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 real value day by day and even hour by hour. In low inflationary economies people are vaguely aware that money loses real 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. For example: ‘Marble Arch was built for 10 000 Pounds’ a TV reporter may state 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 may have been the original cost in historical terms but we live today and absolutely no–one can immediately imagine what the construction cost of Marble Arch is in current terms. It is the same as saying that something cost one Pound 300 years ago. It is impossible to immediately value it now. We live now and not 300 years in the past. We do not 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 real value changes day by day within the UK economy as indicated by the change in the UK Daily CPI.

Companies report an unending stream of information about their performance and results. Sales increased by eight per cent over last year’s figures, for example. These are normally nominal rates. A person has to remember the inflation rate for last year and mentally adjust the reported figures to real rates to understand what the real rate of increase or decrease was.

Money illusion is 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 inflation on the British Pound over the years in question.

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 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. Two per cent annual inflation is not price stability. Two per cent annual inflation is a high degree of price stability. It is some countries´ definition of 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.

In a hyperinflationary economy notes become worthless very quickly. I saw 100 Kwanza notes lying in the street in 1996. The street boys would not even pick them up when hyperinflation in Angola was 3200 per cent per annum while they would fight to pick up a One USD note. In 2010 I held a 100 Trillion Zimbabwe Dollar note which landed up in Portugal via various family connections. It was also worth nothing just like the 100 Kwanza notes lying in the street in Luanda in 1996.

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) 2005-2012 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 only occurs when the annual inflation rate falls below zero per cent (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 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 basic model of accounting implementing IFRS in terms of a Daily CPI or monetized daily indexed unit of account would be the best practice. A low level of inflation (best practice is currently considered to be two per cent annual inflation) to limit the erosion of real value in money and other monetary items. Inflation-adjusting the total money supply in terms of a daily index rate with complete co-ordination would remove the total cost of inflation (not actual inflation) from the economy.  IFRS, excluding the stable measuring unit assumption, for the correct daily valuation of variable items and, thirdly, financial capital maintenance in units of constant purchasing power (CIPPA) as authorized in IFRS in terms of a daily index or other daily rate for automatically maintaining the existing constant real value of owners´ equity constant for an indefinite period of time in all entities that at least break even in real value during inflation and deflation – ceteris paribus – whether they own any revaluable fixed assets or not and without the requirement of extra capital or extra retained profits simply to maintain the existing constant real value of existing constant items (e.g., equity) constant.

Net monetary losses and gains would be calculated and accounted in the income statement during inflation and deflation when CIPPA is implemented for all monetary items not inflation-adjusted on a daily basis. The cost of inflation would be accounted as a loss and deducted from profit before tax and the gain from inflation would be accounted as a gain and added to profit before tax. Reducing the holding of net 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 beforehand to know what the inflation rate will be during any future period. Capital inflation-indexed bonds overcome this problem (2012).

Nicolaas Smith

Copyright (c) 2005-2012 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 will suffer a net monetary loss (less real monetary item value owned / more real monetary item value eroded) during inflation. Entities 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. The opposite is true during deflation.

Net monetary gains and losses are accounted during hyperinflation as required by IAS 29 Financial Reporting in Hyperinflationary Economies. The accounting of net monetary gains and losses was also authorized in IFRS during low and high inflation and deflation, i.e., under the Constant Item Purchasing Power Accounting model with the approval of measurement of financial capital maintenance in units of constant purchasing power in the original Framework (1989), Par. 104 (a). This is due to the fact that the stable measuring unit assumption is not implemented under financial capital maintenance in units of constant purchasing power (CIPPA).  Net monetary gains and losses are not required to be computed under the traditional Historical Cost Accounting model although it can be done according to Kapnick.

‘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.’

(Kapnick, 1976: p 6)

Net monetary gains and losses are constant items once they are accounted in the income statement under CIPPA. All income statement items are constant items under CIPPA.

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. Net monetary item gains and losses are not required to be accounted because the stable measuring unit assumption is implemented under HCA.

‘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.’

(Walgenbach, Dittrich and Hanson, 1973: p 429)

An increase in the general price level (inflation) erodes the real value of unstable money and other unstable monetary items with an underlying monetary nature, e.g., the capital values of nominal bonds and loans. However, inflation has no effect on the real value of non-monetary items.

Constant items never measured in units of constant purchasing power (e.g., trade debtors and trade creditors) are effectively treated as monetary items when the stable measuring unit assumption is implemented as part of the HCA model during 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 inflation. Inflation only erodes the real value of money which is the nominal monetary unit of account in the economy and other monetary items. The erosion of the real value of constant items never maintained constant by the stable measuring unit assumption under HCA would stop when financial capital maintenance is measured in units of constant purchasing power during inflation, i.e., implementing the CIPPA model. There is no stable measuring unit assumption under financial capital maintenance in units of constant purchasing power (CIPPA). It is thus the implementation of the stable measuring unit assumption and not inflation that is doing the eroding.

The generally accepted measure of inflation 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.  

Financial capital maintenance in units of constant purchasing power (CIPPA) requires daily measurement in terms of a Daily CPI or a monetized daily indexed unit of account during non-hyperinflationary periods.

The correct measure of hyperinflation is either (a) the change in a relatively stable foreign currency daily parallel rate, normally the US Dollar daily parallel rate or (b) the change in a Brazilian–style Unidade Real de Valor daily index almost entirely based on the daily USD rate. The CPI published a month and a half to two months after the hyperinflationary changes in the real value of the monetary unit actually occurred (as happened in Zimbabwe), is completely impractical and totally ineffective 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.

Nicolaas Smith

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

Inflation

Inflation

‘Inflation is always and everywhere a monetary phenomenon.’

Milton Friedman

Inflation is a sustained increase in the general price level of goods and services in an economy over a period of time. Inflation is generally accepted to refer to annual inflation. All prices are normally quoted in terms of unstable money. During inflation each unit of the unstable monetary unit buys fewer goods and services. Inflation has no effect on the real value of non–monetary items.

Inflation erodes real value evenly in money and other monetary items. Under the Historical Cost paradigm there are, consequently, real hidden monetary costs to some and real hidden monetary benefits to others from this erosion in purchasing power in unstable monetary items that are assets to some while – a the same time – liabilities to others, e.g., the capital amount of  a monetary loan. Under the HC paradigm the debtor generally 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 pays back less real value during inflation. The creditor 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 attempt to recover this loss in real value by charging interest at a rate they hope will be higher than the inflation rate during the period of the loan.

Capital inflation-indexed government and commercial bonds overcome this problem for lenders.

Nicolaas Smith

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

Money

Money

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 during inflation and deflation. However, all Historical Cost Accounting world–wide is done assuming it is stable in real value when the stable measuring unit assumption is implemented for the valuation of most – not all – constant real value non-monetary items during  inflation and deflation. It is assumed, in practice, that money is perfectly stable when balance sheet constant items and all income statement items (excluding constant items like salaries, wages, rentals, etc., which are measured in units of constant purchasing power on an annual basis, but paid monthly implementing the stable measuring unit assumption) are valued in nominal monetary units when financial capital maintenance in nominal monetary units (HCA) is implemented during 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 would only have a constant real value over time during permanently sustainable zero annual inflation which has never been achieved in the past and is not likely soon to be achieved in the future.

The real values of monetary items (excluding bank notes and coins) would remain constant over time when the total money supply within an economy is inflation-indexed on a daily basis in terms of a Daily CPI or a monetized daily indexed unit of account with complete co-ordination. Chile (2011) inflation-adjusts 20 to 25 per cent of its broad M3 money supply on a daily basis in terms of the Unidad de Fomento which is a monetized daily indexed unit of account in use since 1967. Many countries issue capital inflation-indexed government bonds inflation-adjusted on a daily basis which protect investors against the erosion of the real value of their capital during inflation.

There would be no net monetary losses or gains and also no cost of inflation with complete daily inflation-adjustment of the total money supply with complete co-ordination. There would still be inflation, but it would have no effect in the economy.

Bank notes and coins are physical tokens of money. Unstable money is an unstable monetary item which is used as an unstable monetary medium of exchange. It serves at the same time as an unstable monetary store of value and as the unstable monetary unit of account for the accounting of economic activity in a country or a monetary union. All three basic economic items – monetary, variable and constant items – are valued in terms of unstable money within an economy.

An earlier form of money was commodity money, e.g., gold, silver and copper coins which had substantial real intrinsic value. Today unstable money is fiat money with an insignificant physical intrinsic value created by government fiat or decree.

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

Unstable money is the only generally accepted unit of measure that is not a stable value under all circumstances. All other units of measure are fundamentally stable units of measure, e.g., inch, centimetre, ounce, gram, kilogram, pound, etc.

Nicolaas Smith

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

Valuation of variable items

Valuation of variable items

Variable items are valued in terms of IFRS, excluding the stable measuring unit assumption, under financial capital maintenance in units of constant purchasing power (CIPPA). They are then updated daily in terms of the Daily CPI when they are not valued daily thereafter. They are valued / accounted in terms of the daily parallel rate or the daily index rate during hyperinflation.

Under financial capital maintenance in units of constant purchasing power (CIPPA) all accounting entries contain four elements:

21      An indication whether the item valued / accounted is

a.      A monetary item (m),

b.      A constant item (c) or

c.           A variable item (v).

22      The value of the item expressed in terms of the functional currency.

23      The date of the accounting entry.

24      The Daily CPI or monetized daily indexed unit of account at the date of the accounting entry during low and high inflation and deflation or the daily parallel or other index rate during hyperinflation.

         Variable items valued in terms of IFRS at Historical Cost as well as all other historical variable item IFRS valuations are updated in ledger accounts and in financial reports and publications in whatever format in terms of the Daily CPI till the next valuation in terms of IFRS because there is no stable measuring unit assumption under CIPPA during inflation and deflation. This is done in order to always reflect the IFRS valuation in terms of the current depreciated or appreciated real value of money over time. Variable items are always updated – per se – in terms of the current daily parallel or other daily index rate during hyperinflation.          

         The fact that specific variable items are valued at Historical Cost in terms of IFRS, e.g. stock valued at the lower of cost or net realizable value, does not mean that the HCA model is being implemented because there is no stable measuring unit assumption under financial capital maintenance in units of constant purchasing power (CIPPA).

        The Framework states that the concept of capital maintenance plus the measuring basis chosen determines the accounting model implemented. Under CIPPA financial capital maintenance is measured in units of constant purchasing power: there is no stable measuring unit assumption under CIPPA. Historical Cost is one of the various measurement bases used under CIPPA. HC valuations are thus always updated daily at the current, today´s, Daily CPI under CIPPA; i.e. the stable measuring unit is never applied.

         Under CIPPA monetary items in ledger accounts and in current period financial reports published during the current accounting period are valued / accounted in  nominal monetary units, but, the net monetary loss or gain is always calculated and accounted: i.e. there is no stable measuring unit assumption as implemented under Historical Cost Accounting. The net monetary loss or gain is not calculated and accounted under HCA because the stable measuring unit assumption is implemented.

       Specific variable items are valued at HC in terms of IFRS, but, then they are continuously updated during inflation, deflation and hyperinflation under financial capital maintenance because there is no stable measuring unit assumption under CIPPA.

Nicolaas Smith

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

Four reasons why CIPPA automatically maintains the constant purchasing power of capital constant for an indefinite period of time

Four reasons why CIPPA automatically maintains the constant purchasing power of capital constant for an indefinite period of time

Financial capital maintenance in units of constant purchasing power in terms of a Daily CPI (CIPPA) automatically maintains the constant purchasing power of capital constant for an indefinite period of time in all entities that at least break even in real value during inflation and deflation – ceteris paribus – as a result of the following reasons:

1.      Double entry accounting: For every credit (e.g., capital) there is an equivalent debit (e.g., fixed assets, stock, trade debtors, cash, etc.).

2.      There is no stable measuring unit assumption under this model: (a) monetary items are inflation adjusted daily at the current Daily CPI with the net monetary gain or loss accounted during the current accounting period; (b) variable items are valued daily in terms of IFRS excluding the stable measuring unit assumption and updated daily at the current Daily CPI when not valued daily with revaluations and impairments treated in terms of IFRS and (c) constant items are measured daily in units of constant purchasing power in terms of the current Daily CPI with the net constant item loss or gain accounted during the current accounting period.

3.      The constant real non–monetary value of equity is equal to the real value of net assets in all entities that at least break even in real value during inflation and deflation – ceteris paribus.

4.      A company, in principle, has an unlimited lifetime.

Nicolaas Smith

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

Price–level accounting does not prevail

Price–level accounting does not prevail

Price–level accounting as Harvey Kapnick hoped for in 1976 clearly does not prevail for balance sheet constant real value non–monetary items (e.g., owners´ equity) and most income statement items during low inflation. Income statement items are all constant real value non–monetary items. Price–level accounting does prevail as far as the income statement constant items salaries, wages, rentals, etc. are concerned since they are generally measured annually in units of constant purchasing power in terms of the annual change in the Consumer Price Index, but, they are then paid monthly applying the stable measuring unit assumption.

In terms of the HCA model the stable measuring unit assumption is implemented under which balance sheet constant items are valued at historical cost, i.e., in nominal monetary units thus eroding the existing constant real value of these constant items when they are not maintained constant  during low inflation.

Price–level accounting generally did prevail in the Brazilian economy during the 30 years from 1964 to 1994 when Brazil indexed all non–monetary items (variable and constant items) in their non–monetary or real economy with a daily index value supplied by the different governments during that period. Brazil stopped that with the full implementation of the traditional HCA model, financial capital maintenance in nominal monetary units and the stable measuring unit assumption when they changed the Unidade Real de Valor into their latest currency, the Real, in 1994. They should have changed from daily indexation of all non–monetary items (variable and constant items) during hyperinflation to financial capital maintenance in units of constant purchasing power during low inflation by applying their Daily CPI.

William Paton noted:

‘the value of the dollar — its general purchasing power — is subject to serious change over a period of years... Accountants... deal with an unstable, variable unit; and comparisons of unadjusted accounting statements prepared at intervals are accordingly always more or less unsatisfactory and are often positively misleading.’

As quoted in FAS 33, p. 29.

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

The HCA model would have been rejected by now if it were generally understood that the implementation of the stable measuring unit assumption during low inflation results in the unknowing, unnecessary and unintentional erosion of hundreds of billions of US Dollars of real value in constant items (e.g., banks´ and companies´ equity) never maintained in the world´s constant item economy year in year out.

Nicolaas Smith

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

Accounting cannot and does not create real value out of nothing

Accounting cannot and does not create real value out of nothing

It must be clearly understood that accounting per se cannot and does not create real value out of nothing – out of thin air. Accounting cannot and does not create real value or wealth by simply passing some update or financial capital maintenance in units of constant purchasing power accounting entries when no real value actually exists. Constant real value non-monetary items first have to actually exist for the accounting model (CIPPA) to be able to automatically maintain the real values of those existing constant items constant for an indefinite period of time in all entities that at least break even in real value during inflation and deflation – ceteris paribus. This is achieved by continuously measuring financial capital maintenance in units of constant purchasing power as authorized in IFRS in terms of a daily index or other daily rate. Maintaining the constant purchasing power of capital constant is consequently a basic objective of financial reporting.

The IASB authorized very erosive financial capital maintenance in nominal monetary units (HCA) during inflation and deflation, as well as its real value maintaining remedy, financial capital maintenance in units of constant purchasing power (CIPPA), in one and the same sentence in 1989.

Obviously, at sustainable zero inflation constant items will maintain their real values constant in all companies that at least break even in real value during inflation and deflation – all else being equal- under both HCA and CIPPA. Sustainable zero inflation has never been achieved in the past and is not likely soon to be achieved in the future. Sustainable zero inflation is thus simply a theoretical option.

The IASB confirms the fact that the Historical Cost paradigm is firmly in place when it states in IAS 29 and in the original Framework (1989) that most companies´ primary financial reports are prepared based on the traditional Historical Cost Accounting model without taking changes in the general price level or specific price changes of assets into account, with the exception that investments, equipment, plant and properties (all variable real value non-monetary items) can be revalued. The IASB does not mention the other exception, namely, that salaries, wages, rentals, etc. (all constant real value non-monetary items) are generally measured in units of constant purchasing power on an annual basis.

The IASB does not mention the erosion of the real value of balance sheet constant items never maintained constant when the stable measuring unit assumption (a Generally Accepted Accounting Practice) is implemented during low inflationary periods in companies with insufficient revaluable fixed assets (revalued or not) because this process of erosion of the real value of constant items never maintained constant is not generally understood. The IASB, like the FASB and most others, mistakenly believe that the erosion of companies´ capital and profits is caused by inflation, as specifically stated by the FASB. They also support the stable measuring unit assumption which is based on the fallacy that money is perfectly stable. They both authorized HCA based on the fallacy of financial capital maintenance in nominal monetary units per se during inflation and deflation.

The erosion of the real value of constant items by the implementation of  the stable measuring unit assumption is very well understood and remedied by measuring  them in units of constant purchasing power by applying the annual CPI in the case of the income statement constant items salaries, wages, rentals, etc. The real value maintaining effect on balance sheet constant items is not understood of freely choosing to continuously measure financial capital maintenance in units of constant purchasing power instead of in nominal monetary units – both models being approved in IFRS in the original Framework (1989), Par 104 (a).

The International Accounting Standards Committee (the IASB predecessor body) blamed changing prices in IAS 15 Information Reflecting the Effects of Changing Prices for affecting an enterprise’s results of operation and financial position. They defined changing prices as (1) specific price changes and (2) changes in the general price level which changed the general purchasing power of money, i.e. they blamed specific price changes and inflation for affecting companies´ results and financial position.

The FASB mentioned the stable measuring unit assumption in FAS 33 and FAS 89.

‘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.’

FAS 89, Par. 4, 1986

‘The integrity of the historical cost / nominal dollar system relies on a stable monetary system.’

FAS 33, 1979

The IASB never mentioned the stable measuring unit assumption in either IAS 6 Accounting Response to Changing Prices (approved in March, 1977 for publication in June, 1977) or IAS 15 (approved in June, 1981 for publication in November, 1981 and became effective on 1 January, 1983). IAS 15 completely superseded IAS 6. IAS 15 was withdrawn in December, 2003.

Nicolaas Smith

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

Two per cent inflation also erodes real value

Two per cent inflation also erodes real value

There is a school of thought that the effects of two per cent inflation are not more harmful than zero per cent inflation.  This school of thought is incorrect in two of the three valuation processes in our current HC economy and would also be mistaken in one of the three valuation processes under continuous financial capital maintenance in units of constant purchasing power, i.e., the Constant Item Purchasing Power paradigm during low inflation.  The three valuation processes in our economy under both the HC and CIPP paradigms are the valuation of monetary, variable and constant items.

Variable items are valued in terms of IFRS under both the HC and CIPP paradigms with the stable measuring unit assumption being applied under HCA. The stable measuring unit assumption is never implemented under the CIPP paradigm. The two paradigms are fundamentally different paradigms.

The view that a high degree of price stability of a positive inflation rate of up to two per cent per annum is completely unharmful and that it has no disadvantages compared to absolute price stability is never true in the case of monetary items under any accounting model, either the HCA model or the CIPPA model, since inflation always erodes the real value of monetary items. A high degree of price stability of two per cent per annum in this case erodes two per cent per annum of the real value of money and other monetary items which equates to the erosion of 51 per cent of real value in all current monetary items over the next 35 years. It will over a long enough time period lead to all current monetary items arriving at the point of being completely worthless in economies with continuous two per cent inflation. The five cents coin was recently withdrawn from the South African money supply since it was practically worthless. South Africa has an inflation target of three to six per cent per annum. Swedish rounding whereby the cost of a purchase paid for in cash is rounded to the nearest multiple of the smallest denomination of currency is implemented in a number of countries.

In the case of monetary items we can thus confidently disagree with those who assume that a high degree of price stability of above zero and up to two per cent per annum is unharmful in all respects and that it has absolutely no disadvantages compared to absolute price stability or zero inflation.

The assumption that two per cent inflation is unharmful and that it has no disadvantages compared to zero inflation is acceptable in the case of variable real value non–monetary items valued continuously in terms of IFRS (excluding the stable measuring unit assumption) under the CIPPA model. The nature of the valuing processes in valuing variable real value non–monetary items continuously, for example, at fair value or the lower or cost and net realizable value or market value, etc., in terms IFRS (excluding the stable measuring unit assumption), allows this idea to be justifiable under CIPPA.

The above view is acceptable in this instance, because, in principle, any level of inflation or deflation – high or low – is automatically adjusted for in determining the price of a variable real value non–monetary item at the moment of a transaction in terms of IFRS, excluding valuation in nominal monetary units, under CIPPA.

The above assumption relating to two per cent inflation is acceptable under the HC model with the valuation of variable items in terms of IFRS accept in the case where the stable measuring unit is implemented. It is thus not acceptable per se with reference to variable items under the HC paradigm.

Two per cent inflation erodes two per cent per annum – i.e., 51 per cent over 35 years – of the real value of constant real value non–monetary items never maintained, e.g., retained profits, etc.  under the current HC paradigm. The only constant items generally maintained constant with annual measurement in units of constant purchasing power under the HC paradigm are certain (not all) income statement items, e.g., salaries, wages, rentals, etc. They are, however, paid monthly at the same value after being updated annually. All existing constant real value non–monetary items´ real values would automatically be maintained constant with continuous measurement in units of constant purchasing power at any level of inflation or deflation under the CIPP paradigm for an unlimited period of time in entities that at least break even in real value – ceteris paribus.

We can thus safely disagree in the case of constant real value non–monetary items under the HC paradigm too, that the effects of two per cent inflation is completely unharmful. Two per cent inflation – in fact, any level of inflation or deflation – would be the same as zero inflation as far as the valuation of constant real value non–monetary items under the CIPPA model is concerned.

Nicolaas Smith

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

Absolute price stability in constant items

Absolute price stability in constant items

Constant Item Purchasing Power Accounting is a price–level accounting model where under financial capital maintenance in units of constant purchasing power is implemented at all levels of inflation and deflation.

Continuous financial capital maintenance in units of constant purchasing power was authorized by the IASC Board thirteen years after Harvey Kapnick´s 1976 prediction. The IASC Board approved the original Framework (1989), Par 104 (a), now Conceptual Framework (2010), Par. 4.59 (a), which state:

‘Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power.’

However, the enormous real value eroding effect of implementing the very erosive stable measuring unit assumption when entities choose, also in terms of the original Framework (1989), Par. 104 (a), IASB–approved financial capital maintenance in nominal monetary units (the HCA model) and apply it in the valuing of constant real value non–monetary items never maintained constant, e.g., retained earnings, in low inflationary economies is not generally realized at all. This is clearly verified by the fact that both financial capital maintenance in nominal monetary units (a very popular accounting fallacy) and real value maintaining continuous financial capital maintenance in units of constant purchasing power at all levels of inflation and deflation were approved by the IASB in the original Framework, Par 4.59 (a) in 1989 – in one and the same sentence.

Hundreds of billions of US Dollars is eroded in constant items never maintained constant in the world’s constant item economy per annum by the implementation of the stable measuring unit assumption as part of HCA during low inflation in this manner.

Entities can choose the one or the other and state that they have prepared primary financial statements in terms of IFRS. However, when they choose the traditional HCA model they unknowingly, unintentionally and unnecessarily erode real value on a significant scale in the real or non–monetary economy during low inflation when they implement the very erosive stable measuring unit assumption. When they choose IASB–approved continuous financial capital maintenance in units of constant purchasing power they would maintain the real values of all constant real value non–monetary items during inflation and deflation in companies which at least break even in real value, empowering and enriching those companies, their shareholders and the economy in general with the accompanying benefits to workers and employment for an unlimited period of time – ceteris paribus.

As the Deutsche Bundesbank stated:

‘The benefits of price stability, on the other hand, can scarcely be overestimated, especially as these are, in principle, unlimited in duration and accrue year after year.’

Deutsche Bundesbank, 1996 Annual Report, P 83.

Financial capital maintenance in units of constant purchasing power would result in absolute price stability under complete co-ordination in constant real value non–monetary items for an unlimited period of time in companies that at least break even in real value at all levels of inflation and deflation – all else being equal – without the need for extra capital from capital providers or more retained earnings simply to maintain the existing constant real value of existing constant real value non–monetary capital constant. The IASB predecessor body, the IASC Board, approved absolute price stability in income statement and balance sheet constant real value non–monetary items when they authorized the original Framework (1989), Par 104 (a) approving the option of continuously measuring financial capital maintenance in units of constant purchasing power at all levels of inflation and deflation.

Nicolaas Smith

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

Price-level accounting

Price-level accounting

Entities generally choose to measure financial capital maintenance in nominal monetary units and thus apply the very erosive stable measuring unit assumption as part of the traditional HCA model. They generally value all balance sheet constant items, e.g., owners´ equity, trade debtors, trade creditors, etc. as well as most income statement items, which are all constant items, at Historical Cost. They value them in nominal monetary units as a result of the fact that they assume that changes in the purchasing power of the unstable monetary unit are not sufficiently important to require financial  capital maintenance in units of constant purchasing power during low inflation and deflation.

Entities, in practice, assume unstable money is perfectly stable for this purpose. They, in practice, assume there has never been inflation or deflation in the past, there is no inflation and deflation in the present and there never will be inflation and deflation in the future as far as the valuation of most constant real value non-monetary items is concerned. They only value certain income statement constant items, e.g. salaries, wages, rentals, etc. in real value maintaining units of constant purchasing power annually by means of the annual CPI during low inflation. They then pay these items monthly in fixed nominal amounts, again implementing the stable measuring unit assumption.

IAS 29 Financial Reporting in Hyperinflationary Economies does not require the valuation of non–monetary items in units of constant purchasing power at the time of the transaction or event. IAS 29 simply requires the restatement of Historical Cost or Current Cost financial statements in terms of the period–end monthly published CPI in order to make them ‘more useful’ during hyperinflation. The non–monetary or real economy of a hyperinflationary economy can only be maintained relatively stable by applying the daily parallel US Dollar exchange rate or a Brazilian–style URV daily index to the valuation of all non–monetary items instead of simply restating HC or CC financial statement in terms of the period–end monthly published CPI as required by IAS 29.

The Framework is applicable

The concepts of capital, the capital maintenance concepts and the profit / loss determination concepts are not covered in IAS, IFRS or Interpretations. These concepts were covered in the original Framework for the Preparation and Presentation of Financial Statements (1989), now The Conceptual Framework for Financial Reporting (2010), Chapter 4: The Framework (1989): the remaining text. There are no specific IAS or IFRS relating to these concepts. The Framework is thus applicable as per IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors, Par.11.

Deloitte states:

‘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 8, Par. 11 states:

‘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.’

The valuation of the constant items issued share capital, retained earnings, other items in owners´ equity and other constant  items was thus covered in IFRS in the original Framework (1989), Pa. 104 (a), now the Conceptual Framework (2010), Par. 4.59 (a).

Harvey Kapnick in the Sax Lecture in 1976 correctly predicted the course of the development of International Financial Reporting Standards:

‘Confusion constantly arises between changes in value and changes in purchasing power. The fact is both are occurring and, while there may be an interrelationship, the effects of each should be accounted for separately. Thus, the debate concerning whether value accounting or price–level accounting should prevail is not on point, because in the long run both should prevail. The real changes in value should be segregated from changes resulting only from changes in price levels.’

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

Nicolaas Smith

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