Historical Cost Accounting should be banned during hyperinflation

Historical Cost Accounting should be banned during hyperinflation

Valuation in units of constant purchasing power is required for all non-monetary items (variable and constant real value non-monetary items) in IFRS during hyperinflation as per the Constant Purchasing Power Accounting (CPPA) inflation accounting model defined in IAS 29 Financial Reporting in Hyperinflationary Economies. The only way a hyperinflationary country can maintain its non-monetary or real economy relatively stable (at a rate of real value erosion by the stable measuring unit assumption in constant real value non-monetary items never maintained constant limited to a rate equal to the annual rate of inflation of the hard currency used for determining the parallel rate – normally the US Dollar) during hyperinflation is by continuously measuring all non-monetary items (variable and constant real value non-monetary items) in units of constant purchasing power.  However, not by restating HC and Current Cost financial statements at the end of the reporting period in terms of the period-end CPI to make them more useful as required by IAS 29, but, by applying the daily parallel US Dollar exchange rate,  or -  as was done in Brazil during the 30 years from 1964 to 1994 - with daily indexation which is, in principle, the better than measurement in units of constant purchasing power by applying the daily US Dollar parallel rate since Brazilian-style indexation, theoretically, keeps the constant item economy perfectly stable: the erosion of the real value of constant items never maintained caused by the stable measuring unit assumption as applied to the US Dollar is eliminated in the formulation of the index value.

Zimbabwe

The implementation of IAS 29 Financial Reporting in Hyperinflationary Economies by Zimbabwean listed companies as required by the Zimbabwean Stock Exchange made no difference to the Zimbabwean economy during the final stages of the hyperinflationary erosion of the real value of the monetary unit in Zimbabwe, i.e. the Zimbabwe Dollar. The IASB has agreed that it was not possible to implement IAS 29 during severe hyperinflation at the end of the hyperinflationary period in Zimbabwe since there was no CPI available. The daily Old Mutual Implied Rate (OMIR) was, however, available till 20^th November, 2008, the day Gideon Gono, the governor of the Reserve Bank of Zimbabwe issued regulations that closed down the Zimbabwe Stock Exchange and effectively led to the end of the Zimbabwe Dollar.

         Severe hyperinflation is only possible when there is exchangeability with at least one relatively stable foreign currency. The one exchange rate that lasted till the end of hyperinflation in Zimbabwe was the Old Mutual Implied Rate (OMIR).

“The ratio of the Old Mutual share price in Harare to that in London equals the

Zimbabwe dollar/sterling exchange rate." P 8  ¹

Severe hyperinflation stops the moment exchangeability between the currency and all foreign currencies does not exist.

“Zimbabwe’s hyperinflation came to an abrupt halt. The trigger was an intervention by the Reserve Bank of Zimbabwe. On November 20, 2008, the Reserve Bank’s governor, Dr. Gideon Gono, stated that the entire economy was “being priced via the Old Mutual rate whose share price movements had no relationship with economic fundamentals, let alone actual corporate performance of Old Mutual itself” (Gono 2008: 7–8). In consequence, the Reserve Bank issued regulations that forced the Zimbabwe Stock Exchange to shut down. This event rapidly cascaded into a termination of all forms of non-cash foreign exchange trading and an accelerated death spiral for the Zimbabwe dollar. Within weeks the entire economy spontaneously “dollarized” and prices stabilized.” P 9-10 ²

¹,² Hanke, S. H. and Kwok, A. K. F., On the Measurement of Zimbabwe’s Hyperinflation,

Cato Journal, Vol. 29, No. 2 (Spring/Summer 2009), pp. 353-64 Available at

http://www.cato.org/pubs/journal/cj29n2/cj29n2-8.pdf

There was severe hyperinflation in Zimbabwe while there was exchangeability with at least one relatively stable foreign currency – the British Pound in this case as made possible via the OMIR. When this last exchangeability stopped it was not possible to set prices in the ZimDollar any more and hyperinflation stopped: no exchangeability means no hyperinflation.

Valuing all non-monetary items as required by the IAS 29 CPPA inflation accounting model in terms of the period-end Consumer Price Index which was published a month or more after the month to which it related when the real value of the Zimbabwe Dollar halved every day, obviously, had no effect at all.

“The Zimbabwe government last published an official Zimbabwe dollar inflation index in July 2008. This, combined with the complexities of not having a stable currency due to the phenomenon described above, meant that there were severe limitations to accurate financial reporting in the period from August 2008 to when the Zimbabwe dollar was abandoned in early 2009. During this period the Institute of Chartered Accountants in Zimbabwe set up a technical subcommittee to address these challenges, as it was impossible to apply IAS 29 “Financial Reporting in Hyperinflationary Economies” without a general price index, or IAS 21 “Exchange Rates” without a single spot rate.”  Inflation Gone Wild, Gordon Whiley, Accountancy SA, March 2010.

http://www.accountancysa.org.za/resources/ShowItemArticle.asp?ArticleId=1885&Issue=4.640

The stable measuring unit assumption as it forms part of the Historical Cost Accounting model - as accepted by the IASB and PricewaterhouseCoopers (amongst others) as an appropriate accounting model to be restated during hyperinflation - unnecessarily, unknowingly and unintentionally eroded Zimbabwe´s real economy by implementing HCA during the financial year, as required by the IASB in IAS 29, and then restated their year-end HC financial statements of their very much hyper-eroded companies in terms of the year-end CPI (while the CPI was made available in Zimbabwe) to make them more useful for comparison purposes. That did not stop them from unknowingly eroding their real or non-monetary economy with HCA - as supported by the IASB and PricewaterhouseCoopers - during the course of the financial year during hyperinflation.

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

"Inflation-adjusted financial statements are an extension to, not a departure from, historic cost accounting."

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

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

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

Nicolaas Smith

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

Valuing the three basic economic items - Part 2

Valuing the three basic economic items - Part 2

Monetary items

(1) Accountants value and account monetary items at their original historical cost nominal values in nominal monetary units during the current accounting period under all accounting models and under all economic models: during low inflation, hyperinflation and deflation. Low inflation, deflation and hyperinflation determine the always current real value of the monetary unit (US Dollar, Euro, British Pound, Bolívar, Yen, Yuan, etc.) and other monetary items within a monetary economy or monetary union like the European Monetary Union. This is the result of the fact that the real value of money and other monetary items cannot be updated or inflation-adjusted or valued in units of constant purchasing power during the current accounting period because of the monetary nature of money. The real value of the monetary unit and other monetary items in the monetary economy changes equally (all monetary units are affected evenly) normally on a monthly basis during low inflation and deflation. The change is confirmed or quantified with the monthly publication of the new CPI value. Currently, the applicable CPI value can become available up to a month and a half after the date of a transaction in many low inflationary economies. The daily black market or parallel US Dollar exchange rate or street rate is generally constantly (24/7, 365 days a year) available in a hyperinflationary economy. The CPI is the internal exchange rate between the real value of a unit of the monetary unit and real value in an economy. The daily parallel US Dollar (or other hard currency) exchange rate or a Brazilian-style daily index rate fulfils this role in a hyperinflationary economy. 

Variable items 

(2) Variable real value non-monetary items in a national economy are valued and accounted in terms of IFRS or GAAP at, for example, fair value, market value, net realizable value, recoverable value, present value, etc. These prices change all the time: even minute by minute in many markets.  

Constant real value non-monetary items 

(3) The real values of constant real value non-monetary items in the constant real value non-monetary item economy have to be continuously maintained constant under Constant Item Purchasing Power Accounting during low inflation and deflation by means of continuous financial capital maintenance in units of constant purchasing power, i.e. valuing / measuring them in units of constant purchasing power monthly during low inflation and deflation by means of the CPI as originally authorized in IFRS in the Framework (1989), Par 104 (a). Annual measurement in units of constant purchasing power is only currently being done under the Historical Cost Accounting model, generally in the case of certain (not all) income statement items, e.g., salaries, wages, rentals, etc. in non-hyperinflationary economies.  

Harvey Kapnick was correct when he stated in the Saxe Lecture in 1976: “In the long run both value accounting and price-level accounting should prevail.”

Nicolaas Smith

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

Valuing the three basic economic items

Valuing the three basic economic items

 Economic items are made up of monetary items, variable real value non-monetary items and constant real value non-monetary items. Accountants value, record, classify, summarize and report transactions and events involving economic items in terms of depreciating functional currencies during inflation and appreciating functional currencies during deflation.

 Monetary items

 (1) The real value of the monetary unit and all other monetary items in the monetary economy generally changes every month during low inflation and deflation when the new CPI value is published. Months of zero annual inflation are rare and not sustained over a significant period of time. During hyperinflation the real value of the monetary unit and all other monetary items generally changes once per day, but, during severe hyperinflation it can change every 8 hours or so.

 Variable items

 (2) The real value of variable real value non-monetary items may change all the time, e.g. the price of foreign currencies, precious metals, quoted shares, commodities, properties, finished goods, services, raw materials, etc.

 Constant real value non-monetary items

 (3) The real values of constant real value non-monetary items stay the same (or are supposed to stay the same) all the time – all else except inflation and deflation being equal – e.g. salaries, wages, rentals, issued share capital, retained profits, shareholders equity, trade debtors, trade creditors, taxes payable, taxes receivable, etc.

Accountants have to take all three scenarios - occurring simultaneously - into account over time when they account economic activity and prepare and present financial reports.

Nicolaas Smith

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

Financial reporting does not simply report on what took place

             Financial reporting does not simply report on what took place

            There is no substance in the statement that financial reporting simply reports on what took place. It can be correctly stated that the above statement has no substance when we refer to the IFRS-approved basic accounting option of continuous financial capital maintenance in units of constant purchasing power which requires the valuing of only constant real value non-monetary items in units of constant purchasing power during low inflation and deflation as orginally authorized in the Framework (1989), Par 104 (a) which states: “Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power.”

The first option in Par 104 , namely, financial capital maintenance in nominal monetary units during inflation and deflation is a fallacy: it is impossible to maintain the real value of capital constant in nominal monetary units per se during inflation and deflation. Continuous financial capital maintenance in units of constant purchasing power during low inflation and deflation is generally applicable in the economy as a result of the absence of specific IFRS as per IAS 8, Par 11. However, that is not the same as comprehensive CPI-based adjustment of accounts themselves as accountants and accounting authorities automatically assume when financial capital maintenance in units of constant purchasing power during low inflation and deflation is suggested. Only constant real value non-monetary items (not variable real value non-monetary items) are continuously valued in units of constant purchasing power by continuously applying the CPI on a monthly basis during low inflation and deflation to implement a constant purchasing power capital concept of invested constant purchasing power and a constant purchasing power financial capital maintenance concept with measurement in units of constant purchasing power which includes a constant purchasing power profit or loss determination concept with the continuous valuation of only constant real value non-monetary items in units of constant purchasing power during low inflation and deflation.

The real values of banks´ and companies´ existing constant real value non-monetary items never maintained constant, e.g. retained profits, are unnecessarily, unknowingly and unintentionally being eroded at a rate equal to the annual rate of inflation when companies´  boards of directors choose to apply the stable measuring unit assumption as it forms part of the traditional HCA model during low inflation.

It is a fact that continuous financial capital maintenance in units of constant purchasing power (CIPPA) as originally authorized in IFRS in the Framework (1989), Par 104 (a), i.e. measurement of only constant real value non-monetary items (not variable items) in the economy in units of constant purchasing power during low inflation automatically remedies this unknowing, unintentional and unnecessary erosion by the application of the stable measuring unit assumption as it forms part of the HCA model in companies that at least break even whether they own revaluable fixed assets or not and without the requirement of extra capital from capital providers in the form of extra money or extra retained profits simply to maintain the existing constant real value of quity constant.

Nicolaas Smith

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

Accountants value everything they account

            Accountants value everything they account

            The debate concerning whether value accounting or price-level accounting should prevail is not on point, because in the long run both should prevail.

 Harvey Kapnick, Chairman, Arthur Andersen & Company, “Value Based Accounting – Evolution or Revolution”, Sax Lecture, 1976.

 Accounting is a measurement instrument.

David Mosso, Comment letter, Proposal for a Principles-based Approach to US Standard Setting, 2002, p1.

http://www.fasb.org/cs/BlobServer?blobcol=urldata&blobtable=MungoBlobs&blobkey=id&blobwhere=1175818119471&blobheader=application%2Fpdf

 Economic items have economic value. Accountants deal with economic items all the time. They deal with economic values when they account economic items and prepare financial reports. Accountants value economic items when they account economic transactions and events. Financial reporting does not simply report on what took place in the past. Accountants are not just scorekeepers of what happened in the past. Accountants value everything they account in the economy.

 The three fundamentally different basic economic items in the economy, namely variable real value non-monetary items, monetary items and constant real value non-monetary items, have economic values expressed in terms of money; i.e. the monetary unit. Accountants account economic transactions and events involving these three basic economic items in an organized manner when they implement the double entry accounting model: journal entries, general ledger accounts, trial balances, cash flow statements, income and expenses in the income statement, assets and liabilities in the balance sheet plus other financial, management and costing reports.

 Accountants value economic items when they account economic activity in the accounting records and prepare financial reports of economic entities based on the double entry accounting model. Accounting entries are valuations of the economic items (the debit items and the credit items) being accounted.

Many accountants still think that accounting is simply a recording exercise during which they merely record past economic activity. That is not correct. Accountants value economic items when they account them. Financial reporting / accounting – under CIPPA –  is, firstly, the automatic maintenance of the constant purchasing power of capital in all entities that at least break even for an indefinite period of time and, secondly, the  provision of continuously updated decision-useful financial information about the reporting entity to capital providers and other users.

 It includes the valuing, recording, classifying, summarizing and reporting of an entity’s economic activity.

Nicolaas Smith

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

Objectives of general purpose financial reporting / accounting

            The objectives of general purpose financial reporting / accounting are:

1)  Automatic maintenance of the constant purchasing power of capital in all entities that at least break even - ceteris paribus.¹ ² ³

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

            An entity has continuously maintained the constant real non-monetary value of equity (equal to net assets) if it has as much equity - expressed in units of constant purchasing power - at the end of the reporting period as it had at the beginning of the period, after excluding any distributions to, and contributions from, owners during the period. Consequently: a profit is earned only if the constant purchasing power of equity at the end of the period exceeds the constant purchasing power of equity at the beginning of the period, after excluding any distributions to, and contributions from, owners during the period.

The German economist Werner Sombart (1863-1941) wrote in "Medieval and Modern Commercial Enterprise" that "The very concept of capital is derived from this way of looking at things; one can say that capital, as a category, did not exist before double-entry bookkeeping. Capital can be defined as that amount of wealth which is used in making profits and which enters into the accounts." ^

^ Lane, Frederic C; Riemersma, Jelle, eds (1953). Enterprise and Secular Change: Readings in Economic History. R. D. Irwin. p. 38.  (quoted in "Accounting and rationality)."

The objectives of general purpose financial reporting are supposed to answer the question: what is financial reporting, i.e. accounting, supposed to do? The only accounting model possible to be used by entities implementing a capital concept is double-entry accounting: without double-entry accounting the concept of capital as an legal economic item separate from its owner or owners is not possible: for every debit/asset (e.g. cash) there is an equivalent credit/liability (e.g. capital) in double-entry accounting. The existing constant real non-monetary value of this existing capital has to be automatically maintained constant in all entities that at least break even during inflation and deflation for an indefinite period of time. This is only possible with financial capital maintenance in units of constant purchasing power.

Every concept of capital logically gives rise to its respective capital maintenance concept.

The IASB´s Conceptual Framework for Financial Reporting (2010)

The following paragraphs remain the same as originally stated in the Framework (1989).

Concepts of Capital Maintenance and the Determination of Profit

Par. 4.59. The concepts of capital in paragraph 4.57 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. *

*The Conceptual Framework (2010), Par 4.59.

The concepts of capital in the Conceptual Framework (2010), paragraph 4.57 give rise to the following three concepts of capital during low inflation and deflation:

(A) Physical capital. See Par 4.57 & 4.58

(B) Nominal financial capital. See Par 4.59 (a).

(C) Constant purchasing power financial capital. See Par 4.59 (a).

The concepts of capital in Par 4.57 give rise to the following three concepts of capital maintenance during inflation and deflation:

(1) Physical capital maintenance: optional during low inflation and deflation. Current Cost Accounting model prescribed by IFRS. See Par 4.61.

(2) Financial capital maintenance in nominal monetary units (Historical Cost Accounting): authorized in IFRS but not prescribed—optional during low inflation and deflation. See Par 4.59 (a). Financial capital maintenance in nominal monetary units per se during inflation and deflation is a fallacy: it is impossible to maintain the constant real non-monetary value of financial capital constant with measurement in nominal monetary units per se during inflation and deflation.

(3) Financial capital maintenance in units of constant purchasing power (Constant Item Purchasing Power Accounting – CIPPA – during low inflation and deflation): authorized in IFRS but not prescribed—optional during low inflation and deflation. See Par 4.59 (a). Financial capital maintenance in units of constant purchasing power is, however, prescribed in IAS 29 during hyperinflation: i.e. Constant Purchasing Power Accounting (CPPA) which is mostly unsuccessfully attempted via the restatement of Historical Cost of Current Cost financial statements during hyperinflation.

Only financial capital maintenance in units of constant purchasing power can automatically maintain the existing constant real non-monetary value of financial capital constant during low inflation, deflation and hyperinflation in all entities that at least break even—ceteris paribus—for an indefinite period of time. This would happen whether these entities own revaluable fixed assets or not and without the requirement of more capital in the form of more money or additional retained profits simply to maintain the real value of shareholders´ equity constant.

Financial capital maintenance in nominal monetary units (HCA) per se during inflation and deflation is impossible. It is a very popular accounting fallacy. It was originally authorized by the IASB in IFRS in the Framework (1989), Par 104 (a). It is based on the 3000 years old stable measuring unit assumption under which it is assumed that money is, in principle, stable in real vale. It is a Generally Accepted Accounting Practice. It is the concept of capital maintenance and one of the measurement bases used in traditional Historical Cost Accounting generally implemented worldwide. It still is an accounting fallacy that costs the world economy hundreds of billions of US Dollars per annum in existing constant real non-monetary value unknowingly, unnecessarily and unintentionally eroded by the implementation of the very erosive stable measuring unit assumption.

Financial capital maintenance in nominal monetary units during low inflation is only possible in entities that continuously invest at least 100% of the updated original real  value of all contributions to equity in revaluable fixed assets with an updated equivalent fair value (revalued or not)  .

Only CIPPA automatically maintains the real value of all constant real value non-monetary items constant in all entities that at least break even, including banks´ and companies´ capital base, for an unlimited period of time (forever) - all else being equal - whether these entities own revaluable fixed assets or not and without the requirement of additional capital from capital providers in the form of extra money or extra retained profits simply to maintain the real value of equity. This is opposed to the traditional HCA model under which the stable measuring unit assumption unknowingly, unnecessarily and unintentionally erodes the real value of that portion of shareholders´ equity never maintained constant as a result of insufficient revaluable fixed assets (revalued or not) during low inflation.

Continuous financial capital maintenance in units of constant purchasing power (CIPPA) automatically maintains the constant purchasing power of all constant items constant for an indefinite period of time in all entities that at least break even by continuously applying the monthly change in the annual CPI to the valuation of only constant items during low inflation and deflation. The daily parallel US Dollar (or other hard currency) exchange rate is continuously applied in the valuation of all non-monetary items (variable and constant items) during hyperinflation (CPPA) which only results in automatically maintaining the real or non-monetary economy relatively – not absolutely – stable. The constant item economy in a hyperinflationary economy is still subject to real value erosion at a rate equal to the annual inflation rate applicable to the hard currency (normally the US Dollar) used in supplying the parallel rate. The real economy would theoretically be completely stable during hyperinflation when a Brazilian-style daily index (which allows for the elimination of the stable measuring unit assumption in the parallel hard currency rate too) is used in the valuing of all non-monetary items (variable and constant items) during hyperinflation.
      

            Variable items are continuously valued in terms of IFRS excluding the stable measuring unit assumption during low inflation and deflation under CIPPA. Variable items are continuously valued in units of constant purchasing power (CPPA) by applying the daily parallel US Dollar (or other hard currency) exchange rate or a Brazilian-style daily index rate when it is intended to keep the real economy stable during hyperinflation.

Monetary items are money held and items with an underlying monetary nature valued in nominal monetary units during the current reporting period. The net monetary loss or gain from holding monetary items is calculated and accounted in the income statement under both CIPPA and CPPA, i.e. during low inflation, deflation and hyperinflation in terms of IFRS.

¹ “It is the overall objective of reporting for price changes to ensure the maintenance of the business as an entity.”

Accounting for Price Changes: An Analysis of Current Developments in Germany, Adolf G Coenenberg and Klaus Macharzina, Journal of Business Finance & Accounting, 3.1 (1976), P 53.

² Framework (1989), Par 104 (a): "Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power.”

³ It is essential to the credibility of financial reporting to recognize that the recovery of the real cost of investment is not earnings — that there can be no earnings unless and until the purchasing power of capital is maintained.

FAS 33 (1979), p 24

Nicolaas Smith

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

Brazilian indexation compared to accounting dollarization

Brazil indexed all non-monetary items (variable and constant items) during the 30 years from 1964 to 1994 by means of a daily non-monetary index supplied by the various governments over that period for everybody in the economy to use daily. Although the Brazilian indexes used during those 30 years were almost entirely based on the daily US Dollar exchange rate with the Brazilian currency, it was not a parallel rate used parallel to another “official” US Dollar exchange rate arbitrarily set by the government as happens in most cases where a parallel market for the US Dollar develops in hyperinflationary economies. However, the daily index supplied by the government was not the actual daily US Dollar exchange rate. Thus, although the Brazilian indexation was financial capital maintenance in units of constant purchasing power during those 30 years, and very similar to accounting dollarization, it was not exactly the same. It was better than accounting dollarization.
 

Brazilian indexation theoretically maintained the constant real value non-monetary item economy perfectly stable whereas there is still real value erosion in the constant real value non-monetary item economy as a result of the stable measuring unit assumption at a rate equal to the inflation rate in the US Dollar when accounting dollarization is employed. Brazilian-style indexation is thus better than accounting dollarization since real value erosion because of the use of the stable measuring unit assumption is completely eliminated with financial capital maintenance in units of constant purchasing power in terms of the daily index rate.

Nicolaas Smith

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

Accounting dollarization

Accounting dollarization is not the same as normal dollarization of an economy. An economy is dollarized when the national monetary unit is physically substituted with a relative stable foreign currency, normally the US Dollar. That is how the phrase “dollarization” originated. The national currency is not used anymore. There is no national currency in use in the economy. Its legal tender is legally terminated. Dollarization is generally adopted after a period of severe hyperinflation, e.g. in Zimbabwe in 2008.

Accounting dollarization as opposed to functional currency dollarization is doing all your daily business operations and accounting in US Dollars or in a any other relatively stable foreign currency during hyperinflation in your national monetary unit in an economy that does not use the US Dollar as a functional currency. It most probably never means that you do all your actual business transaction in US Dollars. You normally do some business in US Dollars and some in the local hyperinflationary currency. You may even do no business in actual US Dollars.

You simply note down the daily – normally unofficial - parallel US Dollar rate and use it in all your daily accounting and business operations. The existence of a parallel rate is essential for the application of accounting dollarization. When there is only one official US Dollar rate and no parallel rate the economy will normally not be in hyperinflation and accounting dollarization will not be required. Sometimes the US Dollar parallel rate changes more than the normal once per day. It can change every 8 hours, for example, during severe hyperinflation.

Accounting dollarization is the same as Constant Purchasing Power Accounting as defined in IAS 29 which requires financial capital maintenance in units of constant purchasing power during hyperinflation under which all non-monetary items (variable and constant items) are measured in units of constant purchasing power, but, not applying the period-end CPI, as required in IAS 29, but the daily US Dollar parallel rate.

I implemented it for the first time in Auto-Sueco (Angola), the Volvo agents in Angola, starting in January, 1996. Auto-Sueco (Angola) is the subsidiary of Auto-Sueco in Portugal.

 Accounting dollarization is also not the same as the US GAAP requirement that US companies with subsidiaries in hyperinflationary economies simply translate the year-end HCA financial statements prepared in the hyperinflationary local currency into US Dollars at the year-end rate before consolidation into the controlling US company´s consolidated accounts. Accounting dollarization is running any local business in a hyperinflationary economy in US Dollars on a daily basis applying the daily parallel rate in all accounting and business operations. This eliminates the hyper-eroding effect of the stable measuring unit assumption only as far as the local hyperinflationary currency is concerned as implemented under HCA on the existing real value of all non-monetary items (variable and constant real value non-monetary items) in a hyperinflationary economy.

    Accounting dollarization is a price-level accounting model applying financial capital maintenance in units of constant purchasing power as originally authorized in IFRS in the Framework (1989), Par 104 (a).

Nicolaas Smith

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

Capital is a variable or monetary item in the economy

Capital is a constant real value non-monetary item.

However, there is currently no constant real value capital in the world economy under HCA during low inflation and deflation. The portion of the original real value of all contributions to Shareholders´ Equity in companies covered by revaluable fixed assets is, in fact, treated as a variable real value non-monetary item under HCA during low inflation. This existing constant real non-monetary value is not maintained constant under the HCA model during low inflation and deflation. Its real value depends on the variable real non-monetary value of the fixed assets determined at fair value from time to time in terms of IFRS and US GAAP during low inflation since equity is equal to net assets under HCA with financial capital maintenance measured in nominal monetary units.

The portion of the original real value of all contributions to Shareholders´ Equity not covered by revaluable fixed assets is unknowingly, unnecessarily and unintentionally  being eroded by the stable measuring unit assumption (mistakenly believed to be inflation) at a rate equal to the annual rate of inflation as part of financial capital maintenance in nominal monetary units when the traditional HCA model is implemented during low inflation. This unknowing erosion by the stable measuring unit assumption amounts to about R200 billion in the SA constant real value non-monetary item economy and hundreds of billions of US Dollars in the world´s constant item economy each and every year.

When companies have no revaluable fixed assets at all under HCA, Capital is, in principle, treated the same as a monetary item (money or cash) and the stable measuring unit assumption erodes its real value at a rate equal to the annual rate of inflation in low inflationary economies.

Capital  will only – for the first time ever during low inflation and deflation - correctly be treated as a constant item and its existing constant value maintained constant in entities that at least break even for an unlimited period of time – ceteris paribus - when financial capital maintenance in units of constant purchasing power as authorized in IFRS in the Conceptual Framework (2010), Par 4.59 (a) is freely chosen by entities. There is no other way during low inflation and deflation.

Financial capital maintenance in units of constant purchasing power during low inflation and deflation was originally authorized in the IASB´s Framework for the Preparation and Presentation of Financial Statements in 1989.

Nicolaas Smith

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

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 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 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 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 over time; conversely, annual 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 (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 for an indefinite period of time 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 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.

Constant Item Purchasing Power Accounting - Abstract - Part 5 of 5

The cost of the stable measuring unit assumption

It is clearly known and admitted that there is real value being eroded 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. It is just not realized that the stable measuring unit assumption - not inflation - is doing the eroding during inflation.

Everybody knows the actual cost of inflation – the net monetary loss from holding a net monetary balance of monetary item assets during the accounting period – is not calculated and accounted under HCA during low inflation and deflation. It is thought that it is the central bank´s task to reduce inflation which reduces the cost of inflation and “the erosion of business profits and invested capital caused by inflation”.

First of all, the erosion of business profits and invested capital is not caused by inflation but by the stable measuring unit assumption 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 during inflation. 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 being eroded unnecessarily by the stable measuring unit assumption during inflation.

On the other hand, continuous financial capital maintenance in units of constant purchasing power during low inflation and deflation (CIPPA) will automatically eliminate the entire cost of the stable measuring unit assumption forever at any level of inflation in all entities that at least break even 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 – in all entities that at least break even.

The cost of the stable measuring unit assumption is considered to be the same as the cost of inflation which is not calculated and accounted under HCA during low inflation. Everybody is consequently satisfied that a generally accepted accounting practice of not accounting the net monetary loss or gain from inflation during low inflation is correctly followed when “the erosion of business profits and invested capital caused by inflation” is referred to, which is in fact, not the cost of inflation, but, the cost of the very erosive stable measuring unit assumption. The erosion of the existing constant real value of companies´ profits and capital (the erosion of the existing constant real value of constant items never maintained constant under HCA) is not seen as separate from the erosion of the real value of money and other monetary items actually caused by inflation. The net monetary loss from holding a net balance of monetary item assets and the “erosion of business profits and invested capital caused by inflation” are seen as both being the same thing – both caused by inflation and not required to be calculated and accounted. That is a fundamental mistake.

Consequently, no-one looks for a solution in IFRS: 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 (CIPPA) has until now been ignored mainly because the split in non-monetary items in variable and constant items has only been identified in 2005.

Not only one, but, two enemies in the economy

The one very well known; the other a stealth enemy camouflaged by general acceptance in US GAAP and authorization in IFRS. The one – inflation - seen as an enemy in most instances; the other – the 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 erosive stealth enemy perfectly camouflaged by US GAAP and IFRS authorization during low inflation and IFRS acceptance during hyperinflation as supported by Big Four accounting firms like PricewaterhouseCoopers which states: “Inflation adjusted financial statements are an extension to and not a departure from historic cost accounting.”  Understanding IAS 29

In most companies annual erosion 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 eroded 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 - CIPPA), 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 erosion 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 when it is in fact caused by the stable measuring unit assumption: stop the stable measuring unit assumption and there is no erosion of real value in constant items in all entities that at least break even.

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 eroded by the stable measuring unit assumption over time at a rate equal to the annual rate of inflation.

Nicolaas Smith 

Copyright © 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Constant Item Purchasing Power Accounting - Abstract - Part 4 of 5

Both HC variable and HC constant items are considered to be simply HC non-monetary items under HCA.


Non-monetary items under the HCA model include HC items based on the stable measuring unit assumption. Both variable real value non-monetary items (e.g. inventory and fixed property) valued at HC in terms of IFRS and US GAAP, as well as constant real value non-monetary items (e.g. shareholders´ equity items) also valued at HC in terms of IFRS and US GAAP, are valued in nominal monetary units applying the very erosive stable measuring unit assumption during non-hyperinflationary periods. Both HC variable and HC constant items are thus considered to be simply HC non-monetary items. There is no split under HCA.

The very erosive stable measuring unit assumption means it is simply assumed under the HCA model that changes in the real value or purchasing power of money are not sufficiently important to continuously measure financial capital maintenance in units of constant purchasing power in low inflationary and deflationary economies for the purpose of valuing most constant items which are valued as HC items.

It is a generally accepted accounting practice not to apply the stable measuring unit assumption to the valuing of only certain income statement constant items, namely salaries, wages, rentals, etc. which are generally inflation-adjust annually. All other income statement items (all income statement items are constant items) and all balance sheet constant items are valued in nominal monetary units when the stable measuring unit assumption is applied during low inflation and deflation.

It is impossible to maintain the real value of financial capital constant with financial capital maintenance in nominal monetary units per se applying the very erosive stable measuring unit assumption during inflation and deflation. The monetary measuring unit (money) is not perfectly stable during inflation and deflation. Inflation erodes the real value of only money and other monetary items while deflation creates more real value in only 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 and US GAAP is a popular accounting fallacy. IFRS and US GAAP 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.” Framework (1989)

Shareholders´ equity’s constant real value can only be maintained constant (excluding continuous additions of fresh capital) with financial capital maintenance in nominal monetary units during inflation when at least 100% of the updated original real value of all contributions to shareholders´ equity are invested in revaluable fixed assets with an equivalent updated fair value – revalued or not. This is generally the case only in, for example, hotel, hospital and property groups. Valuing a revaluable fixed asset at HC does not erode 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 / exchanged.

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 being treated the same as a monetary item (e.g. cash). Its real value is eroded at a rate equal to the annual rate of inflation because it is freely chosen in terms of US GAAP and the Framework, Par 104 (a) to implement financial capital maintenance in nominal monetary units and apply the very erosive stable measuring unit assumption during low inflation.

The stable measuring unit assumption

The stable measuring unit assumption is based on the fallacy that changes in the purchasing power of money are not sufficiently important to require the continuous measurement of financial capital maintenance in units of constant purchasing power during low inflation and deflation. 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 erosion 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, e.g. in all companies with no revalueable fixed assets) is currently considered as not sufficiently important for the implementation of continuous financial capital maintenance in units of constant purchasing power (CIPPA). The stable measuring unit assumption currently erodes 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 traditional HCA as authorized in US GAAP and IFRS. CIPPA automatically stops this forever in all entities that break even during inflation whether they own any revaluable fixed assets or not.

Nicolaas Smith

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

Constant Item Purchasing Power Accounting - Abstract - Part 3 of 5

Three concepts of capital maintenance in IFRS

There are not only two concepts of capital - as generally accepted and specifically stated in IFRS - authorized in IFRS, namely, physical and financial capital.

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

• (1) Physical capital. See the Framework (1989), 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. See 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. See Par 104 (a) and 108. Only constant real value non-monetary items (not variable items) are continuously measured/valued in units of constant purchasing power by applying the monthly change in the annual CPI during low inflation and deflation (CIPPA). Variable items are measured in terms of specific IFRS or US GAAP during low inflation and deflation. Monetary items are and can only be measured in nominal monetary units. The net monetary loss or gain from holding net monetary item assets or net monetary item liabilities is calculated and accounted in the income statement during low inflation and deflation. The stable measuring unit assumption is rejected under this concept.

Accounting cannot and does not create real value out of nothing.

CIPPA is the only accounting model that automatically maintains the real value of all existing constant items constant forever 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 in the form of extra money or extra retained profits simply to maintain the existing constant real value of existing shareholders´ equity constant during low inflation and deflation.

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 HC or Current Cost financial statements by applying the period-end CPI during hyperinflation in order to make these statements more meaningful. This book is not about CPPA inflation accounting during hyperinflation as required in IAS 29 or any other inflation accounting model. CIPPA is not an inflation accounting model. Inflation accounting is used during hyperinflation. CIPPA is used during low inflation and deflation.

The difference between CIPPA and CPPA:

CPPA

In terms of IAS 29 CPPA is required only during hyperinflation: All non-monetary items are measured in units of constant purchasing power.

CIPPA

In terms of the Framework (1989), Par 104 (a) CIPPA is optional during low inflation and deflation: only constant items are measured in units of constant purchasing power. Variable items are measured in terms of US GAAP or IFRS.

Nicolaas Smith

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