAS 29 Financial Reporting in Hyperinflationary Economies and with the measurement of financial capital maintenance in units of constant purchasing power in terms of the IASB´s Framework, Par 104 (a) during low inflation and deflation. Net monetary gains and losses are not required to be computed under the traditional Historical Cost Accounting model although it can be done.

“Computing the gains or losses from holding monetary items can be done and the information disclosed when the books are maintained on a historical-cost basis.”

Harvey Kapnick, Chairman of Arthur Anderson & Company, Value based accounting: Evolution or revolution, Saxe Lecture, 1976, Page 6. http://newman.baruch.cuny.edu/DIGITAL/saxe/saxe_1975/kapnick_76.htm

Net monetary gains and losses are constant real value non-monetary items once they are accounted in the income statement.

This omission to compute the gains and losses from holding monetary items is one of the consequences of the stable measuring unit assumption.

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

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

The practice of calculating and accounting net monetary gains and losses under hyperinflation and under low inflation and deflation only with the implementation of IFRS-authorized financial capital maintenance in units of constant purchasing power, but, not during the implementation of the traditional Historical Cost Accounting model is one of the various confounding generally accepted perplexities in the accounting profession.

Kindest regards

Buy the ebook for $2.99 or £1.53 or €2.68
Nicolaas Smith
realvalueaccounting@yahoo.com

Copyright © 2010 Nicolaas J Smith

Wednesday 14 April 2010

Cost of inflation to be deducted from profit before tax during low inflation

Deflation is a sustained absolute annual decrease in the general price level of goods and services. Deflation happens when the annual inflation rate falls below zero percent (a negative annual inflation rate), resulting in an increase in the real value of money. Deflation allows one to buy more goods with the same amount of money. This should not be confused with disinflation, a slow-down in the inflation rate (i.e. when inflation decreases, but still remains positive). Disinflation is a decrease in the rate of increase in the general price level. Inflation destroys the real value of money over time; conversely, deflation increases the real value of money in a national or regional economy over a period of time.

Inflation and deflation are both undesirable economic processes. As far as the understanding of inflation and deflation allows us at the moment, it can be stated that whatever level of deflation - however low - is to be avoided completely. A low level of inflation in an economy with financial capital maintenance in units of constant purchasing power as the fundamental model of accounting implementing IFRS or GAAP, is the best practice:

A low level of inflation to limit the destruction of real value in money and other monetary items; IFRS or GAAP for the correct valuation of variable items and, thirdly, financial capital maintenance in units of constant purchasing power for maintaining the real value of constant items constant during low inflation and deflation in all entities that at least break even without the requirement for extra capital or extra retained profits simply to maintain the existing real value of existing constant items constant.

Net monetary losses or gains would be calculated and accounted in the income statement during low inflation and deflation: basically, the cost of inflation would be accounted as a loss and deducted from profit before tax. Reducing the holding of monetary items (cash and other monetary items) over time would reduce the net monetary loss to a minimum during low inflation.

Kindest regards

Nicolaas Smith
realvalueaccounting@yahoo.com

Copyright © 2010 Nicolaas J Smith

Tuesday 13 April 2010

The inflation conundrum

Inflation is always and everywhere a monetary phenomenon.

Milton Friedman, A monetary history of the United States 1867 - 1960 (1963)

Inflation is a sustained annual increase in the general price level of goods and services in an economy. Prices are generally quoted in terms of money. When the general price level rises more than the annual increase in real value in the economy, each unit of the functional currency buys fewer goods and services; consequently, annual inflation only destroys the real value of each monetary medium of exchange unit evenly over time. Inflation has no effect on the real value of non-monetary items.

Annual inflation destroys real value evenly in money and other monetary items over time. There are, consequently, hidden monetary costs to some and monetary benefits to others from this destruction in purchasing power in monetary items that are assets to some while - a the same time - liabilities to others; e.g. the capital amount of loans. The debtor gains during inflation since he or she has to pay back the nominal value of the loan, the real value of which is being destroyed by annual inflation. The debtor pays back less real value during inflation. The creditor loses out because he or she receives the nominal value of the loan back, but, the real value paid back is lower as a result of inflation. Efficient lenders recover this loss in real value by charging interest at a rate higher than the expected inflation rate.

Increases in the general price level (inflation) destroy the real value of money (the functional currency) and other monetary items with an underlying monetary nature, e.g. the capital values of bonds and loans. However, inflation has no effect on the real value of variable real value non-monetary items (e.g. property, plant, equipment, cars, gold, inventories, finished goods, foreign exchange, etc) and constant real value non-monetary items (e.g. issued share capital, retained profits, capital reserves, other shareholder equity items, salaries, wages, rentals, pensions, trade debtors, trade creditors, taxes payable, taxes receivable, deferred tax assets, deferred tax liabilities, dividends payable, dividends receivable, etc).

Fixed constant real value non-monetary items never updated are effectively treated like monetary items by SA accountants implementing the stable measuring unit assumption as part of the HCA model during low inflation. SA accountants unknowingly destroy their real values at a rate equal to the rate of inflation because they choose to measure them in nominal monetary units during low inflation. Inflation destroys the real value of the Rand which is the nominal monetary unit of account in SA. This unknowing destruction in fixed constant items never maintained during low inflation will stop when SA accountants choose to measure financial capital maintenance in units of constant purchasing power. It is thus SA accountants´ choice of the HC accounting model and not inflation that is doing the destroying.

SA accountants choose to implement the stable measuring unit assumption during low inflation when they value constant items in fixed nominal monetary units. Accountants´ choice of implementing the stable measuring unit assumption instead of measuring constant items´ real values in units of constant purchasing power, as they have been authorized to do in the Framework, Par 104 (a) twenty one years ago, results in the real values of these fixed constant items being destroyed at a rate equal to the rate of inflation when they are never updated during low inflation because inflation destroys the real value of money which is the monetary unit of account. Fixed constant items never updated are effectively treated as monetary items under HCA.

The extremely rapid destruction of the real value of money during hyperinflation is compensated for by the rejection of the stable measuring unit assumption in International Accounting Standard IAS 29 Financial Reporting in Hyperinflationary Economies. IAS 29, which has to be implemented during hyperinflation, requires all non-monetary items (variable items and constant items) to be measured in units of constant purchasing power. The stable measuring unit assumption is thus rejected in presentation of restated HC or CC financial statements but not in operation since the IASB still accepts HC or CC financial statements to be restated with the implementation of IAS 29 during hyperinflation.

The main measure of inflation in low inflation economies is the inflation rate, calculated from the annualized percentage change in a general price index - normally the Consumer Price Index. The correct measure of inflation is the parallel rate in hyperinflationary economies - where a parallel rate is in use. The CPI is completely impractical as a measure of inflation during hyperinflation when the aim is to stabilize the real economy during hyperinflation.

Kindest regards

Nicolaas Smith
realvalueaccounting@yahoo.com

Copyright © 2010 Nicolaas J Smith

Monday 12 April 2010

Money is the only unit of measure without a fundamental constant

Money is the greatest economic invention of all time. Money did not exist and was not discovered. Money was invented over a long period of time. Money is not the same as constant real value during inflation. Bank notes and coins are physical token instances of money. Money is a monetary item which is used as a monetary medium of exchange and serves at the same time as a monetary store of value and as the monetary unit of account for the accounting of economic activity in a country or a monetary union.

All three basic economic items - monetary items, variable items and constant items - are valued in terms of money. The European Monetary Union uses the Euro as its monetary unit. The US Dollar is the monetary unit most widely traded internationally. The Rand Common Monetary Area which includes South Africa, Namibia, Swaziland and Lesotho employs the Rand as the common monetary unit or functional currency.

An earlier form of money was commodity money; e.g. gold, silver and copper coins. Today money is generally fiat money created by government fiat or decree.

Money is a medium of exchange which is its main function. Without that function it can never be money. The historical development of money led it also to be used as a store of value and as the unit of measure to account the values of economic items.

Money is the only unit of measure that is not a stable value under all circumstances. Money is only perfectly stable in real value at zero per cent inflation. This has never been achieved over a sustainable period of time. All other units of measure are fundamentally stable units of measure, e.g. inch, centimetre, ounce, gram, kilogram, pound, etc.

Kindest regards

Nicolaas Smith
realvalueaccounting@yahoo.com

Copyright © 2010 Nicolaas J Smith

Friday 9 April 2010

Traditional Historical Cost Accounting is not an appropriate accounting policy for SA companies

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

The implementation of the stable measuring unit assumption which is based on a fallacy and financial capital maintenance in nominal monetary units per se which is a fallacy during inflation and deflation means that the implementation of the HCA model is not an appropriate accounting policy for SA companies during inflation and deflation. The IASB already agrees that the stable measuring unit assumption and financial capital maintenance in nominal monetary units per se are not appropriate accounting policies in hyperinflationary economies.

IAS 29 Financial Reporting in Hyperinflationary Economies states that:

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

Traditional Historical Cost Accounting is not an appropriate accounting policy for SA companies when it results in SA accountants unknowingly, unnecessarily and unintentionally destroying about R200 billion in the real value of constant real value non-monetary items, e.g. retained profits never maintained with sufficient revaluable fixed assets each and every year in the SA non-monetary economy.

No-one can disprove that.

The remedy, namely, financial capital maintenance in units of constant purchasing power has been authorized in International Financial Reporting Standards in the Framework, Par 104 (a) twenty one years ago.

No-one can disprove that.
Copyright © 2010 Nicolaas J Smith

Thursday 8 April 2010

SA accountants have to state why they freely choose to destroy their companies´ capital and profits

Audited annual financial statements provided by SA companies which prepare them using the traditional Historical Cost basis, i.e., when the board of directors choose to measure financial capital maintenance in nominal monetary units instead of in units of constant purchasing power in terms of the IASB´s Framework, Par 104 (a), are compliant with IFRS, but, do not fairly present the financial position of the companies as required by Art. 29.1(b) of the Companies Act.

The SA Companies Act, No 71 of 2008, Article 29.1 (b) states:

“If a company provides any financial statements, including any annual financial statements, to any person for any reason, those statements must-

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

Audited financial statements prepared under the HC basis do not fairly present the financial position of SA companies, as required by the Companies Act, when the directors do not:

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

(2) state that this includes the destruction of the real value of Shareholders´ Equity when the company does not have sufficient fixed assets that are or can be revalued via the Revaluation Reserve equal to the updated original real value of all contributions to Shareholders’ Equity under the HC basis;

(3) state the percentage and amount of Shareholders´ Equity that are not being maintained; i.e., the percentage and amount of Shareholders´ Equity that are subject to real value destruction at a rate equal to the annual inflation rate because of the directors´ choice, in terms of the Framework, Par 104 (a), to maintain financial capital maintenance in nominal monetary units instead of in units of constant purchasing power – both methods being compliant with IFRS;

(4) state the amount of real value destroyed during the last and previous financial years in Shareholders´ Equity and all other constant items never maintained because of the directors´ choice to implement the Historical Cost Accounting model;

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

(6) state the change in the updated real value of Shareholders´ Equity if the directors should decide – as they are freely allowed to do at any time - to measure financial capital maintenance in units of constant purchasing power instead of in nominal monetary units (which is a very popular accounting fallacy approved by the IASB) as authorized by the IASB in the Framework, Par 104 (a);

(7) state the directors´ estimate of the amount of real value to be destroyed by their implementation of the stable measuring unit assumption (which is based on another popular accounting fallacy approved by the IASB) during the following accounting year under the HC basis;

(8) state that the real value calculated in (7) represents the amount of real value the company would gain during the following accounting year and every year there after for an unlimited period of time – ceteris paribus - when the directors´ choose to measure financial capital maintenance in units of constant purchasing power – which is compliant with IFRS – as provided in the Framework, Par 104 (a) in 1989 which they are free to choose any time they decide;

(9) state the directors´ reason(s) for choosing financial capital maintenance in real value destroying nominal monetary units instead of in real value maintaining units of constant purchasing power in terms of the IASB´s Framework, Par 104 (a).

See Comment Letter 32 to the International Accounting Standard Board´s Exposure Draft: Management Commentary.

Kindest regards

Nicolaas Smith
realvalueaccounting@yahoo.com

Copyright © 2010 Nicolaas J Smith

Monday 5 April 2010

What to do if Malema´s "kill the Boer" leads to very high inflation in SA

If after the weekend killing of Eugene Terreblanche it so happens in the months and years to come that Julius Malema´s song "Kill the Boer" leads over time to the Rand weakening leading to much higher prices for imported goods resulting in an import inflation spiral in SA as well as Numsa and other trade unions demanding and getting 20% and higher wage increases SA may start to experience much higher rates of inflation.

If SA accountants just keep doing normal Historical Cost Accounting they will accelerate the downward course of the SA economy by destroying the SA real economy with traditional accounting like Zimbabwean accountants did over the last 30 years in that country.

Or, SA accountants can follow the Brazilian example and index all non-monetary prices by applying a daily index normally the US Dollar parallel rate daily. Brazil did that from 1964 to 1994. They had hyperinflation in their monetary economy but they stabilized their real economy with daily indexation. Indexation is in principle the same as implementing continuous financial capital maintenance in units of constant purchasing power as authorized in IFRS in the Framework, Par 104 (a) in 1989.

Kindest regards

Nicolaas Smith
realvalueaccounting@yahoo.com

Copyright © 2010 Nicolaas J Smith

Thursday 1 April 2010

It is not inflation doing the destroying

Accountants simply assume that changes in the real value or constant purchasing power of the functional currency (money) are not sufficiently important for them to continuously measure financial capital maintenance in units of constant purchasing power as they have been authorized in IFRS in the Framework, Par 104 (a) in 1989 in low inflationary and deflationary economies for the purpose of valuing most constant items which they account as HC items; they measure them in nominal monetary units when they choose financial capital maintenance in nominal monetary units and implement the stable measuring unit assumption.

It is a generally accepted accounting practice for accountants not to apply the stable measuring unit assumption to the valuing of certain income statement constant items, namely salaries, wages, rentals, etc which they generally inflation-adjust annually. Accountants value all other income statement items and all balance sheet constant items in nominal monetary units when they implement financial capital maintenance in nominal monetary units during low inflation and deflation.

However, it is impossible to maintain the real value of financial capital constant with financial capital maintenance in nominal monetary units per se applying the stable measuring unit assumption during inflation and deflation. The measuring unit (money) is not perfectly stable during inflation and deflation. Inflation destroys the real value of money and other monetary items while deflation creates more real value in money and other monetary items over time. Sustainable zero annual inflation has never been achieved in the past and is not likely to be achieved any time soon in the future. Financial capital maintenance in nominal monetary units per se during inflation and deflation as authorized in IFRS in the Framework, Par 104 (a) is a popular accounting fallacy. IFRS should not be based on popular accounting fallacies as they currently are.

“Under a financial concept of capital, such as invested money or invested purchasing power, capital is synonymous with the net assets or equity of the entity.” The Framework, Par 102

Shareholders´ Equity’s real value can only be maintained constant (excluding continuous additions of fresh capital or additional retained profits at the rate of inflation) with financial capital maintenance in nominal monetary units (traditional HCA) during low inflation when 100% of the updated original real value of all contributions to the Shareholders´ Equity balance are invested in revaluable fixed assets with an equivalent updated fair value – revalued or not. Valuing a revaluable fixed asset at HC (in nominal monetary units applying the stable measuring unit assumption) does not destroy its real value. It would normally be revalued when it is eventually sold or exchanged. It can also be revalued via the Revaluation Reserve before it is finally sold.

However, the portion of Shareholders´ Equity’s real value, under HCA, that is never maintained constant with sufficient revaluable fixed assets during low inflation, is unknowingly and unnecessarily being treated by accountants the same as a monetary item (e.g. cash). Accountants unknowingly, unnecessarily and unintentionally destroy its real value at a rate equal to the annual rate of inflation because they freely choose in terms of the Framework, Par 104 (a) - as authorized in IFRS - to implement financial capital maintenance in nominal monetary units and apply the stable measuring unit assumption during low inflation. Shareholders´ Equity´s value is expressed in terms of a monetary unit of account (the functional currency or money) and inflation destroys the real value of money.

It is not inflation doing the destroying: it is accountants´ free choice of financial capital maintenance in nominal monetary units when they implement their very destructive stable measuring unit assumption as authorized in IFRS in the Framework, Par 104 (a) during low inflation. When they freely choose the other option also authorized in the Framework, Par 104 (a), namely continuous financial capital maintenance in units of constant purchasing power, they would maintain the real value of all constant real value non-monetary items constant for an unlimited period of time – ceteris paribus – in all entities that at least break even whether these entities own revaluable fixed assets or not and without the requirement of additional capital or additional retained profits simply to maintain the existing constant real value of existing Shareholders´ Equity constant at all levels of inflation and deflation.

Inflation can only destroy the real value of money and other monetary items – nothing else. Inflation is always and everywhere a monetary phenomenon. Inflation has no effect on the real value of non-monetary items. Shareholders´ Equity is a constant real value non-monetary item.

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

Ümit GUCENME, Aylin P. ARSOY, Changes in financial reporting in Turkey, Historical Development of Inflation Accounting 1960 – 2005 (Bursa: Uludag University, 2005) 9.

http://www.mufad.org/index2.php?option=com_docman&task=doc_view&gid=9&Itemid=100

Kindest regards

Nicolaas Smith
realvalueaccounting@yahoo.com

Copyright © 2010 Nicolaas J Smith

Wednesday 31 March 2010

Constant and variable items defined in IFRS

The terms constant real value non-monetary items and variable real value non-monetary items are new specific terms for old concepts.

IFRS only define two economic items directly: monetary items (IAS 29 Par 12 and IAS 21 Par 8) and non-monetary items (IAS 29 Par 14). There are, however, three fundamentally different basic economic items in the economy:

1. Monetary items

2. Variable real value non-monetary items

3. Constant real value non-monetary items

Constant real value non-monetary items and variable real value non-monetary items are defined indirectly in IFRS.

According to the Framework, Par 104 (a) financial capital maintenance can be measured in units of constant purchasing power during low inflation and deflation. Although IAS 29 is only to be applied during hyperinflation, it defines monetary and non-monetary items in general. According to IAS 29 Par 12: “Monetary items are not restated because they are already expressed in terms of the monetary unit current at the balance sheet date.”

IAS 29 Par 14 defines non-monetary items as all items that are not monetary items. Since monetary items are not restated only non-monetary items can thus be measured in units of constant purchasing power or inflation-adjusted or restated or updated. As such, non-monetary items measured in units of constant purchasing power during low inflation and deflation are thus constant real value non-monetary items; e.g. all income statement items, all items in shareholders´ equity, trade debtors, trade creditors, taxes payable and receivable, etc.

Non-monetary items that are not measured in units of constant purchasing power during low inflation and deflation are thus variable real value non-monetary items since they have variable real values over time and are valued in terms of specific IFRS.

Kindest regards

Nicolaas Smith
realvalueaccounting@yahoo.com

Copyright © 2010 Nicolaas J Smith

Tuesday 30 March 2010

Basis for Historical Cost Accounting

“In most countries, primary financial statements are prepared on the historical cost basis of accounting without regard either to changes in the general level of prices or to increases in specific prices of assets held, except to the extent that property, plant and equipment and investments may be revalued.” IAS 29 Par 6. HCA is the generally accepted traditional basic accounting model used by most entities during low inflation and deflation.

IFRS only define two economic items: monetary items (IAS 29 Par 12 and IAS 21 Par 8) and non-monetary items (IAS 29 Par 14). There are, however, three fundamentally distinct basic economic items in the economy as defined above. Constant real value non-monetary items and variable real value non-monetary items are defined indirectly in IFRS. According to the Framework, Par 104 (a) financial capital maintenance can be measured in units of constant purchasing power during low inflation and deflation. Although IAS 29 is only to be applied during hyperinflation, it defines monetary and non-monetary items. According to IAS 29 Par 12: “Monetary items are not restated because they are already expressed in terms of the monetary unit current at the balance sheet date.”

IAS 29 Par 14 defines non-monetary items as all items that are not monetary items. Since monetary items are not restated only non-monetary items can thus be measured in units of constant purchasing power or inflation-adjusted or restated or updated during inflation and deflation. As such, non-monetary items measured in units of constant purchasing power during low inflation and deflation are thus constant real value non-monetary items; e.g. all income statement items, all items in shareholders´ equity, trade debtors, trade creditors, taxes payable and receivable, etc. Non-monetary items that are not measured in units of constant purchasing power during low inflation and deflation are thus variable real value non-monetary items since they have variable real values over time and are valued in terms of specific IFRS.

Non-monetary items also include Historical Cost items based on the stable measuring unit assumption under the HCA model.

One of the basic principles in accounting is “The Measuring Unit principle: The unit of measure in accounting shall be the base money unit of the most relevant currency.

This principle also assumes the unit of measure is stable; that is, changes in its general purchasing power are not considered sufficiently important to require adjustments to the basic financial statements.” ²

Inflation is always and everywhere a monetary phenomenon. Milton Friedman. Money (the functional currency) is not perfectly stable during inflation and deflation. Inflation destroys the real value of money and other monetary items at the rate of inflation as indicated by the change in the Consumer Price Index. Sustainable zero annual inflation has never been achieved in the past and is not likely to be achieved any time soon in the future.

HC accountants, on the other hand, simply assume that the functional currency (money) is perfectly stable in low inflationary and deflationary economies only for the purpose of valuing balance sheet constant items which they account as HC items; they measure them in nominal monetary units implementing financial capital maintenance in nominal monetary units. In conformity with world practice they do not apply this assumption to the valuing of certain Income Statement constant items, namely salaries, wages, rentals, etc which they inflation-adjust annually. HC accountants value other income statement items in nominal monetary units, i.e. at HC. HC accountants do not regard changes in the general purchasing power or real value of money to be sufficiently important during low inflation and deflation to continuously measure financial capital maintenance in units of constant purchasing power as they have been authorized in IFRS in the Framework, Par 104 (a) in 1989. They generally choose to implement financial capital maintenance in nominal monetary units, also authorized in IFRS in the Framework, Par 104 (a). However, it is impossible to maintain the real value of financial capital constant by measuring financial capital maintenance in nominal monetary units per se during inflation and deflation. Financial capital maintenance in nominal monetary units per se during inflation and deflation is a popular accounting fallacy.

This led accountants to choose to implement the traditional Historical Cost Accounting model during non-hyperinflationary periods where under they select to maintain the stable measuring unit assumption (also IFRS-approved and also based on a fallacy) for an unlimited period of time during indefinite low inflation. They value both variable items stated at HC in terms of IFRS, as well as constant items also stated at HC in terms of the HCA model, in nominal monetary units during non-hyperinflationary periods. Both HC variable and HC constant items are thus considered by accountants to be simply HC non-monetary items.

SA accountants thus treat the portion of Shareholders´ Equity in SA companies not maintained constant by investment in sufficient revaluable fixed assets as a monetary item. They thus unknowingly destroy its real value at a rate equal to the annual rate of inflation amounting in total to about R200 billion per annum in the SA real economy.

Kindest regards

Nicolaas Smith
realvalueaccounting@yahoo.com

Copyright © 2010 Nicolaas J Smith

Monday 29 March 2010

Is your accountant looking after your capital?

No, he or she is not!

It is all actually quite simple to understand: your accountant ASSUMES there is NO inflation (that the Rand is PERFECTLY stable) ONLY when he values constant real value non-monetary items, e.g. the actual capital you used to start your company as it is currently accounted in your balance sheet. I assume you have a small business and you don´t own any revaluable fixed assets in your business. Even if you have the biggest business on the JSE you most probably did not invest 100% of all original contributions to your shareholders´ equity in revaluable fixed assets now with an equivalent updated fair value equal to the updated real value of your equity. In doing that he treats your capital the same as CASH and he unknowingly destroys the real value of your capital because he ASSUMES the Rand is perfectly stable ONLY for this purpose. He will never ever advise you to keep your company cash in the bank at zero interest - but, he is doing that with your capital in your company. He and all other accountants.

He has been authorized 21 years ago to update your capital during LOW inflation. He doesn´t do it because he thinks (because everyone in the world thinks) that inflation is doing the destroying. He and they are wrong. Inflation can only destroy the real value of the Rand - nothing else. Inflation has no effect on the real value of non-monetary items: your capital is a constant real value non-monetary item.

It is not inflation doing the destroying: he is unknowingly doing the destroying because he has been authorized 21 years ago to value your capital in UNITS OF CONSTANT PURCHASING POWER (to inflation-adjust your capital) during LOW inflation.

When he values your capital AS WELL AS ALL OTHER constant real value non-monetary items in your business (ONLY constant items) in UNITS OF CONSTANT PURCHASING POWER he will maintain the constant real value of your capital constant forever - as long as your business breaks even forever - whether you have revaluable fixed assets in your business or not. You are not required to pay in more money for extra capital or retain more profits simply to keep the existing real value of your existing capital constant. It is automatically done when he updates ALL constant items (ONLY constant items, but, ALL of them - including trade debtors) in your business - as long as you break even in your business.

It is not the same as inflation, but, it is SIMILAR to him arranging ZERO INFLATION in all your constant items: e.g. your capital.

Kindest regards

Nicolaas Smith
realvalueaccounting@yahoo.com

Copyright © 2010 Nicolaas J Smith

IFRS define three concepts of Capital Maintenance

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

Buy the ebook.

Copyright © 2010 Nicolaas J Smith

Saturday 27 March 2010

Inflation is not a solution

According to The Economist the merits of inflation as a solution to the rich world’s problems are easily overstated.

Inflation is always and everywhere a monetary phenomenon: Milton Friedman. Inflation only destroys the real value of money and other monetary items, e.g. bonds – nothing else. Inflation has no effect on the real value of non-monetary items. It is impossible for inflation per se to destroy the real value of any non-monetary item.

Banks´ and companies´ capital and profits are constant real value non-monetary items. Constant items, e.g. shareholders´ equity, trade debtors, trade creditors, taxes payable, taxes receivable, all items in the income statement, etc, have constant real non-monetary values over time. Inflation can thus not destroy the real value of banks´ and companies´ capital and profits.

However, everybody believes the fallacy that the erosion of banks´ and companies´ capital and profits is caused by inflation, including the IASB, FASB and most accountants. They and other accounting authorities, accounting professors and lecturers thus clearly know and admit that real value is currently being destroyed in banks´ and companies´ capital and profits. Everyone mistakenly think it is inflation doing the destroying.

It is not inflation, but, accountants´ choice of financial capital maintenance in nominal monetary units, another fallacy, as authorized by the IASB in the Framework, Par 104 (a) in 1989 which states: “Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power” which is doing the destroying. Financial capital maintenance in nominal monetary units is the 700 year old, generally accepted, traditional Historical Cost Accounting model which includes accountants´ very destructive stable measuring unit assumption based on the fallacy that changes in the purchasing power of the monetary unit of account is not sufficiently important during low inflation to require them to measure financial capital maintenance in units of constant purchasing power as authorized by the IASB in the Framework, Par 104 (a) in 1989. It is impossible to maintain the real value of financial capital constant in nominal monetary units per se during low inflation and deflation as stated by the IASB.

Accountants unknowingly and unnecessarily destroy the portion of the real value of banks´ and companies´ capital and profits generally never maintained with sufficient revaluable fixed assets under HCA during low inflation at a rate equal to the annual rate of inflation amounting to hundreds of billions of Euros (probably much more) in the world economy every year. Everyone mistakenly thinks it is inflation doing the destroying. Accountants would knowingly stop this destruction and boost the world economy by hundreds of billions of Euros (probably much more) every year with financial capital maintenance in units of constant purchasing power as authorized by the IASB in the Framework, Par 104 (a) 21 years ago – for an unlimited period of time in all entities that at least break even – ceteris paribus – without extra money or extra retained profits to maintain the existing real value of capital and profits. They would maintain existing constant item real values by not destroying existing values with their very destructive stable measuring unit assumption in a double entry accounting model in real value maintaining units of constant purchasing power instead of in real value destroying nominal monetary units during inflation.

The real value of the portion of capital and profits generally never maintained with sufficient revaluable fixed assets under HCA (normally at least retained profits) are treated like monetary items by accountants with their real values destroyed not by inflation, but, unknowingly by accountants implementing their very destructive stable measuring unit assumption at a rate equal to the annual rate of inflation.

An increase of inflation from 2% to 4% would double the unknowing destruction by accountants in banks´ and companies´ long term capital and investment base besides the effects as stated in the article.

The current 2% or an increased 4% unknowing destruction can knowingly be stopped by entities freely choosing financial capital maintenance in units of constant purchasing power during low inflation and deflation as authorized by the IASB in the Framework, Par 104 (a) 21 years ago. There is no other way during inflation and deflation. It is complaint with IFRS. Currently IFRS are based on fallacies. IFRS should not be based on fallacies.

Copyright © 2010 Nicolaas J Smith

It wasn't them

Accorging to The Economist Alan Greenspan and Ben Bernanke still do not believe monetary policy bears any blame for the crisis.

Part of the remedy for the crisis was strengthening banks’ capital. Most big banks implement IFRS; consequently their accountants have to make a critical choice in terms of the IASB´s Framework, Par 104 (a) authorized twenty one years ago which states: “Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power.” Banks are given this choice during low inflation and deflation. They have to choose the one or the other when they choose a financial concept of capital as all banks do.

They all choose financial capital maintenance in nominal monetary units per se which is a complete fallacy during low inflation and deflation: it is impossible to maintain the real value of financial capital constant when measuring financial capital maintenance in nominal monetary units per se during low inflation and deflation. The only way banks can maintain the real value of their capital constant during low inflation is with 100% investment of the updated original real values of all contributions to shareholders´ equity in revaluable fixed assets with an equivalent updated fair value – revalued or not – under Historical Cost Accounting during low inflation.

Most probably not a single bank qualifies for the 100% investment rule. Most probably not a single bank qualifies for that rule even with respect to just equity excluding retained earnings. The portion of the updated real value of banks´ equity not covered by revaluable fixed assets under HCA is thus treated by their HC accountants as simply the same as a monetary item: i.e. they value it at Historical Cost as part of financial capital maintenance in nominal monetary units during low inflation. The real value of the portion not maintained with sufficient revaluable fixed assets is thus unknowingly, unnecessarily and unintentionally being destroyed at a rate equal to the annual rate of inflation by HC accountants implementing their very destructive stable measuring unit assumption (which is based on a fallacy) as part of financial capital maintenance in nominal monetary units (the IFRS authorized fallacy) during low inflation.

The real value of most probably all banks´ retained earnings is thus unnecessarily, unknowingly and unintentionally being destroyed by their accountant’s free choice of financial capital maintenance in units of nominal monetary units during low inflation as authorized in IFRS in the Framework, Par 104 (a) in 1989.

Amazingly the only and perfect remedy to the problem was authorized in IFRS as a free choice to accountants in the exact same IASB´s Framework, Par 104 (a) twenty one years ago, namely, financial capital maintenance in units of constant purchasing power during low inflation and deflation. All banks´ accountants are free to choose this option any time they want. If they had chosen that option in 1989, the world’s banking system would have been much more robust before, during and after the crisis. No-one stops them from doing it now.

HC accountants world wide are unnecessarily, unknowingly and unintentionally destroying hundreds of billion of Euros (perhaps much more) per annum in the real value of companies´ and banks´ shareholders´ equity never maintained with sufficient revaluable fixed assets at a rate equal to the annual rate of inflation year in year out while they implement traditional Historical Cost Accounting during low inflation. They will stop this unnecessary, unknowing and unintentional destruction forever the moment they freely choose financial capital maintenance in units of constant purchasing power during low inflation as authorized in IFRS in the Framework, Par 104 (a) any time they want. They will knowingly boost the world’s real economy with hundreds of billions of Euros (perhaps much more) per annum for an unlimited period of time when they freely switch over to financial capital maintenance in units of constant purchasing power as authorized in IFRS in the IASB´s Framework, Par 104 (a) twenty one years ago.

Kindest regards

Nicolaas Smith
realvalueaccounting@yahoo.com

Copyright © 2010 Nicolaas J Smith

Friday 26 March 2010

Capital maintenance - Part 1

No-one will disagree that 5.7% annual inflation and not SA accountants destroy the real value of the Rand and other monetary items in the SA monetary economy despite the fact that the SARB regards the destruction of about R114 billion per annum in the real value of the Rand as the achievement and maintenance of “price stability” in the SA economic system. Obviously it is not price stability at all. It is 5.7 % or R114 billion per annum away from price stability. It is the SARB´s choice of “price stability”: their definition of “price stability”. Absolute price stability is a year-on-year increase of zero percent in the Consumer Price Index.

SA accountants freely choose HCA

By doing listed companies´ accounts in terms of IFRS as required by the rules of the Johannesburg Stock Exchange, SA boards of directors – advised by the accountants on the boards - have to choose between a physical and a financial capital concept in terms of the IASB´s Framework, Par 102. According to Par103 the choice of the appropriate concept of capital by a company should be based on the needs of the users of its financial reports.

A company’s capital is synonymous with its Shareholders´ Equity or Net Assets when a financial concept of capital, such as invested purchasing power or invested money, is chosen. Most, if not all, boards of directors of SA companies decide that they will adopt, in terms of the Framework, Par 102, a financial (instead of a physical) concept of capital, namely invested money (instead of invested purchasing power), in preparing their companies’ financial statements. As a result of choosing a financial concept of capital, namely invested money in terms of Par 102, the boards of directors next choose a financial concept of capital maintenance in terms of Par 104.

Under the financial capital maintenance concept a company, in terms of the Framework, Par 104, only earns a profit when the financial (or money) value of the net assets at the end of the accounting period exceeds the financial (or money) value of net assets at the beginning of the period, after excluding any contributions from and distributions to shareholders during the accounting period. This is obviously not correct in real or constant purchasing power terms - only in nominal terms.

SA listed company boards of directors generally choose financial capital maintenance in nominal monetary units in terms of Par 104 (a) because, in their opinion - in terms of Par 103 - the users of the company’s financial statements are primarily concerned with the maintenance of nominal invested capital instead of the maintenance of the purchasing power of invested capital when a financial capital maintenance in units of constant purchasing power concept – as per Par 104 (a) – should be used. The boards of directors thus choose to do their companies´ accounts based on the traditional Historical Cost Accounting model. They believe and support the IASB statement in Par 104 (a) that “financial capital maintenance can be measured in nominal monetary units” which is a complete fallacy during inflation and deflation. It is impossible to maintain the real value of Shareholders´ Equity constant with financial capital maintenance in nominal monetary units per se during inflation and deflation.

In my opinion, the users of SA companies´ financial statements are generally primarily concerned with the maintenance of the constant purchasing power (real value) instead of the nominal value of their invested capital.

It is only possible to maintain the real value of Shareholders´ Equity constant in nominal monetary units when 100% of the inflation-adjusted original real values of all contributions to Shareholders´ Equity are invested in revaluable fixed assets with an equivalent fair value - either revalued or with unrecorded holding gains - under the traditional Historical Cost Accounting model implemented by most companies in South Africa during low inflation. It is not normally the case in the SA economy that companies invest 100% of the original real values of all contributions to Shareholders´ Equity in revaluable fixed assets.

In terms of the Framework, Par 105, the capital maintenance concept deals with how companies define the capital they want to preserve. It is the link between the concept of capital and the concept of profit or loss since it is the point of reference for calculating profit or loss. A company first has to choose a capital maintenance concept before its return of capital and return on capital can be calculated. Only acquired net asset values greater than the capital maintenance requirement can be taken as profit; i.e. a return on capital.

Kindest regards

Nicolaas Smith
realvalueaccounting@yahoo.com

Copyright © 2010 Nicolaas J Smith

Inflation at 5.7% pa. No way: SA accountants assume it is zero per cent - forever.

Statistics SA announces that the annual inflation rate came down to 5.7%

Gill Marcus reduces interest rates by half a per cent.

SA accountants say: No way: there is no such thing as inflation: inflation in SA is zero per cent, always has been zero per cent and will always in the future be zero per cent.
I state that all constant item accounts have to be adjusted during low inflation - as the IASB authorized 21 years ago.
The US Finanial Accounting Standard Board stated in FAS 33: "The erosion of business profits and invested capital caused by inflation" which is a complete fallacy. In June, 2008 I also still believed it. Now I know it is a complete fallacy. Inflation per se has no direct effect and never in the past had any direct effect on any non-monetary item. Inflation is always and everywhere a monetary phenomenon. Inflation can only destroy or erode the real value of money and other monetary items - nothing else. The fact that the FASB, the IASB and most accountants believe that the erosion of business profits and invested capital is caused by inflation will never make it so.

So, although the IASB authorized SA accountants 21 years ago to measure financial capital maintenance in units of constant purchasing power during low inflation (see the Framework, Par 104 a) they refuse point blank to do it.

SA accountants will rather unknowingly destroy about R200 billion each and every year in SA companies´ capital and profits never maintained, than listen to the IASB and implement financial capital maintenance in units of constant purchasing power - as the IASB authorized them to do 21 years ago.
Yes, I do say they are terrible destroyers of real value in the SA constant item economy, albeit unknowingly and unintentionally. They still do it - year after year after year.

Gill Marcus said: "But growth in private sector fixed capital formation remains negative:" Of course it will remain negative with SA accountants unknowingly destroying about R200 billion pa in SA Shareholders´ Equity never maintained (SA´s fixed capital base) with their very destructive stable measuring unit assumption.

Copyright © 2010 Nicolaas J Smith

Thursday 25 March 2010

SA accountants unknowingly destroy more real value than inflation

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

100% of the inflation-adjusted original real values of all contributions to Shareholders´ Equity have to be invested in revaluable fixed assets with an equivalent maintained fair value (revalued or with unrecorded hidden holding gains) in order not to destroy Shareholders Equity’s real value during low inflation under the traditional Historical Cost Accounting model – i.e. measuring financial capital maintenance in nominal monetary units - implemented by most, if not all, companies in South Africa.

The real value of the portion not invested as such is currently unknowingly being destroyed at a rate equal to the annual rate of inflation when the constant real value non-monetary item Shareholders Equity is measured in nominal monetary units, i.e. implementing the very destructive stable measuring unit assumption as done by most, if not all, accountants in SA when they maintain HCA for an unlimited period of time during indefinite low inflation.

Most companies do not meet the requirement to investment 100% of the original real value of all contributions to Shareholders´ Equity in revaluable fixed assets. In practice this means that the real value of Retained Profits never maintained of most SA companies and banks are unknowingly, unintentionally and unnecessarily being destroyed at a rate equal to the annual rate of inflation by SA accountants implementing the IASB-approved traditional HCA model.

Implementing the IASB-approved alternative, namely, financial capital maintenance in units of constant purchasing power as authorized in 1989 in the exact same Framework, Par 104 (a), would stop this unknowing destruction by SA accountants forever under all levels of inflation in all entities that at least break even - whether they own revaluable fixed assets or not - and without the requirement of more money or more Retained Earnings just to maintain the real value of existing Shareholders´ Equity.
One percent inflation destroys about R20 billion per annum in the real value of the Rand in SA. 5.7% annual inflation (Feb 2010) thus destroys about R114 billion per annum in the real value of the Rand.

SA accountants would maintain instead of currently unknowingly and unnecessarily destroy about R200 billion per annum in constant item real value in the SA real economy when they reject the stable measuring unit assumption as approved by the IASB in the Framework, Par 104 (a). SA accountants thus unknowingly, unnecessarily and unintentionally destroy more real value in the SA real economy than inflation.

This R200 billion per annum completely unnecessary real value destruction can be reduced to zero overnight by SA accountants simply implementing the other option authorized by the IASB twenty one years ago in the Framework, Par 104 (a), namely financial capital maintenance in units of constant purchasing power.

Makes you think, doesn´t it?
Copyright © 2010 Nicolaas J Smith

Wednesday 24 March 2010

The difference between disinflation and deflation

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

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

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

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

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

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

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

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

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

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

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

Kindest regards

Nicolaas Smith
realvalueaccounting@yahoo.com

Copyright © 2010 Nicolaas J Smith

Tuesday 23 March 2010

One who does not ask a question remains a fool forever

One who asks a question is a fool for five minutes; one who does not ask a question remains a fool forever. Chinese Proverb

The Framework applies

SA accountants of companies listed on the Johannesburg Stock Exchange have to prepare primary financial reports in terms of the IASB´s International Financial Reporting Standards. IFRS are Standards, Interpretations and the definitions, recognition criteria and measurement concepts for assets, liabilities, income and expenses in the IASB´s Framework for the Preparation and Presentation of Financial Statements in the absence of a Standard or an Interpretation that specifically applies to a transaction.

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

IAS8, 11:
“In making the judgement, management shall refer to, and consider the applicability of, the following sources in descending order:
(a) the requirements and guidance in Standards and Interpretations dealing with similar and related issues; and
(b) the definitions, recognition criteria and measurement concepts for assets, liabilities, income and expenses in the Framework.”

There are no specific IFRS relating to the valuation of the constant items Issued Share Capital, Retained Earnings, other items in Shareholders Equity, the concepts of capital, the concepts of capital maintenance and the determination of profit or loss. The definitions, the concepts for their measurement and the criteria for their recognition in the Framework are thus applicable in terms of IAS8.11.

A fundamental attribute of the traditional Historical Cost Accounting model which SA boards of directors select when they decide on behalf of JSE listed companies to measure financial capital maintenance in nominal monetary units (a generally accepted accounting fallacy) in terms of the IASB´s Framework, Par 104 (a) is that the companies´ accountants unknowingly, unnecessarily and unintentionally destroy the real values of constant items never maintained as a result of their implementation of the very destructive stable measuring unit assumption.

Accountants, on the other hand, unknowingly create real value in constant items never maintained constant (not decreased at a rate equal to the rate of deflation) as a result of their implementation of the real value creating stable measuring unit assumption during deflation (today mainly in Japan).

Kindest regards

Nicolaas Smith
realvalueaccounting@yahoo.com

Copyright © 2010 Nicolaas J Smith

Monday 22 March 2010

Three concepts of capital maintenance under IFRS

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

Buy the ebook.

© 2010 Nicolaas J Smith. All rights reserved
No reproduction without permission

Friday 19 March 2010

Value does not always exist independently of how we measure it

Professor William Paton noted in 1922, "the value of the dollar — its general purchasing power — is subject to serious change over a period of years... Accountants... deal with an unstable, variable unit; and comparisons of unadjusted accounting statements prepared at intervals are accordingly always more or less unsatisfactory and are often positively misleading.” As quoted in FAS 33 p. 29.

Shareholder’s equity forms part of an entity’s financial resources.

“Management commentary should set out the critical financial and non-financial resources available to the entity and how those resources are used in meeting management’s stated objectives for the entity.” IASB Exposure Draft: Management Commentary, June 2009, Par 29.

Shareholders´ equity is a financial resource with a constant real non-monetary value expressed in terms of monetary unit of measure. The IASB statement in the Framework, Par 104 (a) that “financial capital maintenance can be measured in nominal monetary units” is a fallacy.

There is no substance in the claim that the existence and value of economic resources, for example shareholders´ equity items, exist independently of how we measure them - and that the choice of the measuring unit does not affect their fundamental values, only how we choose to represent that value – and that we can use Rands, Rands of constant purchasing power, US Dollars, whatever we think best represents that value and will make sense to whoever is using the information produced. See Paton above. There is no substance in the claim that it is fine to represent value in terms of constant purchasing power and to argue that that would be a better method than using historic cost and maintaining a fiction as to the stability of the measuring unit - but that doesn't affect the nature of the underlying resources. There is no substance in the claim that the choices SA accountants make will not change that value and will not affect the SA economy.

If SA accountants understood that the implementation of the stable measuring unit assumption during low inflation results in the unknowing, unnecessary and unintentional destruction by SA accountants of massive amounts of real value in constant items never maintained in the SA constant item economy, they would have called for its rejection by now.
Copyright © 2010 Nicolaas J Smith

Thursday 18 March 2010

The Historical Cost Mistake

Constant ITEM Purchasing Power Accounting, the financial capital maintenance in units of constant purchasing power model is, unfortunately, not chosen by a single SA accountant in SA to measure financial capital maintenance in real value maintaining units of constant purchasing power despite the fact that it is authorized in the IASB´s Framework, Par 104 (a) since 1989 as an alternative to the very destructive traditional HC model at all levels of low inflation and deflation. SA accountants value balance sheet constant real value non-monetary items using the traditional HC model in terms of which they implement the stable measuring unit assumption. SA accountants unknowingly destroy the real values of constant items never maintained at a rate equal to the rate of inflation because they, unfortunately, choose to measure financial capital maintenance in nominal monetary units when they apply the very destructive stable measuring unit assumption for an unlimited period of time during indefinite inflation. They unknowingly make the wrong choice. Since they all do it, since it is the traditional choice and since it is also authorized in the Framework, Par 104 (a) which is applicable in the absence of specific IFRS, they unknowingly make the Historical Cost Mistake.

In the same breath, SA accountants do exactly the opposite: they acknowledge that inflation is destroying the real value of the depreciating Rand used as a depreciating monetary medium of exchange and they index or inflation-adjust by means of the CPI constant real value non-monetary income statement items like salaries, wages, rentals, etc by increasing their nominal values at a rate at least equal to the rate of inflation thus keeping their non-monetary real values constant over the time period in question.

On the one hand they acknowledge that the nominal values of income statement items like salaries and wages have to be indexed or inflation-adjusted by means of the CPI because inflation is destroying the real value of the Rand and on the other hand they assume - at exactly the same time and during exactly the same period - that the constantly depreciating Rand is perfectly stable, but, only for the valuation of balance sheet constant real value non-monetary items like Retained Earnings, Issued Share capital, capital reserves, provisions, other shareholder equity items, etc as well as for the other income statement items not inflation adjusted. SA accountants thus, unknowingly, destroy their real values at a rate equal to the rate of inflation to the amount of about R200 billion (Date 2010), year in year out, decade after decade when they maintain the stable measuring unit assumption for an unlimited period of time during indefinite inflation.

Kindest regards

Nicolaas Smith

Copyright © 2010 Nicolaas J Smith

Wednesday 17 March 2010

Inflation has no effect on the real value of non-monetary items

Inflation cannot erode or destroy the real value of non-monetary items. Erode is in the case of the functional currency, in fact, the same as destroy – there is absolutely no difference. Inflation can only destroy the real value of the unstable monetary medium of exchange (the unstable functional currency - the unstable Rand) used to transfer the constant real non-monetary values of salaries and wages from the employer to the employee.

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

Prof Dr. Ümit GUCENME, Dr. Aylin Poroy ARSOY, Changes in financial reporting in Turkey, Historical Development of Inflation Accounting 1960 - 2005, Page 9.

The destruction at a rate equal to the rate of inflation of all constant real value non-monetary items never maintained during inflation stops the very moment the Boards of Directors of SA companies and SA accountants choose to implement the IASB-approved financial capital maintenance in units of constant purchasing power model no matter what the level of inflation in the SA economy. The choice is theirs. The power to stop killing the real economy is in their hands - as authorized since 1989 in the IASB´s Framework, Par 104 (a) which is applicable in the absence of specific IFRS. It is SA accountants´ choice of accounting model and not inflation that maintains or destroys the real value of constant real value non-monetary items in SA´s low inflationary economy.

The constant real non-monetary values of salaries and wages expressed in terms of the depreciating unstable Rand as the depreciating unstable monetary unit of account are presently being maintained at the actual levels currently being achieved in SA when their nominal monetary values are indexed or inflation-adjusted by means of the CPI in SA´s low inflationary environment. This happens not because of a lowering of inflation, but because of SA accountants and SA trade unions valuing salaries and wages in units of constant purchasing power - inflation-adjusting them - instead of the Historical Cost measurement basis for this particular purpose.

If the parties to the salary and wage determination process were to agree to value salaries and wages at fixed Historical Cost – like Iceland recently decided to freeze salaries because of their financial crisis - then their constant real non-monetary values would be destroyed at a rate equal to the rate of inflation since constant real value non-monetary salaries and wages are expressed in term of the depreciating monetary unit of account in SA, namely, in depreciating Rands and are normally paid in depreciating Rands. Salaries and wages are not depreciating monetary items. They are constant real value non-monetary items. They are, however, normally paid in depreciating Rands which are depreciating monetary items during inflation.

“Income Statement

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

All items in the income statement are constant real value non-monetary items to be expressed or maintained or inflation-adjusted in terms of the measuring unit current (normally the CPI) at the balance sheet date in the case of IAS 29 and CIPPA models. Salaries and wages, being income statement items, are constant real value non-monetary items.

The real values of salaries and wages would thus not be destroyed by inflation if they were valued in nominal monetary units, but by the choice of the measurement basis, namely, Historical Cost which means the implementation of the very destructive stable measuring unit assumption whereby SA accountants consider that the continuous destruction of the purchasing power of the Rand – currently at 6.2% p.a. - is not sufficiently important to index or inflation-adjust the nominal values of constant real value non-monetary salaries and wages by means of the CPI in order to maintain their real values constant. What SA accountants do, in essence, is they assume the constantly depreciating monetary unit of account – the depreciating Rand – is perfectly stable when they implement the stable measuring unit assumption. SA accountants assume the depreciating Rand is perfectly stable, but, only for this particular purpose.

Constant purchasing power indexation or inflation-adjustment or measurement in units of constant purchasing power as authorized in the Framework, Par 104 (a) is thus applicable for financial capital maintenance in units of constant purchasing power since there is no particular IFRS which deals with it. It is a SA Generally Accepted Accounting Practice and well understood in SA´s low inflationary economy, but, currently, only for some - not all - constant real value non-monetary items in the income statement, e.g. salaries, wages, rentals, etc.
Copyright © 2010 Nicolaas J Smith

Tuesday 16 March 2010

SA accountants are unknowingly doing the destroying - not inflation

We commonly find that SA companies state in their opening notes to their balance sheet that their financial reports have been prepared based on the traditional Historical Cost model. We normally find that they use different measurement bases to different degrees and in different combinations including constant items in the income statement that are indexed or inflation-adjusted or valued in units of constant purchasing power by applying the CPI in SA´s low inflationary economy: e.g. salaries, wages, rentals, utility fees, transport fees, etc. Indexation or inflation-adjustment or valuing in units of constant purchasing power is thus already a generally accepted accounting practice in SA´s low inflationary economy, but, only for some, not all, income statement items and not at all for balance sheet constant items. SA accountants generally choose financial capital maintenance in nominal monetary units implementing their very destructive stable measuring unit assumption unknowingly destroying about R200 billion per annum in the SA real economy.
The annual indexation or inflation-adjustment of salaries and wages in SA´s low inflationary environment is a blessing to users since it enables them to maintain the real values of salaries and wages during inflation. This involves labour union negotiations with employer bodies. They usually agree on an annual increase in the depreciating Rand payment values for constant real value non-monetary salaries and wages to maintain their purchasing power constant in the low inflationary SA economy where the real value of the Rand is continuously being destroyed by inflation of about 6% per annum which is the SARB´s definition of "price stability". The nominal values of constant real value non-monetary salaries and wages are thus increased or indexed or inflation-adjusted by means of the CPI to cover or compensate for at least the expected rate of destruction in the real value of the depreciating Rand which is the depreciating unstable monetary unit of account for accounting purposes as well as the depreciating unstable monetary medium of exchange for payment purposes in the SA economy. The period is normally for the year ahead. They normally agree on an additional percentage increase for increases in productivity or for social reasons.

Both parties to the salary and wage negotiations agree that constant real value non-monetary salaries and wages cannot be accounted or valued at traditional nominal Historical Cost implementing the very destructive stable measuring unit assumption whereby SA accountants simply assume that the depreciating Rand is perfectly stable in SA´s low inflationary economy. Workers would not receive the constant purchasing power values of their salaries and wages when fixed HC salaries and wages are paid in depreciated Rands whose real values are continuously being destroyed by inflation. They would not receive their full real values of their salaries and wages.

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

Inflation can only destroy the real value of the depreciating unstable monetary medium of exchange (depreciating unstable money, i.e. the depreciating unstable functional currency inside an inflationary economy) - the depreciating unstable Rand in South Africa’s case - and other depreciating unstable monetary items.

Inflation has no effect on the real values of salaries and wages which are constant real value non-monetary items. Inflation can only destroy the real value of money and other monetary items. Accountants implementing the very destructive stable measuring unit assumption as part of the traditional HCA model unknowingly destroy the real value of salaries and wages when they do not inflation-adjust them by means of the CPI when they maintain the stable measuring unit assumption for an unlimited period of time during indefinite inflation; i.e. when they keep salaries fixed.

SA accountants are unknowingly doing the destroying - not inflation (as they so mistakenly believe) - and that inflation has no effect on the real value of any non-monetary item. Also inform them that SA accountants - with their full support - unknowingly destroy about R200 billion per annum in the SA constant item economy with financial capital maintenance in nominal monetary units per se - a complete fallacy - as authorized by the IASB in 1989. It is impossible to maintain the real value of financial capital constant in nominal monetary units per se during inflation and deflation.

Although, I am sure they realize that by now.
Copyright © 2010 Nicolaas J Smith

Monday 15 March 2010

CIPPA during low inflation authorized by the IASB 21 years ago

Monetary Items

Current period monetary item accounts cannot be indexed or inflation-adjusted or valued in units of constant purchasing power under any accounting model because the real value of money cannot be maintained constant during inflation or deflation.

Variable items

It is not proposed on this blog that the historical costs of variable real value non-monetary items are to be value in units of constant purchasing power or to be consistently indexed or inflation-adjusted by SA accountants by means of the CPI for the purpose of valuation during the current accounting period, for financial capital maintenance and for calculating the period-end profit or loss during low inflation. I have never advocated inflation accounting during low inflation in SA.

Variable items are valued by SA accountants in terms of IFRS or SA Generally Accepted Accounting Practice. The IASB specifically requires the implementation of IAS 29 Financial Reporting in Hyperinflationary Economies during hyperinflation. Variable items are required to be valued in units of constant purchasing power during hyperinflation in terms of IAS 29. SA has never experienced hyperinflation like, for example, Germany, Brazil and Turkey. That may explain a possible lack of profound analysis of price-level accounting in SA.

I believe SA will never experience hyperinflation. The culture of relatively low inflation and the understanding by the public in SA that low inflation is what long term sustainable economic growth is based upon are already solid parts of the SA economic identity.

It is very clear from the IASB´s Framework, Par 104 (a) that measuring financial capital maintenance in real value maintaining units of constant purchasing power is authorized by the IASB as the basis for a Constant ITEM Purchasing Power Accounting (CIPPA) model at any level of inflation and deflation. The IASB does not state that financial capital maintenance can be measured in nominal monetary units (the traditional HCA model) only during low inflation and that it can be measured in units of constant purchasing power only during high and hyperinflation. In typical international accounting standard fashion it simply states that either the one or the other can be used. That means at all levels of inflation and deflation.

The IASB does, however, specifically require the implementation of IAS 29 during hyperinflation. IAS 29 is based on the CPP inflation accounting model requiring all non-monetary items to be inflation-adjusted by means of the CPI during hyperinflation. This results in most accountants, accounting authorities, accounting professors and lecturers assuming that price-level accounting always refers only to inflation accounting. They thus ignore the CIPPA model authorised by the IASB in the Framework, Par 104 (a) in 1989 for financial capital maintenance in units of constant purchasing power during low inflation.

In the Framework, Par 101 the IASB states that companies most commonly use the traditional HC model to prepare their financial reports and that other measurement bases are used in combination with HC. The IASB does, however, specifically require entities only in hyperinflationary economies – being exceptional circumstances - to implement IAS 29.

The IASB - as far as measurement bases are concerned - specifically deals with historical cost, current cost, realizable (settlement) value, present value, market value, recoverable value and fair value, all of which SA accountants, in fact, use to value variable items in terms of IFRS or SA GAAP during low inflation in SA.

In the Framework, Par 104 (a) the IASB authorizes SA accountants to measure financial capital maintenance in real value maintaining units of constant purchasing power at all levels of inflation and deflation – including low inflation. Whenever they choose to do that, it would indicate that they choose the CIPPA model instead of their current choice, the very destructive traditional Historical Cost model.

Although SA accountants choose to measure financial capital maintenance in nominal monetary units, that is, they choose the very destructive HC model, they do, in fact, also use the real value maintaining constant purchasing power measurement basis to index or inflation-adjust some - not all - income statement constant real value non-monetary items like salaries, wages, rentals, transport fees, utility fees, etc by means of the CPI. They measure them in units of constant purchasing power instead of in nominal monetary units. SA accountants can also use real value maintaining units of constant purchasing power, in terms of the Framework, Par 104 (a), to value balance sheet constant items like Retained Earnings, Issued Share capital, other shareholder equity items, etc to implement a constant purchasing power concept of financial capital maintenance. The IASB notes that entities use various different measurement bases in varying combinations and to different degrees in their financial reports.

Copyright © 2010 Nicolaas J Smith

Friday 12 March 2010

How to kill the stable measuring unit assumption

Non-monetary items are subdivided in variable and constant items. Only constant items have to be inflation-adjusted in terms of the Framework, Par 104 (a) to maintain their real values constant during low inflation in order to measure financial capital maintenance in units of constant purchasing power instead of in nominal monetary units. That is what this blog is about. Variable items are valued in terms of IFRS or SA GAAP in a manner that takes into account all elements - including inflation - which determine the variable item’s real value at the date of valuation during low inflation and deflation. Monetary items are always valued at their original nominal monetary values under all accounting models and under all economic environments.

This blog is about SA accountants maintaining the real values of all constant real value non-monetary items - e.g., SA banks´ and companies´ Shareholders´ Equity – constant during low inflationary conditions for an unlimited period of time – ceteris paribus - by implementing the real value maintaining financial capital maintenance in units of constant purchasing power model as approved in the IASB´s Framework, Par 104 (a) in 1989.

This blog is about SA accountants indexing or inflation-adjusting only constant items by implementing the Constant ITEM Purchasing Power Accounting model as approved in the IASB´s Framework, instead of unknowingly and unintentionally destroying their real values on a massive scale with their implementation of the very destructive stable measuring unit assumption as it forms part of the traditional HCA model when they maintain the stable measuring unit assumption for an unlimited period of time during indefinite inflation.

This blog is about SA accountants choosing to measure financial capital maintenance in SA banks and companies in real value maintaining units of constant purchasing power during low inflation as approved in the IASB´s Framework, Par 104 (a) instead of in nominal monetary units as a result of their choice to implement the very destructive stable measuring unit assumption during low inflation also authorized by the IASB in the Framework, Par 104 (a) twenty one years ago.

This blog is about SA accountants rejecting the stable measuring unit assumption and instead adopting IASB-approved real value maintaining constant purchasing power units as the measurement basis for only constant items including SA banks´ and companies´ Shareholders´ Equity and not only for income statement constant items, e.g. salaries, wages, rentals, etc during non-hyperinflationary conditions.

This blog is about stopping SA accountants unknowingly destroying about R200 billion per annum in real value in the SA real economy because they choose to implement the traditional HCA model when they maintain the very destructive stable measuring unit assumption for an unlimited period of time during indefinite inflation instead of the IASB-approved real value maintaining CIPPA model.

SA accountants make the Historical Cost Mistake by implementing the very destructive stable measuring unit assumption during inflation as part of the traditional HCA model for an unlimited period of time during indefinite inflation.

This blog is about SA accountants being able to maintain about R200 billion per annum of real value in the SA real economy for an unlimited period of time complying with IFRS instead of unknowingly destroying that value year in year out as they unknowingly do at the moment when they maintain the stable measuring unit assumption for an unlimited period of time during indefinite inflation.

This blog is about SA accountants abandoning the very destructive traditional HCA model and adopting the real value maintaining CIPPA model in SA´s low inflationary economy as authorized in 1989 in the IASB´s Framework, Par 104 (a).

Kindest regards

Nicolaas Smith

Copyright © 2010 Nicolaas J Smith

Wednesday 10 March 2010

SA accounting profession clueless about CIPPA

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

Income statement constant real value non-monetary items like salaries, wages, rentals, utilities, transport fees, etc are normally valued by accountants in units of constant purchasing power during low inflation in most economies including South Africa. Payments in money for these items are normally inflation-adjusted by means of the CPI to compensate for the destruction of the real value of the unstable monetary medium of exchange by inflation. Inflation is always and everywhere a monetary phenomenon and can only destroy the real value of money (the functional currency inside an economy) and other monetary items. Inflation can not and does not destroy the real value of non-monetary items. See GUCENME and ARSOY.

Constant real value non-monetary items´ real values can be maintained by accountants choosing the CIPPA model as per the IASB´s Framework during low inflation as authorized since 1989 instead of currently unknowingly being destroyed by them by the implementation of the traditional HCA model when they apply the very destructive stable measuring unit assumption for an unlimited period of time during indefinite inflation. It is thus accountants´ choice of accounting model and not inflation that maintains or destroys the real value of constant real value non-monetary items like Retained Earnings, Issued Share capital, capital reserves, other shareholder equity items, etc when accountants choose to implement the very destructive stable measuring unit assumption for an unlimited period of time during indefinite inflation.

Implementing the low inflation CIPPA model as approved in the Framework, Par 104 (a) means accountants choose to reject the stable measuring unit assumption which they implement when they choose to measure financial capital maintenance in nominal monetary units – also in terms of the Framework, Par 104 (a).

SA accountants do not select financial capital maintenance in units of constant purchasing power and SA accounting professors and lecturers do not teach SA accounting students to select the real value maintaining IASB approved alternative to the 700 year old very destructive generally accepted traditional Historical Cost Accounting model because

(1) they automatically assume that any price-level accounting model always refers to the CPP inflation accounting model,

(2) they do not understand the fact that they unknowingly destroy real value on a massive scale (at least R200 billion per annum) in the SA real economy when they select to measure financial capital maintenance in nominal monetary units, and

(3) they do not understand the fact that they can stop that by simply selecting the alternative approved by the IASB predecessor body, the IASC Board, 21 years ago, namely, the measurement of financial capital maintenance in units of constant purchasing power as approved in the Framework, Par 104 (a) which is compliant with IFRS and was adopted by the IASB in 2001.

(4) they believe and implement the IASB´s authorization of the fallacy that "Financial capital maintenance can be measured in nominal monetary units."

(5) they believe and implement the stable measuring unit assumption that is based on a fallacy.

(6) they believe the fallacy that "the erosion of business profits and capital is caused by inflation."

If they understood it, they would have stopped the stable measuring unit by now.
Copyright © 2010 Nicolaas J Smith

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Daily CPI

1. Argentina Daily CPI - CER (Coeficiente de Estabilización de Referencia)

Click in sequence: "Estadísticas e Indicadores"

"Monetarias y Financieras"
"Descarga de paquetes estandarizados de series estadísticas":

At the bottom of the page you will see: "Coeficiente de estabilización de referencia (CER), serie diaria", then choose a year and open the excel file.

2. Chile - UF: Daily Unidad de Fomento Index. Not a Daily CPI, but a monetized daily indexed unit of account.

3. Colombia - Real Value Unit A Monetized Daily Indexed Unit of Account

4. Denmark Inflation-Linked Bonds

5. Eurozone Daily CPI Click on "Download historical data"

6. France Daily CPI Click on "Download historical data"

7. Germany Daily Reference Index

8. Iceland - Daily CPI

8. Iceland- CPIs - including Daily CPI

9. Ireland Inflation-Linked Bonds

10. Italy Inflation-Linked Bonds

11. Japan - Daily CPI

12. Mexico - Unidad de Inversion Click on UDI and then select Export to HTML