Capital maintenance is rarely used

Capital maintenance is rarely used

In September 2012 I submitted the following request to the IASB:

IFRIC POTENTIAL AGENDA ITEM REQUEST

The Issue:

The Conceptual Framework (2010), Par. 4.59 states:

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

Par. 4.59 (a) does not specifically indicate whether financial capital maintenance in units of constant purchasing power is applicable during low inflation, high inflation, hyperinflation or deflation.

IAS 29 Financial Reporting in Hyperinflationary Economies, Par. 8 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.’

As a result of the fact that it is currently generally accepted by accountants in countries implementing IFRS that IAS 29 is always required during hyperinflation, please indicate whether the following two statements are valid or not:

1. In terms of The Conceptual Framework (2010), Par. 4.59 (a), financial capital maintenance in units of constant purchasing power is applicable during low inflation, high inflation, hyperinflation and deflation.

2. In terms of IAS 29 Financial Reporting in Hyperinflationary Economies, Par. 8, this standard is only required for the restatement of historical cost and current cost financial statements and not in the case of financial capital maintenance in units of constant purchasing power during hyperinflation since all items in the latter financial statements would already be measured either

(a) in terms of the measuring unit current at the balance sheet date (e.g., the CPI); or
(b) in terms of IFRS-authorized measurement bases current at the end of the reporting period (e.g., fair value, net realizable value, recoverable value, present value, etc.), excluding nominal Historical Cost (updated Historical Cost to be used under financial capital maintenance in units of constant purchasing power), i.e., excluding the stable measuring unit assumption which is never implemented under financial capital maintenance in units of constant purchasing power.

The IASB, having a lack of understanding about the fundamental role a capital maintenance concept has within the accounting framework and petty-mindedly refusing to continue working with me on this request after I told Michael Stewart, the IASB´s Director of Implementation Activities, that his statement that "financial reporting has NO EFFECT on the economy" is completely wrong and reminded him that IAS 29 had no positive effect in Zimbabwe after being implemented during the final 8 years of hyperinflation in that country, distorted my request as follows:

"The Interpretations Committee considered the following two questions: 

(a) whether an entity is permitted to use the financial capital maintenance concept defined in terms of constant purchasing power units that is described in the Conceptual Framework when the entity’s functional currency is not the currency of a hyperinflationary economy as described in IAS 29 Financial Reporting in Hyperinflationary Economies; and 

(b) if such use is permitted, whether the entity needs to apply IAS 29 to its financial statements prepared under a specific model of that concept of financial capital maintenance when it falls within the scope of IAS 29."

Note that the IASB - clearly demonstrating their lack of understanding about the fundamental role a capital maintenance concept has within the accounting framework - avoided the detail I stated about financial capital maintenance in units of constant purchasing power, by simply referring to it as "a specific model".

The IASB had to rewrite (distort) my request because they are clueless about capital maintenance as now pointed out directly by CPA Australia and The Institute of Chartered Accountants of Australia. They had to change my request to something they understood and could attempt to answer. Kenichi Yoshimura, the author of all three staff papers (the first - Agenda Ref 20 - of which is total junk and was withdrawn (see Agenda Paper 20 here) after I wrote about it to Hans Hoogervorst, the Chairman of the IASB) on this request - under the direction of "financial reporting has NO EFECT on the economy" Michael Stewart - officially informed me by email that he has a lack of understanding about capital maintenance in units of constant purchasing power. Instead of then withdrawing from the project he carried on authoring all three staff papers and is still on the project.

The IASB then contrived the following guidance for their distorted version of my request:


"Consequently the guidance in the Conceptual Framework relating to the use of a particular capital maintenance concept cannot be used to override the requirements of any individual IFRSs. An entity is not permitted to apply a concept of capital maintenance that conflicts with the existing requirements in a particular IFRS, when applying that IFRS." 

I fully agree with CPA Australia and The Institute of Chartered Accountants Australia that the IASB has a lack of understanding about the fundamental 
role a capital maintenance concept has within the accounting framework.

In light of the IASB´s clearly demonstrated lack of understanding about the fundamental role a capital maintenance concept has within the accounting framework, the above guidance from the IASB is thus of almost no importance at all.

Nicolaas Smith 

Copyright (c) 2005-2014 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Deloitte and Canadian AcSB support IASB´s delusional view that IFRSs do not permit financial capital maintenance in units of constant purchasing power during non-hyperinflationary conditions

Deloitte and the Canadian Accounting Standards Board support the IASB´s delusional view that IFRSs do not permit financial capital maintenance in units of constant purchasing power during non-hyperinflationary conditions

The IASB in its interpretation of this matter admitted that:

“Par. 14 . The selection of the capital maintenance concept is a choice that is available within the Conceptual Framework that provides a fundamental basis of preparation of financial statements. Paragraph 4.58 of the Conceptual Framework states that “the selection of the appropriate concept of capital by an entity should be based on the needs of the users of its financial statements”. Accordingly, those who support this view argue that the entity is permitted to use the financial capital maintenance concept defined in constant purchasing power units if this concept, among the alternative concepts described in the Conceptual Framework, provides the most useful information to users.

Par. 15. Having made a choice of using the financial capital maintenance concept in constant purchasing power units, the entity would develop accounting policies by referring to an IFRS that addresses a transaction, other event or condition analysed in accordance with paragraph 10 of IAS 8. The entity would need to adapt each IFRS for the use under that capital maintenance concept.”

Agenda ref 12 STAFF PAPER 10–11 September 2013 IFRS Interpretations Committee Meeting Project IAS 29 Financial Reporting in Hyperinflationary Economies

Paper topic Applicability of the concept of financial capital maintenance defined in constant purchasing power units

However the IASB managed to find two supporters - Deloitte and the Canadian Accounting Standards Board - for their delusional view that IFRSs do not permit financial capital maintenance in units of constant purchasing power during non-hyperinflationary conditions.

I suggested to the IASB during these proceedings that they contact top accounting authorities in formerly hyperinflationary countries like Dr Gustavo Franco, the ex-Governor of the Central Bank of Brazil and Dr Cemal Kucusozen from Turkey, but they simply rejected my suggestions. They rather rely on people who had no experience of high and hyperinflation. 

In fact, the IASB Interpretations Committee - in a very petty-minded way - stopped communicating with me, the submitter of this IFRIC request, when I pointed out to Michael Stewart, the IASB´s Director of Implementation Activities that his remark (during a 8 January 2013 teleconference regarding this topic) that "financial reporting has NO EFFECT on the economy" was completely wrong. 

The above views expressed by the IASB, Deloitte and the Canadia Accounting Standard Board carry little weight since they have previously clearly shown that they are clueless about the critical importance of the capital maintenance concept in the accounting framework as directly stated by Australia CPA and the Institute of Chartered Accountants of Australia, specifically about the IASB as follows:

"We think this approach suggests a lack of understanding (by the IASB) about the fundamental role a capital maintenance concept has within the accounting framework."

Canadian accounting authorities demonstrated a similar lack of knowledge about capital maintenance during non-hyperinflationary conditions with the following reply from THE CERTIFIED GENERAL ACCOUNTANTS ASSOCIATION OF CANADA:

"We agree that the IASB should defer its work on capital maintenance until it develops new provisions or revises the extant Standard (IAS 29) on accounting for hyperinflation. "

Canada has no experience of high or hyperinflation. 

Deloitte believes that inflation affects the real value of non-monetary items. Deloitte is similarly clueless about capital maintenance during non-hyperinflationary conditions.

Nicolaas Smith 


Copyright (c) 2005-2014 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Comment Letter to the Discussion Paper: A Review of the Conceptual Framework for Financial Reporting

Comment Letter to the Discussion Paper: A Review of the Conceptual Framework for Financial Reporting

The IFRS Foundation                                                                    14 January 2014

Dear Sirs/Mesdames,

Thank you for the opportunity to comment on the IASB's Discussion Paper: A Review of the Conceptual Framework for Financial Reporting.

Please find my detailed answers in the Appendix.

Yours sincerely,

Nicolaas Smith

Capital Maintenance in Units of Constant Purchasing Power

I promote Capital Maintenance in Units of Constant Purchasing Power in terms of a Daily CPI or other daily index at all levels of inflation and deflation including hyperinflation as originally authorized in IFRS 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.'

CMUCPP 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, including hyperinflation - all else being equal.

The comment letter is published by the IFRS Foundation HERE under the name Capital Maintenance in Units of Constant Purchasing Power. The letter is ID number 167 and appears on page 1 of the table if it is sorted alphabetically by organisation (the default), or page 2 if it is sorted by ID number.

APPENDIX

Answers to the IASB's Discussion Paper: A Review of the Conceptual Framework.

Section 6 Measurement

Question 11

How the objective of financial reporting and the qualitative characteristics of useful financial information affect measurement is discussed in paragraphs 6.6–6.35.

The IASB’s preliminary views are that:

a. the objective of measurement is to contribute to the faithful representation of relevant information about:

I. the resources of the entity, claims against the entity and changes in resources and

claims; and

II. how efficiently and effectively the entity’s management and governing board have

discharged their responsibilities to use the entity’s resources.

b. a single measurement basis for all assets and liabilities may not provide the most relevant information for users of financial statements;

c. when selecting the measurement to use for a particular item, the IASB should consider what information that measurement will produce in both the statement of financial position and the statement(s) of profit or loss and OCI;

d. the relevance of a particular measurement will depend on how investors, creditors and other lenders are likely to assess how an asset or a liability of that type will contribute to future cash flows. Consequently, the selection of a measurement:

i. for a particular asset should depend on how that asset contributes to future cash

flows; and

ii. for a particular liability should depend on how the entity will settle or fulfil that

liability.

e. the number of different measurements used should be the smallest number necessary to provide relevant information. Unnecessary measurement changes should be avoided and necessary measurement changes should be explained; and

f. the benefits of a particular measurement to users of financial statements need to be sufficient to justify the cost.

Do you agree with these preliminary views? Why or why not? If you disagree, what alternative approach to deciding how to measure an asset or a liability would you support?

RESPONSE

No, I do not agree with these preliminary views because they are not complete. They only deal with measurement in terms of financial capital maintenance defined in terms of nominal monetary units. IFRSs are also written from the perspective of an entity using the concept of financial capital maintenance that is defined in terms of units of constant purchasing power.

“Par. 14 . The selection of the capital maintenance concept is a choice that is available within the Conceptual Framework that provides a fundamental basis of preparation of financial statements. Paragraph 4.58 of the Conceptual Framework states that “the selection of the appropriate concept of capital by an entity should be based on the needs of the users of its financial statements”. Accordingly, those who support this view argue that the entity is permitted to use the financial capital maintenance concept defined in constant purchasing power units if this concept, among the alternative concepts described in the Conceptual Framework, provides the most useful information to users.

Par. 15. Having made a choice of using the financial capital maintenance concept in constant purchasing power units, the entity would develop accounting policies by referring to an IFRS that addresses a transaction, other event or condition analysed in accordance with paragraph 10 of IAS 8. The entity would need to adapt each IFRS for the use under that capital maintenance concept.”

Agenda ref 12 STAFF PAPER 10–11 September 2013 IFRS Interpretations Committee Meeting Project IAS 29 Financial Reporting in Hyperinflationary Economies

Paper topic Applicability of the concept of financial capital maintenance defined in constant purchasing power units

IFRS, excluding (1) IAS 29 Financial Reporting in Hyperinflationary Economies and (2) IFRIC 7  Applying the Restatement Approach under IAS 29, are written from the perspective of an entity using the concept of financial capital maintenance that is defined in terms of nominal monetary units (Historical Cost Accounting). This is however a fallacy.

IAS 29 and IFRIC 7 are written from the perspective of an entity using the concept of financial capital maintenance that is defined in terms of units of constant purchasing power in terms of the measuring unit current at the end of the reporting period, i.e., in terms of the monthly published Consumer Price Index. IAS 29 does not result in capital maintenance in units of constant purchasing power during hyperinflation because of the use of the monthly published CPI. IAS 29 had no positive effect in Zimbabwe: the Zimbabwean economy imploded on 20 November 2008 despite the fact that IAS 29 had been implemented during the final 8 years of hyperinflation in that country. Equity can only be maintained constant in real value with capital maintenance in units of constant purchasing power in terms of an index that follows all (at least DAILY) changes in the general price level. This did not and does not happen under IAS 29.

The majority of entities are based on the concept of equity (capital) being equal to net assets under the double-entry accounting model.  I am not referring specifically to the HCA model, but simply to the double-entry accounting model implementing the entity concept. All constant purchasing power of capital (a constant real value non-monetary item) being eroded / destroyed by the stable measuring unit assumption (not inflation) over time during low inflation, high inflation or hyperinflation (for example, in Zimbabwe on 20 November 2008) would mean the end of the entity. Maintaining the constant purchasing power of capital (equity) constant in real value is thus a fundamental objective for an entity.

‘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: 24

It is generally impossible to maintain the real value (constant purchasing power) of capital (equity) constant in nominal monetary units during low inflation, high inflation, hyperinflation and deflation. Financial capital maintenance in nominal monetary units is thus a fallacy during the above periods. It is, however,  the capital maintenance concept most commonly used by entities as a result of historical developments in many areas over the last 3000 years.

The constant purchasing power of capital (equity) is generally automatically maintained constant with capital maintenance in units of constant purchasing power in entities that at least break even in real value - ceteris paribus - in terms of an index that follows all (at least DAILY) changes in the general price level.

Consequently, the IASB may determine that the objectives of general purpose financial reporting / accounting are:

1.  "To provide financial information about  the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity.”  Conceptual Framework

and

2. To legalise measurement bases that result in automatic capital maintenance in units of constant purchasing power in terms of an index that follows all (at least DAILY) changes in the general price level for an indefinite period of time in entities that at least break even in real value - ceteris paribus - during low inflation, high inflation, hyperinflation and deflation.

The Board may determine that the objectives of measurement thus also include:

(III) To contribute to capital maintenance in units of constant purchasing power as defined in the objectives of general purpose financial reporting / accounting above.

For example, the Board may determine that the three basic economic items are

1. Monetary items

2. Variable real value non-monetary items and

3. Constant real value non-monetary items.

The Board may determine that most IFRSs apply to the measurement of variable items under financial capital maintenance in nominal monetary units and thus require adaptation for use under capital maintenance in units of constant purchasing power in terms of an index that follows all (at least daily) changes in the general price level - where necessary.

The Board may determine that monetary items are all items in the money supply.

The Board may determine that the following are some of the items that are considered monetary items under financial capital maintenance in nominal monetary units, but are constant real value non-monetary items under financial capital maintenance in units of constant purchasing power in terms of an index that follows all (at least daily) changes in the general price level:

Trade debtors, trade creditors, all non-monetary payables, all non-monetary receivables, interest, salaries, wages, rent, fees, pensions, taxes, duties, all employee benefits and all similar items to the items already stated.

The Board may determine that constant real value non-monetary items include, but are not limited to: all items in shareholders equity, provisions, all profits and losses, all items in the profit and loss account and in the Other Comprehensive Income Statement.

The Board may determine that variable items, when they are not measured in terms of IFRS on a daily basis, are to be updated on a daily basis in terms of an index that follows all (at least daily) changes in the general price level till they are again measured in terms of IFRS.

The Board may determine that foreign exchange is a variable real value non-monetary item and that forex gains and losses are constant real value non-monetary items like all other gains and losses to be measured in units of constant purchasing power in terms of an index that follows all (at least daily) changes in the general price level.

The Board may determine that financial reports are to be updated to the current (today´s ) Daily Index (e.g., the Daily CPI) after the end of the financial period. The Board may determine that it would thus be best to keep financial reports in digital form and not to print hard copies that would be out-of-date the day after the end of the financial period.

Question 26

Capital maintenance

Capital maintenance is discussed in paragraphs 9.45–9.54. The IASB plans to include the existing descriptions and the discussion of capital maintenance concepts in the revised Conceptual Framework largely unchanged until such time as a new or revised Standard on accounting for high inflation indicates a need for change.

Do you agree? Why or why not? Please explain your reasons.

In my response to Question 11 above I stated my view that the Conceptual Framework should determine that the objectives of measurement also include:

(III) To contribute to capital maintenance in units of constant purchasing power as defined in the objectives of general purpose financial reporting / accounting above.

Accordingly, I do not support the proposal that leaves the existing descriptions and discussion of this issue largely unchanged until such time as any project on accounting for high inflation indicates a need for change. Capital maintenance is not only critical as from the onset of high inflation - although that is the generally accepted view in most - not all - accounting jurisdictions. For example, it is not viewed like that in Australia.

The IASB´s approach suggests a lack of understanding about the fundamental role a capital maintenance concept has within the accounting framework. There is clearly a pressing need to resolve the issues regarding capital maintenance now.

The comment letter is published by the IFRS Foundation HERE under the name Capital Maintenance in Units of Constant Purchasing Power. The letter is ID number 167 and appears on page 1 of the table if it is sorted alphabetically by organisation (the default), or page 2 if it is sorted by ID number.

Nicolaas Smith

Copyright (c) 2005-2014 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Financial reporting unknown known

Financial reporting unknown known

Capital erosion / destruction under financial capital maintenance in nominal monetary units (traditional Historical Cost Accounting) is beyond an "unknown known" during low and high inflation: an intractable fact regarding a fallacy we prefer to forget.

It is a fact that HCA destroys billions of USD per annum in the world´s capital investment base because it is generally a fallacy that the real value (constant purchasing power) of capital (equity) can be maintained constant with financial capital maintenance in nominal monetary units in that portion of equity never maintained constant with the real value of net assets during inflation and deflation.

Although IFRS state in the Conceptual Framework, Par. 4.59 (a) that "Financial capital maintenance can be measured in ...... nominal monetary units ......" it is generally impossible to maintain the real value (constant purchasing power) of capital constant during inflation and deflation in nominal monetary units.

‘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: 24

The term "financial capital maintenance" which implies that the real value of capital is being maintained (constant) during inflation and deflation is thus a fallacy.

The implementation of the stable measuring unit assumption (not inflation) under HCA during inflation results in the unnecessary destruction of hundreds of billions of USD per annum in the real value of the world economy´s investment capital base: in that portion of capital (equity) that is never backed by the real value of net assets.

Only Capital Maintenance in Units of Constant Purchasing Power in terms of an index that follows all (at least DAILY, e.g., the Daily CPI) changes in the general price level can generally maintain the constant purchasing power of capital constant only in entities that at least break even in real value - ceteris paribus - at all levels of inflation and deflation.


Nicolaas Smith 

Copyright (c) 2005-2014 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Institute of Chartered Accountants Australia and CPA Australia recognise three concepts of capital maintenance authorised in IFRS

The Institute of Chartered Accountants Australia and CPA Australia recognise three concepts of capital maintenance authorised in IFRS

ICA Australia and CPA Australia in their combined comment letter to the IASB´s Capital Maintenance Discussion Paper recognised the two major concepts of capital and the three specific concepts of capital maintenance authorised in IFRS.

In their answer to Question 11 they state:

"The IASB should express clearly its view on the issues of the business enterprise and the concept of capital. In the case of the former, does it support a proprietary or entity view? In the case of the latter does it support a (i) financial or (ii) physical concept of capital? We would then like the measurement section to develop the link between the ideal concept of capital, the ideal concept of capital maintenance and the resulting selection of a measurement basis that is the consequence of applying those concepts. 

For example, the Board may determine that in the course of determining the appropriate measure for profit, the ideal concept of capital maintenance is 

(1) the maintenance of financial capital in money terms. It would therefore follow that the appropriate measurement base is historical cost. 

Alternatively, the Board may determine that the ideal concept of capital maintenance is: 

(2) the maintenance of financial capital in real terms with the resulting selection of entry price as a measurement base or 

(3) maintaining the productive (operating) capacity of the entity with the resulting selection of an exit price as the appropriate measurement base." 

ICA Australia and CPA Australia thus recognise that the three specific concepts of capital maintenance authorised in IFRS are:

(I) Financial capital maintenance in nominal monetary units (Historical Cost Accounting) during inflation and deflation.

(II) Financial capital maintenance in units of constant purchasing power under which the real value (constant purchasing power) of capital can generally only be maintained constant in terms of an index that recognises all - at least daily - changes in the general price level (normally a Daily CPI) during inflation and deflation.

(III) Physical capital maintenance under which the physical capital is maintained in terms of physical units of output per day.

The complete comment letter is available HERE dated 2014-01-06 on Page 1.

Nicolaas Smith Copyright (c) 2005-2014 Nicolaas J Smith. All rights reserved. No reproduction without permission.