Definition of monetary item

Definition of monetary item


The correct definition of monetary items is critical for the correct classification of non–monetary items since the latter are correctly defined as all items that are not monetary items. If the definition of monetary items is wrong – as it currently is in IFRS – then some constant real value non–monetary items are incorrectly classified as monetary items. This happens mainly with the incorrect classification of trade debtors and trade creditors as monetary items under current IFRS. This affects the correct valuing of these items, the calculation of the net monetary gain or loss and consequently the profit or loss for the reporting period which influences the correctness of the financial statements in terms of IAS 29 during hyperinflation. In an amazing contradiction of basic economic logic, there is no net monetary gain or loss calculation required when the traditional HCA model is chosen during low inflation and deflation. The calculation of the net monetary gain or loss is an essential part of the CIPPA model while it is non–existent under the HCA model. This is one of the fundamental failures of the HCA model which is corrected under the CIPPA model.

The incorrect treatment of the constant real value non–monetary items trade debtors and trade creditors and other non–monetary payables and receivables as monetary items is mainly due to the incorrect definition of monetary items in International Financial Reporting Standards.

It is taught that there are only two distinct economic items in the economy, namely, monetary and non–monetary items and that the economy is divided in the monetary and non–monetary or real economy.

Monetary items are defined by the International Accounting Standards Board in IAS 21 The Effects of Changes in Foreign Exchange Rates, Par 8 as follows:

“Monetary items are units of currency held and assets and liabilities to be
received or paid in a fixed or determinable number of units of currency.”

and in IAS 29 Financial Reporting in Hyperinflationary Economies, Par 12 as follows:

“Monetary items are money held and items to be received or paid in money.”

The correct defintion of Monetary Items

Monetary items constitue the Money supply.

Updated on 11-05-2013

The US Financial Accounting Standards Board and PricewaterhouseCoopers also define trade debtors and trade creditors incorrectly as monetary items. PwC is simply following the IASB lead.

The second part of the IAS 29 definition is not correct. When a non–monetary item, e.g. raw material, is bought on credit, the trade debtor amount in the supplier’s accounts is not a monetary item just because it will be paid in money or because it will be paid in a fixed or determinable number of units of currency. It can be paid in strawberries or diamonds too, if the supplier will accept strawberries or diamonds as a medium of payment. That will not make the non–monetary raw material a strawberry item or diamond item, just like payment in money does not make non–monetary raw material a monetary item. Money or strawberries or diamonds are simply used as the mutually agreed medium of exchange. The constant real value non–monetary trade debtor amount relates to the sale of a non–monetary item, namely the non–monetary raw material. The trade debt has an underlying non–monetary nature. All items – monetary and non–monetary items – are normally received or paid in money.

The buyer did not decide or agree to borrow money – exactly equal to the amount of the trade debt – from the supplier the moment the buyer decided not to pay the purchase cash on delivery or even if it was beforehand agreed that the buyer would not pay cash on delivery, but, would be granted credit. The supplier did not decide or agree to lend the buyer money– exactly equal to the amount of the trade debt – the moment the buyer did not pay the purchase cash on delivery. The trade debt relates to a non–monetary item: raw material. The trade debt is thus a constant real value non–monetary item the moment it comes about. The underlying non–monetary nature of the debt (raw material, furniture, vehicle, etc.) results in it being a constant real value non–monetary item the moment the debt comes about which has to be updated – over time – during low inflation, hyperinflation and deflation. Street vendors in hyperinflationary economies – some of whom have never been to school – know this instinctively.

When inflation erodes the real value of the monetary medium of exchange at 2% per annum, 2% more money has to be paid over a year to pay off the constant real value non–monetary item, the trade debtor amount.

Inflation is always and everywhere a monetary phenomenon – as per Milton Friedman. Money is only the monetary medium of exchange used for payment. Inflation can only erode the real value of money and other monetary items – nothing else. Inflation has no effect on the real value of non–monetary items. The debt is for the constant real non–monetary value of a non–monetary item mutually agreed and generally accepted to be paid in money: not for a monetary item. Money is simply the medium of exchange. No–one lent any money to anyone else. There is generally no money loans involved with trade creditors and trade debtors.


Nicolaas Smith

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

Money illusion and Historical Cost values

Money illusion and Historical Cost values


(The following is adapted from a live–event on US TV. Any resemblance to a living person is purely coincidental ;–)

Let us assume a highly respected 75–year–old grandfather tries to encourage his grandson to accept a low starting salary in a very good company as a good starting point for the youngster’s career. The grandfather may mention that when he started work he earned 25 Dollars per week – meaning that he also started with a low salary and worked his way up. Stating his starting salary at its original historical cost value of maybe more than 50 years ago completely falsified the example he gave. He was trying to say – and he certainly did, incorrectly (unintentional though it may have been) create the impression – that he started work at a low salary and had to work his way up. When the original historical cost value of 25 US Dollars of the grandfather’s first weekly pay packet is updated in units of constant purchasing power for real value erosion in the US Dollar during the fifty or more years of his working life till the date of his comments on TV, we find that he started work at a monthly salary of about 5 000 US Dollars current at the date of his comments. So, at 60 000 US Dollar per year the grandfather had a very good starting salary – which is exactly the opposite of what he was trying to say to his grandson.

That is money illusion at work. Money illusion is so pervasive in our low inflation societies that we do not even notice it any more. It is a complete state of mind – a way of thinking.

We have to stop thinking in nominal terms and start thinking in real value terms. As long as there is inflation in an economy, the national currency created and used in that inflationary economy is not a store of perfectly stable real value. It is a store of decreasing real value. Money is losing real value all the time when an economy is in a state of inflation. 2% inflation is not price stability; 2% inflation is a high degree of price stability. It is some countries´ definition of price stability. It is not absolute price stability. All currently existing bank notes and coins will actually be completely worthless sometime in the future when an economy remains in an inflationary mode for a long enough period of time.

Money developed upon the mistaken belief that it is stable – as in fixed – in real value in the short to medium term in economies with low inflation. The term stable money is seen as meaning that money’s real value stays intact over the short to medium term in low inflationary economies. Money illusion is still very evident today in most economies in money, other monetary items and constant real value non–monetary items that are mistakenly considered to be monetary items under the Historical Cost paradigm; for example, trade debtors, trade creditors, dividends payable, dividends receivable, taxes payable, taxes receivable, etc.


Nicolaas Smith

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

Money illusion

Money illusion

Definition: Money illusion is the mistaken belief that money is stable 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 often 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 was 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 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 within the UK economy as indicated by the monthly change in the CPI.

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 Jaguar. 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 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 the effect of the stable measuring unit assumption – the assumption that money is stable in real value over time – as related to the British Pound over the years in question.

Nicolaas Smith

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

Deflation

Deflation


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 and all other monetary items. 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 annual inflation rate (i.e. when annual inflation decreases, but still remains positive). Disinflation is a decrease in the annual rate of increase in the general price level. Annual inflation erodes the real value of money and other monetary items over time; conversely, annual deflation increases the real value of money and other monetary items 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 (CIPPA) as the fundamental model of accounting implementing IFRS, is the best practice: a low level of inflation (best practice is currently regarded as 2% annual inflation) to limit the erosion of real value in money and other monetary items; IFRS for the correct valuation of variable real value non–monetary items and, thirdly, financial capital maintenance in units of constant purchasing power (CIPPA) as authorized in IFRS for automatically maintaining the existing constant real values of existing constant real value non–monetary items constant forever during low inflation and deflation in all entities that at least break even – ceteris paribus - without the requirement for extra capital or extra retained profits simply to maintain the existing constant real value of existing constant real value non–monetary items (e.g. equity) constant. Net monetary losses and gains are calculated and accounted in the income statement during low inflation and deflation when CIPPA is implemented: basically, the cost of inflation is 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.

Entities do their best to compensate for the net monetary loss from holding cash and other monetary items by trying to invest them at rates higher than the expected inflation rate. Obviously, it is not possible before the event to know what the inflation rate will be during any future period. It is possible to invest money in some economies in inflation–proof investments: the interest paid is stated at the start of the contract to be equal to the inflation rate plus 2 or 3 or 4 per cent to give a real return on the investment.


Nicolaas Smith

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

Net monetary gains and losses

Net monetary gains and losses

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

Net monetary gains and losses are calculated and accounted during hyperinflation as required by IAS 29 Financial Reporting in Hyperinflationary Economies. The calculation and accounting of net monetary gains and losses have also been authorized in IFRS with the measurement of financial capital maintenance in units of constant purchasing power in the original Framework (1989), Par 104 (a) during low inflation and deflation, i.e. under the Constant Item Purchasing Power Accounting model. 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. All items accounted in the income statement are constant real value non–monetary items.

This omission under the Historical Cost paradigm to compute the gains and losses from holding monetary items is one of the consequences of the stable measuring unit assumption as implemented as part of the traditional Historical Cost Accounting model.

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 during hyperinflation and during low inflation and deflation only with the implementation of IFRS–authorized financial capital maintenance in units of constant purchasing power (CIPPA), but, not during the implementation of the Historical Cost Accounting model during low inflation and deflation is one of the various confounding generally accepted perplexities in traditional Historical Cost Accounting.

Nicolaas Smith

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

Inflation is always and everywhere a monetary phenomenon

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. During inflation each unit of the monetary unit buys fewer goods and services; consequently, annual inflation only erodes 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.

Inflation erodes real value evenly in money and other monetary items over time. There are, consequently, hidden monetary costs to some and hidden monetary benefits to others from this erosion 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 a loan. The debtor (in the case of a monetary loan) gains during inflation since he, she or it (a company) has to pay back the nominal value of the loan, the real value of which is being eroded by inflation. The debtor (of a monetary loan) pays back less real value during inflation. The creditor (in the case of a monetary loan) loses out because he, she or it 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 they hope will be higher than the actual inflation rate during the period of the loan.

An increase in the general price level (inflation) erodes the real value of money 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 as monetary items when the stable measuring unit assumption is implemented as part of the HCA model during low inflation. Implementing the HCA model unknowingly, unintentionally and unnecessarily erodes their real values at a rate equal to the annual rate of inflation because they are measured in nominal monetary units during low inflation. Inflation only erodes the real value of money which is the nominal monetary unit of account in the economy. This unknowing, unintentional and unnecessary erosion in fixed constant real value non–monetary items never maintained constant during low inflation stops when financial capital maintenance is measured in units of constant purchasing power during low inflation; i.e., implementing the CIPPA model. It is thus the implementation of financial capital maintenance in nominal monetary units in terms of the Historical Cost Accounting model and not inflation that is doing the eroding.

The generally accepted measure of inflation in low inflationary economies is the annual inflation rate, calculated from the annualized percentage change in a general price index – normally the Consumer Price Index – published on a monthly basis. The correct measure of inflation in a hyperinflationary economy is a Brazilian-style daily index value almost entirely based on the daily parallel rate (normally the US Dollar parallel rate) – where a parallel rate is in use, officially or unofficially. The CPI published a month and a half to two months after the hyperinflationary changes in the real value of the monetary unit actually happened, is completely impractical and totally ineffective as a measure of inflation when the aim is to stabilize the real economy during hyperinflation as Brazil so effectively did with daily indexation during 30 years of high and hyperinflation. This is only possible with daily indexing of all non–monetary items as was done in Brazil from 1964 to 1994 or with measuring financial capital maintenance in units of constant purchasing power during hyperinflation, i.e. updating all non–monetary items (variable real value non–monetary items and constant real value non–monetary items) on a daily basis applying the daily change in the parallel rate and not the period–end CPI as currently required by IAS 29.


Nicolaas Smith

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

CIPPA update: June 2011

CIPPA update: June 2011

The proposal for publishing the book "Constant Item Purchasing Power Accounting" is with a publisher in SA for more than two months by now. I think this editor is seriously looking at publishing the book. The editor asked me for SA and overseas reviewers. I fortunately managed to get David Mosso to read a 10 page abstract of the book and to agree to write a review for the publisher. David Mosso is almost the US equivalent of Sir David Tweedie, the chairman of the IASB. David Mosso was one of the three dissenting votes with US FAS 89 which made measurement in units of constant purchasing power voluntary for US companies. He and the other two dissenting votes wanted it to be compulsary. He stated in FAS 89 that dealing with the effect of "inflation" in accounting "is the most important item the US FASB will deal with this century." He now agrees that it is not inflation but the stable measuring unit assumption that is doing the damage. His remarks to me after reading the abstract was "Good work" and he agreed to write the review for the publisher.

I am absolutely sure that financail capital maintenance in units of constant purchasing power (CIPPA) will eventually prevail over financial capital maintenance in nominal monetary units (HCA) which is - in fact - a fallacy since it is impossible to maintain the constant purchasing power of capital constant with financial capital maintenance in nominal monetary untis - per se - during inflation and deflation.

Both financial capital maintenance in nominal monetary units (traditional HCA) and in units of constant purchasing power (CIPPA) have been authorized in IFRS in the original Framework (1989), Par 104 (a).

The reason capital maintenance in units of constant purchasing power never went ahead was because non-monetary items were not yet split in variable and constant items in 1986. I identified the split in 2005 and it was peer reviewed (three times) and published in SAICA´s journal Accountancy SA in 2007. (see link on the right).

What is missing now is for the due process of CIPPA to be completed. IFRS authorization in 1989 was only the start: a very important start. Due process for CIPPA to be completed requires peer review, publication, discussion, practical implementation, software updates, education, staff training, etc.

A lot of that is still to come.

IFRS authorization was a very important first step. The IFRS Foundation (IASB) has done its part brilliantly in 1989.

The split of non-monetary items in variable and constant items enabled the completion of the constant item purchasing power accounting (CIPPA) model.

The publication of the book will be an important third step.

Then practical implementation.

Education, adaptation of accounting software packages, development of auditing of CIPPA, etc, etc will then follow.

Nicolaas Smith

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

Money makes the world go round

Money makes the world go round

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 perfectly stable in real value even though all historical cost accounting world-wide is done assuming that when the stable measuring unit assumption is implemented for the valuation of most – not all – constant real value non-monetary items during low inflation and deflation. It is assumed, in principle, that money is perfectly stable when all balance sheet constant real value non–monetary items, e.g. issued share capital, retained earnings, capital reserves, all other items in shareholders´ equity, provisions, trade debtors , trade creditors, all non–monetary payables, all non–monetary receivables and all income statement items (excluding constant real value non–monetary items like salaries, wages, rentals, transport fees, etc. which are correctly updated annually) are valued at their historical costs when financial capital maintenance in nominal monetary units (the Historical Cost Accounting model) is implemented during low inflation and deflation as authorized in IFRs in the original Framework (1989), Par 104 (a).

Money is not the same as constant real value during inflation and deflation. Money only has a constant real value over time during sustainable zero annual inflation which has never been achieved in the past and is not likely soon to be achieved in the future.

Bank notes and coins are physical tokens 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 real value non–monetary items and constant real value non–monetary 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 and monetary unit of account.

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 annual 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.


Nicolaas Smith

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

CIPPA increases a company’s net asset value

CIPPA increases a company’s net asset value over time as compared to carrying on with implementing the very erosive stable measuring unit assumption as it forms part of the Historical Cost Accounting model. The stable measuring unit assumption is never implemented under CIPPA.

Nicolaas Smith

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

HCA is not an appropriate accounting policy

HCA is not an appropriate accounting policy


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 the appropriateness of accounting policies for a company.

The implementation of the very erosive 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 use of the HCA model is – in principle - not an appropriate accounting policy for companies during inflation and deflation.

The IASB, on the one hand, 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

Very unfortunately, the IASB, on the other hand – in the same standard, authorizes and supports the use of the HCA model during hyperinflation:

“The financial statements of an entity whose functional currency is the currency of a hyperinflationary economy, whether they are based on a historical cost approach or a current cost approach, shall be stated in terms of the measuring unit current at the end of the reporting period.” IAS 29, Par 8

Big Four audit firms, e.g. PricewaterhouseCoopers, also support the use of HCA during hyperinflation:

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

Financial Reporting in Hyperinflationary Economies – Understanding IAS 29, PricewaterhouseCoopers, May 2006, p 5.

When it is clearly demonstrated and the board of directors knows that a company’s HC accounting policy - freely selected by the board - continuously erodes a significant amount of the existing constant real non-monetary value of the company´s Shareholders´ Equity as a result of the company’s implementation of the very erosive stable measuring unit assumption when the company assumes that it would be for an unlimited period of time during indefinite inflation, then the traditional HCA model is , in principle, not an appropriate accounting policy. When the board knows that financial capital maintenance in units of constant purchasing power during low inflation (CIPPA) - as approved by the IASB in the original Framework (1989), Par 104 (a) - is an IFRS–compliant alternative freely available to the company and when the board knows that CIPPA would automatically stop the unnecessary erosion of existing constant real non–monetary value in existing constant items never maintained constant for an indefinite period of time in all entities that at least break even during low inflation – ceteris paribus - then the traditional HCA model is , in principle, not an appropriate accounting policy.

The principle of financial capital maintenance in units of constant purchasing power during low inflation and deflation has been subjected to a “thorough, open, participatory and transparent, due process” at the IASB, and elsewhere, before it was approved in the original Framework (1989), Par 104 (a) twenty two years ago. The principle is thus generally accepted in the accounting and auditing professions. However, the practice of financial capital maintenance in unit of constant purchasing power during low inflation and deflation (CIPPA) is not yet generally accepted sine the due process is not yet complete. Neither have accounting software packages been adapted for the implementation of CIPPA, nor has accounting personnel been trained to implement financial capital maintenance in units of constant purchasing power during low inflation and deflation, nor have audit procedures been adapted by auditors to audit companies implementing the Constant Item Purchasing Accounting model. That is: the due process is not yet complete for CIPPA.

Currently financial capital maintenance in units of constant purchasing power during low inflation and deflation (CIPPA) is thus an appropriate accounting policy in principle but is not yet generally implemented in practice. HCA is thus not an appropriate accounting policy, in principle, but, is generally implemented in practice. The current implementation of the HCA model is thus still an appropriate (very costly to the world economy) accounting policy, in practice, but not in principle. However, as soon as the practical implementation of financial capital maintenance in units of constant purchasing power accounting during low inflation and deflation (CIPPA) has passed proper due process; accounting software packages have been adapted to CIPPA; accounting personnel have been trained to implement CIPPA and audit procedures have been adapted by audit firms to audit companies implementing CIPPA, then the HCA model will certainly not be an appropriate accounting policy – in principle and in practice.

This will not happen overnight. As was stated in US FAS 89 in 1986:

“Mr. Mosso dissented to the issuance of Statement 33 and he dissents to its rescission, both for the same reason. He believes that accounting for the interrelated effects of general and specific price changes is the most critical set of issues that the Board will face in this century.”

and

“Relative to most changes in financial reporting, the changes required by Statement 33 were monumental. Because most accountants and users of financial statements have been inculcated with a model of financial reporting that assumes stability of the monetary unit, accepting a change of this consequence would take a lengthy period of time under the best of circumstances.”

Any single entity can now implement CIPPA since non-monetary items have been properly split in variable and constant items since 2005.


Nicolaas Smith

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

Nine requirements for audited HC financial statement to fairly present an entity´s financial position

Nine requirements for audited HC financial statement to fairly present an entity´s financial position

Audited annual financial statements provided by companies which prepare them using the traditional Historical Cost Accounting model, i.e., when the board of directors choose to measure financial capital maintenance in nominal monetary units during low inflation and deflation instead of in units of constant purchasing power in terms of the IASB´ original Framework (1989), Par 104 (a), are compliant with IFRS, but, do not - in principle - fairly present the financial position of the companies.
The SA Companies Act, No 71 of 2008, Article 29.1 (b), for example, 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 in terms of the HCA model do not - in principle - fairly present the financial position of companies during low inflation when the directors do not:

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

(2) state that this includes the erosion of the constant real value of Shareholders´ Equity when the company does not have sufficient revaluable fixed assets that are or can be revalued via the Revaluation Reserve with an updated fair value equal to the updated original constant real non-monetary value of all contributions to Shareholders’ Equity under the HCA model during low inflation;

(3) state the percentage and updated amount of constant real non-monetary value of Shareholders´ Equity that are not being maintained constant; i.e., the percentage and updated amount of constant real non-monetary value of Shareholders´ Equity that are subject to constant real value erosion at a rate equal to the annual inflation rate because of the directors´ free choice, in terms of the original Framework (1989), Par 104 (a), to measure financial capital maintenance in nominal monetary units (which is a popular accounting fallacy since it is impossible per se during inflation) – i.e. their free choice to implement the very erosive stable measuring unit assumption during inflation - instead of automatically maintaining the constant real value of Shareholders´ Equity constant for an indefinite period of time in units of constant purchasing power (both methods being compliant with IFRS) when their companies at least break even – ceteris paribus.

(4) state the amount of updated constant real non-monetary value eroded during the last and previous financial year in Shareholders´ Equity and all other constant real value non–monetary items never maintained constant because of the directors´ free choice to implement the Historical Cost Accounting model;

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

(6) state the change in the updated constant real non-monetary 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 which would automatically maintain the constant purchasing power of Shareholders´ equity constant forever in entities that at least break even during inflation and deflation – ceteris paribus - instead of in nominal monetary units also authorized in IFRS in the original Framework (1989), Par 104 (a);

(7) state the directors´ estimate of the amount of constant real non-monetary value to be eroded by their free choice to implement the very erosive stable measuring unit assumption (which is based on the popular accounting fallacy - also approved by the IASB - that changes in the purchasing power of money are not sufficiently important during low inflation and deflation to require financial capital maintenance in units of constant purchasing power) during the following accounting year under the HC basis;

(8) state that the updated constant real non–monetary value calculated in (7) represents the amount of constant real non–monetary value the company would gain during the following accounting year and every year thereafter for an unlimited period of time as long as the company at least break even during inflation and deflation – ceteris paribus – when the directors choose to measure financial capital maintenance in units of constant purchasing power as authorized in IFRS in the original Framework (1989), Par 104 (a) - which they are free to choose any time they decide;

(9) state the directors´ reason(s) for freely choosing financial capital maintenance in constant real value eroding nominal monetary units which is a fallacy since it is impossible per se during inflation and deflation instead of in real value maintaining units of constant purchasing power which would automatically maintain the constant purchasing power of Shareholders´ Equity constant forever in all entities that at least break even during inflation and deflation – ceteris paribus.


Nicolaas Smith

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

Three concepts of capital maintenance under IFRS

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.

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Nicolaas Smith

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

Nominal financial capital maintenance concept commonly chosen

Nominal financial capital maintenance concept commonly chosen by entities in the world economy implementing the very erosive stable measuring unit assumption as it forms part of the HCA model responsible for hundreds of billion of US Dollars of erosion of constant item real value per annum in the world´s constant item economy.

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Nicolaas Smith

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

No revaluable fixed assets required per se to automatically maintain capital constant forever

No revaluable fixed assets required per se to automatically maintain capital constant forever


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

100% of the updated original constant real value 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 erode any Shareholders´ Equity’s existing constant real non–monetary value during low inflation under the traditional Historical Cost Accounting model – i.e. measuring financial capital maintenance in nominal monetary units as implemented by most entities.

The existing constant real non–monetary value of that portion of existing shareholders´ equity not invested in revaluable fixed assets (revalued or not) is currently unknowingly, unintentionally and unnecessarily being eroded 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 erosive stable measuring unit assumption as done by most entities when they implement the HCA model for an unlimited period of time during indefinite low inflation.

Most entities do not meet the requirement to investment 100% of the updated original real value of all contributions to Shareholders´ Equity in revaluable fixed assets. Entities that possibly meet the 100% of the updated original real value of all contributions to shareholder´s equity requirement are hotel, hospital, property and similar companies. In practice this means that the real value of Retained Earnings never maintained constant of most companies and banks are unknowingly, unintentionally and unnecessarily being eroded at a rate equal to the annual rate of inflation by entities implementing the IFRS–approved traditional HCA model during low inflation.

Implementing the IFRS–authorized alternative, namely, financial capital maintenance in units of constant purchasing power during low inflation and deflation (CIPPA) as authorized in 1989 in the original Framework (1989), Par 104 (a), automatically stops this unknowing, unintentional and unnecessary erosion by the implement of the stable measuring unit assumption forever at all levels of inflation in all entities that at least break even – ceteris paribus – whether they own revaluable fixed assets or not and without the requirement of more money or more Retained Earnings just to maintain the existing constant real non–monetary value of existing Shareholders´ Equity constant.

No–one will disagree that inflation and not the stable measuring unit assumption erodes the real value of money and other monetary items in the monetary economy despite the fact that central banks and monetary authorities regard the erosion of from 2 to 6% per annum of the real value of the monetary unit as the achievement and maintenance of “price stability” in the economic system. Obviously it is not price stability at all. It is 2 to 6% per annum away from price stability. It is the central bank´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. Positive annual inflation of up to 2% is a high degree of price stability. It is not absolute price stability.

The IASB only requires the implementation of IAS 29 Financial Reporting in Hyperinflationary Economies during hyperinflation. The IASB defines hyperinflation as cumulative inflation over three years approaching or equal to 100%, i.e. annual inflation of 26% for three years in a row. This means that central banks could define “price stability” as annual inflation at any rate from 0.001 to 25.99% per annum.


Nicolaas Smith

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

The difference between deflation, disinflation and inflation

The difference between deflation, disinflation and inflation


Deflation is a sustained absolute decrease in the general price level resulting in a sustained increase in the real value of the monetary unit (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 is generally a relatively stable currency of another (generally 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 two 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 erodes the real value of money and other monetary items over time. Deflation creates more real value in money and other monetary items over time.

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 erosion 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 erodes the real value of money. Disinflation erodes 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. When the general price level moves even lower past zero percent, 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.


Nicolaas Smith

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

The Framework applies

The Framework applies
 

Companies listed on stock exchanges 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 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: 21^st March, 2010 http://www.iasplus.com/standard/framewk.htm

IAS 8.11:

“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 real value non–monetary items Issued Share Capital, Retained Earnings, most 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 IAS 8.11.

A fundamental attribute of the traditional Historical Cost Accounting model which  boards of directors select when they decide on behalf of companies to measure financial capital maintenance in nominal monetary units (a generally accepted accounting fallacy not yet extinct) in terms of the IASB´s original Framework (1989), Par 104 (a) is that it unknowingly, unnecessarily and unintentionally erodes the existing constant real non–monetary value of that portion of shareholders´ equity never maintained constant as a result of insufficient revaluable fixed assets (revalued or not) with the implementation of the very erosive stable measuring unit assumption during low inflation.

The implementation of the HCA model, on the other hand, unnecessarily, unknowingly and unintentionally creates real value in constant real value non–monetary items never maintained constant (not decreased at a rate equal to the annual rate of deflation) as a result of the implementation of the real value creating stable measuring unit assumption during deflation (recently mainly in Japan).

Nicolaas Smith

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

Objectives of CIPPA

Objectives of CIPPA


The first objective of this book is to undeniably demonstrate that the implementation of the very erosive stable measuring unit assumption (which is based on the fallacy that changes in the purchasing power of the monetary unit of account – money – is not sufficiently important to require financial capital maintenance in units of constant purchasing power during low inflation and deflation) as applied as part of the traditional generally accepted globally implemented HCA model, unnecessarily, unknowingly and unintentionally erodes the real value of existing constant real value non–monetary items never maintained constant, e.g. that portion of shareholders´ equity never maintained constant as a result of insufficient revaluable fixed assets (revalued or not) during low inflation, amounting to hundreds of billions of US Dollars each and every year in the world´s constant item economy because it is freely chosen to measure financial capital maintenance in nominal monetary units (which is a fallacy since it is impossible to maintain the real value of financial capital constant in nominal monetary units per se during inflation and deflation) as authorized in IFRS in the original Framework (1989), Par 104 (a).

The second objective of this book to show that measuring financial capital maintenance in real value maintaining units of constant purchasing power per se during low inflation and deflation (CIPPA) – also authorized in IFRS in the original Framework (1989), Par 104 (a) – which is applicable in the absence of specific IFRS, is the only way to automatically maintain the existing constant real non–monetary value of all existing constant items constant forever in all entities that at least break even whether they own revaluable fixed assets or not – ceteris paribus.


Nicolaas Smith

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

CIPPA financial statements fairly present an entity´s financial position (where applicable)

CIPPA financial statements fairly present an entity´s financial position (where applicable)

Balance sheet constant real value non–monetary items are valued under HCA using the traditional HC model in terms of which the very erosive stable measuring unit assumption is applied. This unknowingly, unintentionally and unnecessarily erodes the real values of constant real value non–monetary items never maintained constant at a rate equal to the annual rate of inflation. Unknowingly, unintentionally and unnecessarily the wrong choice is made. Since everyone does it, since it is the traditional, generally accepted choice and since it is also authorized in the original Framework (1989), Par 104 (a) which is applicable in the absence of specific IFRS, it results in the Historical Cost Mistake.

On the other hand, the exact opposite is also generally accepted: it is acknowledged that inflation is eroding the real value of the depreciating monetary unit used as the depreciating monetary medium of exchange and depreciating monetary unit of account and some, not all, constant real value non–monetary income statement items like salaries, wages, rentals, etc. are updated or measured in units of constant purchasing power on an annual basis by increasing their nominal values at a rate at least equal to the annual rate of inflation thus keeping their non–monetary real values constant over the time period in question.

So, on the one hand it is currently acknowledged that the nominal values of some (not all) income statement items, e.g. salaries, wages, rentals, etc., have to be indexed or updated by means of the CPI because the stable measuring unit assumption cannot be applied and, on the other hand, it is assumed – at exactly the same time and during exactly the same period – that the constantly depreciating monetary unit 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, trade debtors, trade creditors, etc. as well as for the other income statement items not updated. The constant real values of all constant items never maintained constant during HCA are thus unknowingly, unintentionally and unnecessarily eroded at a rate equal to the annual rate of inflation amounting of hundreds of billions of US Dollars in the world´s constant item economy, year in year out, decade after decade when the stable measuring unit assumption is implemented during inflation.

Companies listed on stock exchanges comply with IFRS. If a country should enter into hyperinflation they would implement IAS 29. They would then apply the CPPA inflation accounting model and restate all income statement items plus balance sheet constant real value non–monetary items as well as all variable real value non-monetary items (only required during hyperinflation) in their period-end HC or CC financial statements by means of the period-end CPI in an attempt to maintain these items´ real values during hyperinflation. They would restate, for example, issued share capital and retained earnings for all listed companies and banks from the dates these items were originally contributed or came about and attempt to maintain their existing constant real non–monetary values constant, but, only for as long as the economy is in hyperinflation.

When the economy is not in hyperinflation any more they would stop implementing IAS 29 and generally go back to the real value eroding HC model (as Brazil did in 1994 and Turkey did in 2005) and again erode the existing constant real non-monetary values of all constant real value non–monetary items never maintained constant (e.g. the portion of shareholders´ equity not maintained constant with sufficient revaluable fixed assets under HCA) at a rate equal to the annual rate of inflation when they again implement the stable measuring unit assumption during low inflation. When they choose CIPPA it automatically maintains the constant real value of all constant items constant forever in all entities that at least break even during inflation and deflation – ceteris paribus.

Auditors would certify – when applicable – that a company´s financial statements fairly present the financial position of the company and comply with IFRS when boards of directors choose to implement CIPPA, i.e. when they choose to continuously measure financial capital maintenance in units of constant purchasing power during low inflation and deflation as authorized in the original Framework (1989), Par 104 (a).

Nicolaas Smith

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

Salaries and wages maintained constant during low inflation

Salaries and wages maintained constant during low inflation

The annual indexation or measurement in units of constant purchasing power of salaries and wages in a low inflationary environment is a blessing to users since it enables them to maintain the real values of salaries and wages constant during inflation. This often involves labour union negotiations with employer bodies. They usually agree on an annual increase in the depreciating monetary unit payment values for constant real value non–monetary salaries and wages to maintain their purchasing power constant on an annual basis in a low inflationary economy where the real value of the monetary unit of account is continuously being eroded by inflation. The nominal values of constant real value non–monetary salaries and wages are thus updated or indexed in terms of the annual CPI to cover or compensate for at least the expected annual rate of erosion in the real value of the depreciating monetary unit which is the depreciating monetary unit of account for accounting purposes as well as the depreciating monetary medium of exchange for payment purposes in the economy during low inflation. The period is normally for the year ahead. They often agree on an additional percentage increase for increases in productivity and / or for social security 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 erosive stable measuring unit assumption whereby it is simply assumed that changes in the purchasing power of depreciating money are not sufficiently important to require measurement in units of constant purchasing power during inflation. Workers would not receive the constant purchasing power values of their salaries and wages when fixed HC salaries and wages are paid in depreciated monetary units whose real values are continuously being eroded by inflation. They would not receive the full constant real non–monetary values of their salaries and wages.

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

Inflation can only erode the real value of the depreciating monetary medium of exchange (depreciating money, i.e. the depreciating monetary unit inside an inflationary economy) and other depreciating 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 erode the real value of money and other monetary items – nothing else. Inflation has no effect on the real value of non-monetary items. The very erosive stable measuring unit assumption implemented as part of the traditional HCA model when salaries and wages are fixed over time, unknowingly, unintentionally and unnecessarily erodes the real value of salaries and wages when they are not measured in units of constant purchasing power in terms of the monthly CPI during low inflation.

Inflation cannot erode the real value of non–monetary items. Inflation can only erode the real value of the unstable monetary medium of exchange (the unstable monetary unit – unstable money) 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.

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

The erosion at a rate equal to the annual rate of inflation of all constant real value non–monetary items never maintained constant under HCA during inflation automatically stops forever the very moment the Boards of Directors of companies implement the IFRS–approved financial capital maintenance in units of constant purchasing power model (CIPPA) in all entities that at least break even during low inflation – all else being equal. The choice is theirs. The power to stop the erosion of real value in the real economy is in their hands – as authorized in IFRS since 1989 in the IASB´s original Framework (1989), Par 104 (a) which is applicable in the absence of specific IFRS. It is the choice of the accounting model (CIPPA or HCA) and not inflation that automatically maintains or generally erodes the existing constant real non–monetary value of constant real value non–monetary items never maintained constant in low inflationary economies.

The constant real non–monetary values of salaries and wages expressed in terms of the depreciating unstable monetary unit as the depreciating unstable monetary unit of account are presently being maintained constant on an annual basis in the first month of payment in low inflationary economies when their nominal monetary values are indexed or updated by means of the CPI in low inflationary environments. This happens not because of a lowering of inflation, but because of employers and trade unions valuing salaries and wages in units of constant purchasing power on an annual basis instead of the Historical Cost measurement basis for this particular purpose. Salaries and wages are then normally kept fixed for the 12 month period of the accounting year; i.e. they are not updated or measured in units of constant purchasing power on a monthly basis. The stable measuring unit assumption is generally applied with monthly payments after the annual update.

If the parties to the salary and wage determination process were to agree to value salaries and wages annually at fixed Historical Cost (in nominal monetary units) – like Iceland recently decided to freeze salaries because of their financial crisis –  then their annual constant real non–monetary values are eroded at a rate equal to the annual rate of inflation because constant real value non–monetary salaries and wages are expressed in term of the depreciating monetary unit of account and are normally paid in depreciating monetary units. Salaries and wages are not depreciating monetary items. They are constant real value non–monetary items on an annual and on a monthly basis. They are, however, - after the annual update - normally paid monthly in depreciating money during low 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 continuously updated by applying the monthly change in the annual CPI during low inflation and deflation. The real values of salaries and wages would thus not be eroded by inflation if they were valued in nominal monetary units (fixed salaries and wages), but by the choice of the measurement basis, namely, Historical Cost, i.e. in nominal monetary units, which means the implementation of the very erosive stable measuring unit assumption whereby it is considered that the continuous erosion of the purchasing power of the monetary unit is not sufficiently important during low inflation in order to require the indexation or measurement in units of constant purchasing power of the existing constant real values of constant real value non–monetary salaries and wages by means of the monthly CPI in order to maintain their existing constant real non–monetary values constant. What is done, in essence, is it is assumed that the constantly depreciating monetary unit of account – the depreciating monetary unit – is perfectly stable when the stable measuring unit assumption is applied. It is assumed, in principle, that the depreciating monetary unit is perfectly stable whenever the stable measuring is implemented.

Nicolaas Smith.

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

CIPPA is not inflation accounting

CIPPA is not inflation accounting


This project is not about inflation accounting during high and hyperinflationary periods.

This project is not about implementing 1970–style inflation accounting in low inflationary economies by inflation–adjusting all non–monetary items equally by means of the CPI.

The following peer reviewed article Financial Statements, Inflation & The Audit Report I wrote was published in SAICA´s journal– Accountancy SA – in September 2007.

“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.” ¹


The International Accounting Standards Board (IASB) only recognizes two economic items:


1.) Monetary items defined as “money held and items to be received or paid in money;” and


2.) Non–monetary items: All items that are not 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.


They also include Historical Cost items based on 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.” ²


This makes these Historical Cost items equal to monetary items in the case of companies´ Retained Income balances and the issued share capital values of companies with no well located and well maintained land and/or buildings or other variable real value non–monetary items able to be revalued at least equal to the original real value of each contribution of issued share capital.


Retained Income is a constant real value non–monetary item valued at Historical Cost which makes it subject to the destruction of its real value by inflation – exactly the same as in cash.


It is an undeniable fact that South Africa’s monetary unit’s internal real value is constantly being destroyed by 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.


The combination of the Historical Cost Accounting model and low inflation is thus indirectly responsible for the destruction of the real value of Retained Income equal to the annual average value of Retained Income times the average annual rate of inflation. This value is easy to calculate in the case of each and every company in South Africa with Retained Income. It is also possible to calculate this value for all companies in the world economy with Retained Income.


It is broadly known that the destruction of the internal real value of the monetary unit of account is a very important matter and that inflation thus destroys the real value of all variable real value non–monetary items when they are not valued at fair value, market value, present value, net realizable value or recoverable value.


But, everybody suddenly agrees, in the same breath, that for the purpose of valuing Retained Income – a constant real value non–monetary item – the change in the real value of money is not regarded as important to update the value of Retained Income in the financial statements. Everybody suddenly then agrees to destroy hundreds of billions of Dollars in real value in all companies´ Retained Income balances all around the world.


Yes, inflation is very important!


All central banks and thousands of economists and commentators spend huge amounts of time on the matter. Thousands of books are available on the matter. Financial newspapers and economics journals dedicate thousands of columns to the fight against inflation.


But, when it comes to constant real value non–monetary items, it doesn’t seem as if inflation is important. We happily destroy hundreds of billions of Dollars in Retained Income real value year in year out.


However, when you are operating in an economy with hyperinflation (perhaps only Zimbabwe at the moment with 3 713% inflation), then we all agree that you have to update everything in terms of International Accounting Standard IAS 29 Financial Reporting in Hyperinflationary Economies. You have to update variable AND constant real value non–monetary items.


But, ONLY as long as your annual inflation rate has been 26% for three years in a row adding up to 100% – the rate required for the implementation of IAS 29.


Once you are not in hyperinflation anymore, for example, 15% annual inflation for as many years as you want, then you are not allowed to update constant real value non–monetary items any more. Then you must destroy their real value again – at 15% per annum. Or 7.0% per annum in the case of South Africa (April 2007).


For example:


Shareholder value permanently  destroyed by the implementation of the Historical Cost Accounting model in Exxon Mobil's Retained Income during 2005 exceeded $4.7bn for the first time. This compares to the $4.5bn shareholder real value permanently destroyed in 2004 in this manner. (Dec 2005 values).


The application by BP, the global energy and petrochemical company, of the stable measuring unit assumption in the accounting of their Retained Income resulted in the destruction of at least $1.3bn of shareholder value during 2005. (Dec 2005 values).


Royal Dutch Shell Plc, a global group of energy and petrochemical companies, permanently destroyed $2.974 billion of shareholder value during 2005 as a result of the application of the stable measuring unit assumption in the accounting of their Retained Income. (Dec 2005 values).


Should this value be reflected in the financial statements?


Maybe it should.


Nicolaas Smith”


Footnotes

¹ International Accounting Standards Committee, (1995), International Accounting Standard 1995, London, IASC, Page 502


² Paul H. Walgenbach, Norman E. Dittrich and Ernest I. Hanson, (1973), Financial Accounting, New York: Harcourt Brace Javonovich, Inc. Page 429.

http://www.accountancysa.org.za/resources/ShowItemArticle.asp?ArticleId=1235&issue=857

This article was first published in Accountancy SA (September 2007, pg 38). Accountancy SA is published by the South African Institute of Chartered Accountants. www.accountancysa.org.za

The understanding of the global, economy–wide erosion of banks´ and companies´ capital and profits (equity) during low inflation caused by the implementation of the stable measuring unit assumption is an ongoing process. In 2007 I, like almost everyone else, still believed that inflation eroded the real value of non–monetary items. Since then I have realized that I made a mistake by believing what everyone else believes and state with regard to the erosive effect of inflation on the real value of non–monetary items. I realized since then that inflation is in fact always and everywhere only a monetary phenomenon, as the late Milton Friedman so eloquently stated. I realized since then that inflation can only erode the real value of money and other monetary items – nothing else. I realized since then that inflation has, in fact, no effect on the real value of non–monetary items as so correctly stated by Prof Dr. Ümit GUCENME and Dr. Aylin Poroy ARSOY from Uludag University, Bursa, Turkey:

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

The theme of this project is thus not inflation–accounting. Inflation accounting is an accounting model to be applied only during very high and hyperinflation. Inflation accounting is specifically defined in IAS 29 Financial Reporting in Hyperinflationary Economies and required by IFRS only during hyperinflation.

The theme of this project is financial capital maintenance in units of constant purchasing power accounting during low inflation and deflation (as implemented via the Constant Item Purchasing Power Accounting model) as authorized in IFRS in the original Framework (1989), Par 104 (a). Stated differently: the theme of this project is the rejection of the stable measuring unit assumption, i.e. the rejection of the generally accepted, globally implemented, traditional Historical Cost Accounting model, during low inflation and deflation . HCA is also authorized in IFRS in the exact same original Framework (1989), Par 104 (a). The rejection of the stable measuring unit assumption is authorized in IFRS since financial capital maintenance in units of constant purchasing power during low inflation and deflation (CIPPA) is authorized in IFRS as an alternative to financial capital maintenance in nominal monetary units, i.e. the Historical Cost Accounting model under which the stable measuring unit assumption is implemented.

Non–monetary items are subdivided in variable real value non–monetary items and constant real value non–monetary items as published in the above Accountancy SA article. Only constant real value non–monetary items are updated under financial capital maintenance in units of constant purchasing power (CIPPA) to maintain their existing constant real non–monetary values constant during low inflation and deflation in order to measure financial capital maintenance in units of constant purchasing power instead of in nominal monetary units. That is what this project is about. Variable real value non–monetary items are valued in terms of IFRS or GAAP in a manner that takes into account all elements – including inflation – which determine the variable real value non–monetary 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. Constant real value non–monetary items are also valued in terms of IFRS in units of constant purchasing power when financial capital maintenance is measured in units of constant purchasing power during low inflation and deflation by implementing the CIPPA model.

This project is about the existing real values of constant real value non–monetary items – e.g., banks´ and companies´ shareholders´ equity – automatically being maintained constant forever in all entities that at least break even – ceteris paribus – during low inflation and deflation by continuously implementing the real value maintaining financial capital maintenance in units of constant purchasing power model (CIPPA) as approved in the IFRS in the original Framework (1989), Par 104 (a).

This project is about knowingly indexing or updating or measuring in units of constant purchasing power only constant real value non–monetary items by implementing the CIPPA model during low inflation and deflation as approved in IFRS in the original Framework (1989), instead of unknowingly, unintentionally and unnecessarily eroding their real values on a massive scale with the implementation of the very erosive stable measuring unit assumption as it forms part of the traditional HCA model when financial capital maintenance is measured in nominal monetary units during inflation.

This project is about knowingly choosing to measure financial capital maintenance in banks and companies in real value maintaining units of constant purchasing power during low inflation and deflation as approved in IFRS instead of in real value eroding nominal monetary units as a result of the choice to implement the very erosive stable measuring unit assumption during low inflation also authorized in IFRS in the same original Framework (1989), Par 104 (a).

This project is about rejecting the stable measuring unit assumption and instead adopting IFRS–approved real value maintaining constant purchasing power units as the measurement basis for only constant real value non–monetary items including banks´ and companies´ shareholders´ equity and not only for income statement constant real value non–monetary items, e.g. salaries, wages, rentals, etc during non–hyperinflationary conditions.

This project is about stopping the implementation of the Historical Cost Accounting model which unknowingly, unintentionally and unnecessarily erodes hundreds of billions of US Dollars per annum of existing constant real value in existing constant real value non–monetary items (bank´s and companies´ capital) in the constant item economy because the traditional HCA model is chosen when the very erosive stable measuring unit assumption is implemented during inflation instead of the IFRS–approved real value maintaining CIPPA model.

The Historical Cost Mistake is the implementation of the very erosive stable measuring unit assumption as part of the traditional HCA model during inflation.

This project is about knowingly, automatically maintaining hundreds of billions of US Dollars per annum of existing constant real non–monetary value in the real economy for an unlimited period of time in all entities that at least break even complying with IFRS instead of unknowingly, unintentionally and unnecessarily eroding that value year in year out as is unknowingly being done at the moment with the implementation of the stable measuring unit assumption during inflation.

This project is about abandoning the very erosive traditional HCA model and adopting the real value maintaining CIPPA model in low inflationary and deflationary economies as authorized in IFRS in the original Framework (1989), Par 104 (a).


Nicolaas Smith

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