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HCA abdicates a fundamental objective of financial reporting

May 30, 2011 in Uncategorized

HCA abdicates a fundamental objective of financial reporting

A fundamental objective of general purpose financial reporting is not just “to convey value information about the economic resources of a business” as Harvey Kapnick stated in the 1976 Sax Lecture.

http://newman.baruch.cuny.edu/DIGITAL/saxe/saxe_1975/kapnick_76.htm

The objectives of general purpose financial reporting are:

1) Automatic maintenance of the constant purchasing power of capital in all entities that at least break even for an indefinite period of time.

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

Historical Cost Accounting abdicates a fundamental objective of general purpose financial reporting to the fiction that money is stable in real value during inflation and deflation. Double-entry accounting (not HCA) makes it possible to automatically maintain the existing constant real non-monetary value of capital constant forever in all entities that at least break even – ceteris paribus – during inflation and deflation whether they own any fixed assets or not. Automatic constant real value financial capital maintenance is, however, only possible with financial capital maintenance in units of constant purchasing power (Constant Item Purchasing Power Accounting) per se during low inflation and deflation. That is to say: it is only possible with the split of non-monetary items in variable and constant items with only constant items being continuously updated (month-after-month) in terms of the CPI. Automatic constant real value capital maintenance is also possible during hyperinflation, but, only with daily valuation of all non-monetary items (variable and constant items) in terms of a daily Brazilian-style non-monetary index or hard currency daily parallel rate.

The stable measuring unit assumption (not inflation) makes it impossible to automatically maintain the constant real value of capital constant during inflation and deflation per se even when entities break even on a nominal basis. To the contrary: the stable measuring unit assumption automatically erodes the existing constant real value of all constant items never maintained constant during inflation. This amounts to hundreds of billions of US Dollars unknowingly, unintentionally and unnecessarily eroded in the world´s constant item economy year after year. CIPPA automatically stops this erosion forever in all entities that break even during inflation and deflation.

Nicolaas Smith

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

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May 27, 2011 in Uncategorized

The two different meanings of the word inflation

It is correct, essential and compliant with IFRS to update constant items by means of the monthly change in the CPI during low inflation and deflation. The reason for this is that constant items are expressed in terms of money, i.e. in terms of an unstable monetary unit of account which is the same as the unstable monetary medium of exchange within an economy or monetary union. Inflation erodes the real value of the unstable monetary medium of exchange – which is also the unstable monetary unit of account in accounting and the economy in general. Constant items thus have to be updated at a rate equal to the rate of low inflation or deflation, i.e. valued or measured in units of constant purchasing power, in order to maintain their real values constant during low inflation and deflation because the unit of measure in accounting is an unstable monetary unit of account and consequently hardly ever absolutely stable during periods of low inflation and deflation. Months of zero annual inflation are very few and far between. Sustainable zero annual inflation has never been achieved before and it does not seem very likely that it will be achieved any time soon in the future.

Variable real value non–monetary items do not need to be and are not valued in units of constant purchasing power during low inflation because they are valued in terms of IFRS or GAAP at, for example, fair value, market value, present value, recoverable value, net realizable value, etc which always automatically take inflation – amongst many other items – into account. Variable real value non–monetary items are only valued in units of constant purchasing power during hyperinflation as required in IFRS in IAS 29 since the IASB regards hyperinflation as an exceptional circumstance.

There is a school of thought that 2% inflation is completely unharmful and that it has no disadvantages compared to absolute price stability (sustainable zero inflation). That is not correct. 2% inflation will erode, for example, 51% of the real value of all monetary items and all constant real value non–monetary items never maintained constant, e.g. Retained Profits never maintained constant, over 35 years – all else being equal – when the stable measuring unit assumption is implemented for an indefinite period of time during indefinite low inflation.

It is not necessary to updated by means of the CPI, which is a general price index, variable real value non–monetary items (e.g. properties, plant, equipment, shares, raw material, etc.) which are subject to product specific price increases for the purpose of valuing these variable items during the accounting period on a primary valuation basis during non–hyperinflationary periods. These variable items are generally subject to market–based real value changes determined by supply and demand. They incorporate product specific price changes also stated as product specific inflation where the word inflation is, very unfortunately, also used to simply mean a product or product group price increase instead of the general use of the word in economics to mean the erosion of the real value of money and other monetary items over time, i.e. an erosion of the general purchasing power of money which is caused by/results in an increase in the general price level over time.

It is thus generally accepted in economics that the word inflation has two different meanings:

(1) inflation meaning the erosion of the real value of only money and other monetary items over time; i.e. an erosion of the general purchasing power of money which is caused by/results in an increase in the general price level over time, and

(2) inflation meaning any single or non-general price increase.

1970–style Constant Purchasing Power Accounting (CPPA) inflation accounting was a popular but failed attempt at inflation accounting at the time. It was a form of inflation accounting which tried unsuccessfully to make corporate accounts more informative when comparing current transactions with previous transactions by updating all non–monetary items (without distinguishing between variable real value non–monetary items and constant real value non–monetary items) equally by means of the Consumer Price Index during high in the 1970´s. 1970–style CPPA inflation accounting was abandoned as a failed and discredited inflation accounting model when general inflation decreased to low levels thereafter.

Constant Item Purchasing Power Accounting (CIPPA) is not an inflation accounting model to be used during high and hyperinflation. IAS 29 requires CPPA for that. CIPPA is the IASB´s alternative to Historical Cost Accounting during low inflation and deflation . CIPPA implements financial capital maintenance in units of constant purchasing power to be used during low inflation and deflation which was authorized in IFRS in the original Framework (1989), Par 104 (a).

Nicolaas Smith

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

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May 26, 2011 in Uncategorized

Current inflation accounting

Presently, inflation accounting describes a complete price–level accounting model, namely the Constant Purchasing Power Accounting (CPPA) inflation accounting model defined, in principle, in IAS 29 Financial Reporting in Hyperinflationary Economies required to be implemented only during hyperinflation. Hyperinflation is an exceptional circumstance according to the IASB. Hyperinflation is defined in IFRS as cumulative inflation over three years approaching or equal to 100%, i.e. 26% annual inflation for three years in a row. IAS 29 serves to make Historical Cost and Current Cost financial statements more useful at the period-end by requiring all non–monetary items – variable real value non–monetary items and constant real value non–monetary items – to be restated at the period-end by measuring them in units of constant purchasing power by applying the period–end Consumer Price Index only during hyperinflation.

“In a hyperinflationary economy, reporting of operating results and financial position in the local currency without restatement is not useful. Money loses value at such a rate that comparison of amounts from transactions and other events that have occurred at different times, even within the same accounting period, is misleading.” IAS 29.2

The fallacy that inflation erodes the real value of non–monetary items is currently still generally accepted. It is still mistakenly accepted as a fact that the erosion of companies´ capital and profits is caused by inflation. “The erosion of business profits and invested capital caused by inflation” was clearly stated in FAS 33 and “the erosive impact of inflation on profits and capital” was stated in both FAS 33 and FAS 89.

Inflation has no effect on the real value of non–monetary items over time. Not inflation, per se, but the implementation of the very erosive stable measuring unit assumption as it forms part of the traditional Historical Cost Accounting model erodes the real value of constant real value non–monetary items never maintained constant over time as a result of insufficient revaluable fixed assets during low inflation and hyperinflation. There is no substance in the statement that inflation erodes the real value of non–monetary items which do not hold their real value over time. Inflation has no effect on the real value on non–monetary items.

The late Milton Friedman, US economist and Nobel Laureate, famously stated that “inflation is always and everywhere a monetary phenomenon.” Friedman was not the only economist who understood that.

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

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

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

The stable measuring unit assumption unknowingly, unintentionally and unnecessarily erodes and its rejection knowingly maintains (please note: not creates) the real value of constant real value non–monetary items (please note: not variable real value non–monetary items) depending on whether the IFRS–approved traditional Historical Cost Accounting model is chosen under which the very erosive stable measuring unit assumption is implemented for an unlimited period of time during indefinite inflation or the IFRS–authorized constant real value non–monetary item real value maintaining financial capital maintenance in units of constant purchasing power model (Constant Item Purchasing Power Accounting) under which it is selected to reject the stable measuring unit assumption at all levels of inflation and deflation for an unlimited period of time.

Inflation is a uniquely monetary phenomenon and can only erode the real value of money and other monetary items over time. It has no effect on the real value of non–monetary items. The traditional Historical Cost Accounting model unknowingly, unintentionally and unnecessarily do the eroding of the real value of constant real value non–monetary items never maintained constant over time, e.g. Retained Earnings, Issued Share capital, other items in Shareholder’s Equity, etc when financial capital maintenance in nominal monetary units as authorized in IFRS in the original Framework (1989), Par 104 (a) is chosen during low inflationary periods.

It is correct, essential and compliant with IFRS to update constant real value non–monetary items by means of the monthly change in the CPI which is a general price index during low inflation and deflation. The reason for this is that constant real value non–monetary items are expressed in terms of money, i.e. in terms of an unstable monetary unit of account which is the same as the unstable monetary medium of exchange within an economy or monetary union. Inflation erodes the real value of the unstable monetary medium of exchange – which is also the unstable monetary unit of account in accounting and the economy in general. Constant real value non–monetary items thus have to be updated or inflation–adjusted at a rate equal to the rate of low inflation or deflation, i.e. valued or measured in units of constant purchasing power, in order to maintain their real values constant during low inflation and deflation because the unit of measure in accounting is an unstable monetary unit of account and consequently hardly ever absolutely stable during periods of low inflation and deflation. Months of zero annual inflation are very few and far between. Sustainable zero annual inflation has never been achieved before and it does not seem very likely that it will be achieved any time soon in the future.

Variable real value non–monetary items do not need to be and are not valued in units of constant purchasing power during low inflation because they are valued in terms of GAAP or IFRS at, for example, fair value, market value, present value, recoverable value, net realizable value, etc which always automatically take inflation – amongst many other things – into account. Variable real value non–monetary items are only valued in units of constant purchasing power during hyperinflation as required by the IASB in IAS 29 since the Board regards hyperinflation as an exceptional circumstance.

There is a school of thought that 2% inflation is completely unharmful and that it has no disadvantages compared to absolute price stability (sustainable zero inflation). That is not correct. 2% inflation will erode, for example, 51% of the real value of all monetary items and all constant real value non–monetary items never maintained constant, e.g. Retained Profits never maintained constant, over 35 years – all else being equal – when the stable measuring unit assumption is implemented for an indefinite period of time during indefinite low inflation.

It is not necessary for accountants to inflation–adjust by means of the CPI, which is a general price index, variable real value non–monetary items (e.g. properties, plant, equipment, shares, raw material, etc.) which are subject to product specific price increases for the purpose of valuing these variable real value non–monetary items during the accounting period on a primary valuation basis during non–hyperinflationary periods. These variable real value non–monetary items are generally subject to market–based real value changes determined by supply and demand. They incorporate product specific price changes or product specific inflation where the word inflation is, very unfortunately, also used to simply mean a product or product group price increase instead of the general use of the word in economics to mean the erosion of the real value of money and other monetary items over time, i.e. an erosion of the general purchasing power of money which is caused by/results in an increase in the general price level over time. It is thus generally accepted in economics that the word inflation has two different meanings:

(1) inflation meaning the erosion of the real value of only money and other monetary items over time and

(2) inflation meaning any single or non-general price increase

1970–style Constant Purchasing Power Accounting (CPPA) inflation accounting was a popular but failed attempt at inflation accounting at the time. It was a form of inflation accounting which tried unsuccessfully to make corporate accounts more informative when comparing current transactions with previous transactions by updating all non–monetary items (without distinguishing between variable real value non–monetary items and constant real value non–monetary items) equally by means of the Consumer Price Index during high and hyperinflation. 1970–style CPPA inflation accounting was abandoned as a failed and discredited inflation accounting model when general inflation decreased to low levels thereafter.

Constant Item Purchasing Power Accounting (CIPPA) is not an inflation accounting model to be used during high and hyperinflation. IAS 29 requires CPPA for that. CIPPA is the IASB´s alternative to Historical Cost Accounting during low inflation and deflation . CIPPA implements financial capital maintenance in units of constant purchasing power to be used during low inflation and deflation which was authorized in IFRS in the Conceptual Framework (2010), Par 4.59 (a).

Nicolaas Smith

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

IAS 29 is fundamentally flawed

May 23, 2011 in Uncategorized

IAS 29 is fundamentally flawed

Inflation accounting describes financial capital maintenance in units of constant purchasing power as applied only during hyperinflation where under all non-monetary items (variable and constant real value non-monetary items) are updated daily in terms of a daily non-monetary index or in terms of a daily official or unofficial parallel rate, normally the US Dollar parallel rate. The Constant Item Purchasing Power Accounting model under which only constant items (not variable items) are measured in units of constant purchasing power by applying the monthly Consumer Price index ONLY during LOW inflation and deflation. CIPPA is not an inflation accounting model.

Hyperinflation, as defined in IFRS, is cumulative inflation approaching or equal to 100% over three years; i.e., 26% annual inflation for three years in a row. Inflation accounting is implemented in order to stop the erosion of real value in all non-monetary items (both variable and constant real value non-monetary items) caused by the implementation of the very erosive stable measuring unit assumption during hyperinflation.

Under the stable measuring unit assumption it is considered that changes in the purchasing power of money are not sufficiently important to require financial capital maintenance in units of constant purchasing power – normally during low inflation and deflation.

Most entities in low inflationary and deflationary economies implement the Historical Cost Accounting model that is based on the stable measuring unit assumption. This means that all balance sheet constant real value non-monetary items (e.g. shareholders´ equity, trade debtors, trade creditors, provisions, other non-monetary payables, other non-monetary receivables, etc.) and most (not all) income statement items are measured at their historical cost, i.e. financial capital maintenance is measured in nominal monetary units as authorized in IFRS. Some income statement items, e.g. salaries, wages, rentals, etc. are updated annually in terms of the CPI, but, are then paid on a monthly basis implementing the stable measuring unit assumption under HCA. It is impossible to maintain the real value of financial capital constant with financial capital maintenance in nominal monetary units per se during inflation, deflation and hyperinflation. Financial capital maintenance in nominal monetary units during inflation and deflation, although authorized in IFRS, is still a popular accounting fallacy not yet extinct.

Complete inflation accounting, i.e. the use of an accounting model to automatically stop the erosion of real value in all non-monetary items (variable and constant items) in all entities that at least break even, is only possible with financial capital maintenance in units of constant purchasing power by applying a daily non-monetary index or relatively stable daily parallel rate (please note NOT the monthly CPI) to the valuation of (please note NOT the “restatement of” Historical Cost or Current Cost period-end financial statements) all non-monetary items during hyperinflation.

This can be stated differently as follows: Only inflation accounting based on daily updating of all non-monetary items in terms of a daily index or daily parallel rate automatically maintains the real value of all non-monetary items in all entities that at least break even during hyperinflation; i.e. maintains the real of non-monetary economy stable during hyperinflation in the monetary unit / economy.

The best example of successful inflation accounting was the use in Brazil of a daily government-supplied non-monetary index to update all non-monetary items daily during the 30 years of very high and hyperinflation in that country from 1964 to 1994.

The IFRS response to the erosion of real value in non-monetary items caused by the implementation of the HCA model, i.e. the implementation of the stable measuring unit assumption, during hyperinflation is stated in IAS 29 Financial Reporting in Hyperinflationary Economies. IAS 29 requires entities operating in hyperinflationary economies, NOT to value or measure all non-monetary items in terms of a daily non-monetary index or a daily parallel rate, but, to simply restate HISTORICAL COST or Current Cost period-end financial statements in terms of the period-end CPI.

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

 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.

The best example of the failure of the implementation of IAS 29 to have any effect at all on a hyperinflationary economy was its application, as duely required by the Zimbabwean Stock Exchange, by listed companies on the ZSE. The Zimbabwean real or non-monetary economy imploded in tandem with Zimbabwe´s monetary unit and monetary economy despite the implementation of IAS 29. The IASB actually officially admitted / agreed that it was impossible to implement IAS 29 during severe hyperinflation in Zimbabwe.

On the other hand, a daily parallel rate was available till the last day of hyperinflation in Zimbabwe, which officially ended on 20th November, 2008, when Gideon Gono, the governor of the Reserve Bank of Zimbabwe issued regulations that closed down the ZSE which stopped the daily Old Mutual Implied Rate (OMIR) being available in Zimbabwe. The (normally unofficial) parallel rate – usually the US Dollar parallel rate, is an excellent, not a perfect, substitute for a daily non-monetary index in a hyperinflationary economy (currently Venezuela). The US Dollar parallel rate was available 24/7, 365 days a year during Zimbabwe´s hyperinflation. Right at the end, during severe hyperinflation when the CPI was not being published any more, the OMIR was still available on a daily basis.

IAS 29 is fundamentally flawed by simply requiring the restatement of HC or CC period-end financial statements in terms of the period-end CPI instead of daily valuation / measurement of all non-monetary items in terms of a daily Brazilian-style index or parallel rate.

Many people are requesting a fundamental review of IAS 29.

Nicolaas Smith

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

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May 21, 2011 in Uncategorized

Constant Item Purchasing Power Accounting is not inflation accounting

 

The world only goes round by misunderstanding. Charles Baudelaire

Inflation accounting describes an accounting model used during hyperinflation. The Constant Item Purchasing Power Accounting model is only used during low inflation and deflation. CIPPA is not an inflation accounting model.

Hyperinflation is defined in IFRS as cumulative inflation approaching or equal to 100% over three years; i.e., 26% annual inflation for three years in a row. Inflation accounting is implemented in order to stop the erosion of real value in all non-monetary items (both variable and constant real value non-monetary items) caused by the implementation of the very erosive stable measuring unit assumption during hyperinflation.

Implementing the stable measuring unit assumption implies that changes in the purchasing power of money are not considered as sufficiently important to require financial capital maintenance in units of constant purchasing power.

Most entities in low inflationary and deflationary economies implement the Historical Cost Accounting model that is based on the stable measuring unit assumption. This means that all balance sheet constant real value non-monetary items (e.g. shareholders´ equity, trade debtors, trade creditors, provisions, other non-monetary payables, other non-monetary receivables, etc.) and most (not all) income statement items are measured at their historical cost, i.e. financial capital maintenance is measured in nominal monetary units. Some income statement items, e.g. salaries, wages, rentals, etc. are updated annually in terms of the CPI, but, are then paid on a monthly basis implementing the stable measuring unit assumption under HCA.

IAS 29 Financial Reporting in Hyperinflationary Economies defines the inflation accounting model authorized in IFRS.

Nicolaas Smith

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

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May 18, 2011 in Uncategorized

The high inflation 1970´s

During the period of high inflation in the 1970´s various inflation accounting models were tried in an attempt to reflect in company financial reports the effect of high inflation on monetary and – mistakenly – non–monetary items too. Inflation has no effect on the real value of non–monetary items. It was not realized that it was simply the free choice of implementing the stable measuring unit assumption that was eroding the real value of existing constant real value non–monetary items never maintained constant as a result of insufficient revaluable fixed assets (revalued or not) during low inflation. The US FASB did mention the stable measuring unit assumption in FAS 89. The IASB never mentioned it in either IAS 6 or IAS 15. Everybody blamed inflation. “The erosion of business profits and invested capital caused by inflation” was clearly stated in FAS 33 and “the erosive impact of inflation on profits and capital” was stated in both FAS 33 and FAS 89.

“Relative to most changes in financial reporting, the changes required by Statement 33 were monumental. Because most accountants and users of financial statements have been inculcated with a model of financial reporting that assumes stability of the monetary unit, accepting a change of this consequence would take a lengthy period of time under the best of circumstances.” FAS 89, 1986, p 6.

The implementation of these changes was eventually made voluntary in FAS 89 and the “monumental” changes only materialized as far as the valuation of variable real value non–monetary items in terms of the requirements stipulated in International Financial Reporting Standards and US GAAP were concerned. These changes were developed and implemented by the IASB in the form of IAS and IFRS relating to the valuing of variable real value non–monetary items in the years that followed. The “monumental” changes envisaged in FAS 33 with regard to the valuation of existing constant real value non–monetary items never happened although they were authorized in IFRS in the Framework (1989), Par 104 (a). They were attempted in IAS 29 but with very little success to date. See the implementation of IAS 29 in Zimbabwe.

During the high inflation 1970´s inflation accounting described a range of accounting models designed to reflect the effect of changing prices on financial reporting. Changing prices included changes in specific prices (of variable real value non–monetary items) as well as changes in the general price level (CPI), – i.e., inflation – which ONLY resulted in the erosion of the purchasing power of monetary items (money and other monetary items) and nothing else. It was and still is generally accepted that inflation affects the real value of non–monetary items. That is not true. Inflation has no effect on the real value of non–monetary items. Inflation is a uniquely monetary phenomenon as so famously stated by Milton Friedman. It is not inflation, but, the selection of the HCA model which includes the implementation of the very erosive stable measuring unit assumption and financial capital maintenance in nominal monetary units (the first based on the fallacy that money is perfectly stable and the second based on the very popular IFRS–approved accounting fallacy that financial capital maintenance can be measured in nominal monetary units which is impossible per se during inflation and deflation) which unknowingly, unintentionally and unnecessarily erodes the real value of existing constant real value non–monetary items never maintained constant during low inflationary periods in the world´s constant real value non–monetary item economy. One of the inflation accounting models that was tried unsuccessfully in the 1970´s and 1980´s was Constant Purchasing Power Accounting (CPPA) under which all non-monetary items (variable and constant items) were measured in units of constant purchasing power by applying the period end CPI during high inflation.

The Financial Accounting Standards Board issued an exposure draft in the United States in January, 1975, that required supplemental financial reports on a Constant Purchasing Power Accounting inflation accounting price–level basis. The Securities and Exchange Commission in the USA proposed in 1976 the disclosure of the current replacement cost of amortizable, depletable and depreciable assets used for production as well as most inventories at the financial year–end. It also proposed the disclosure of the approximate value of amortization, depletion and depreciation as well as the approximate value of cost of sales that would have been accounted in terms of the current replacement cost of productive capacity and inventories.

Both supplemental Constant Purchasing Power Accounting inflation accounting financial statements and value accounting were experimented with in Canada. Australia tried both replacement–cost inflation accounting and CPP price–level inflation accounting. Netherland companies experimented with value accounting. Replacement–cost disclosures for equity capital financed items were considered in Germany. CPP inflation accounting supplemental financial statements were tried in Argentina. Brazil successfully used daily non–monetary indexes during high and hyperinflation to update constant real value non–monetary items and variable real value non–monetary items for the 30 years from 1964 to 1994. In the United Kingdom an original proposal of supplementary CPP financial accounting financial reports was replaced by the Sandilands Committee proposal for a value accounting approach for inventories, marketable securities and productive property. South Africa had published a discussion paper on value accounting at the time.

The FASB issued FAS 33 Financial Reporting and Changing Prices in 1979. It only applied to certain large, publicly held enterprises. No changes were to be made in the primary financial statements; the information required by FAS 33 was to be presented as supplementary information in published annual reports.

These companies were required to calculate and report:

a. Income from continuing operations reflecting the effects of general inflation

b. The purchasing power loss or gain on net monetary items.

c. Calculate income from continuing operations on a current cost basis

d. Calculate the current cost amounts of property, plant, equipment and inventory at the end of the fiscal year

e. Report increases or decreases in current cost amounts of property, plant, equipment and inventory, net of inflation.

FAS 89 Financial Reporting and Changing Prices superseded FASB Statement No. 33 in 1986 and made voluntary the supplementary disclosure of constant purchasing power/current cost information.

Nicolaas Smith

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

What price stability?

May 16, 2011 in Uncategorized

What price stability?

 

“The South African Reserve Bank is the central bank of the Republic of South Africa. It regards its primary goal in the South African economic system as the achievement and maintenance of price stability.

The South African Reserve Bank conducts monetary policy within an inflation targeting framework. The current target is for CPI inflation to be within the target range of 3 to 6 per cent on a continuous basis.” SA Reserve Bank.

Absolute price stability is a year–on–year increase in the Consumer Price Index of zero percent. Alan Greenspan defines price stability as follows:

“Price stability obtains when economic agents no longer take account of the prospective change in the general price level in their economic decision–making.”

http://www.kansascityfed.org/PUBLICAT/SYMPOS/1996/pdf/s96green.pdf

, Page 1.

It can be deduced from Alan Greenspan´s excellent definition that price stability can be defined as permanently sustainable zero per cent per annum inflation.

A year–on–year increase in the CPI of above zero but below 2% is a high degree of price stability – it is not absolute price stability.

  

The ECB´s Governing Council has announced a quantitative definition of price stability:

Price stability is defined as a year–on–year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%.

The Governing Council has also clarified that, in the pursuit of price stability, it aims to maintain inflation rates below, but close to, 2% over the medium term.” European Central Bank

http://www.ecb.int/mopo/strategy/pricestab/html/index.en.html

A below 2% year–on–year increase in the European Monetary Union’s harmonized CPI is the European Central Bank’s chosen definition of price stability. It is not the factual definition of absolute price stability. The SARB´s chosen definition of price stability is for “inflation to be within the target range of 3 to 6 per cent on a continuous basis”.

Accounting, on the other hand, solve the problem of the fact that the monetary unit is never perfectly stable on a sustainable basis by simply assuming that the monetary unit is perfectly stable in the world´s low inflationary economies, but, only for the purpose of valuing balance sheet constant real value non–monetary items and most income statement items which are accounted as Historical Cost items: they are measured in nominal monetary units. In conformity with world practice the stable measuring unit assumption is not applied of the valuing of certain (not all) Income Statement constant real value non–monetary items, namely salaries, wages, rentals, etc. which are measured in units of constant purchasing power on an annual basis in terms of the CPI. These items annually updated items are then paid on a monthly basis again applying the stable measuring unit assumption; they are not updated monthly in terms of the monthly change in the annual rate of inflation. Other income statement items are valued in nominal monetary units, i.e. at HC.

Changes in the general purchasing power or real value of the monetary unit are not regarded to be sufficiently important to continuously measure financial capital maintenance in units of constant purchasing power authorized in IFRS in the original Framework (1989), Par 104 (a). Financial capital maintenance in nominal monetary units (HCA) is generally chosen under which the very erosive stable measuring unit assumption is implemented, also authorized in IFRS in the Framework (1989), Par 104 (a). It is impossible to maintain the existing constant real non-monetary value of existing capital constant by measuring financial capital maintenance in nominal monetary units per se during low inflation or deflation. Financial capital maintenance in nominal monetary units per se during inflation and deflation is a fallacy.

However, this led to the general implementation of the traditional Historical Cost Accounting model during non–hyperinflationary periods. Both variable real value non–monetary items stated at HC in terms of IFRS or GAAP, as well as constant real value non–monetary items also stated at HC in terms of the HCA model, are measured in nominal monetary units during non–hyperinflationary periods. Both HC variable and HC constant real value non–monetary items are thus considered to be simply HC non–monetary items.

There is a fixation in financial reporting that measurement in units of constant purchasing power simply means adjusting HC or CC period-end financial statements in terms of the period-end CPI mainly to make current year financial statements more useful only during hyperinflation. This is called restatement. Measurement in units of constant purchasing power is almost always automatically thought of as inflation accounting applied only during hyperinflation as defined in IAS 29 Financial Reporting in Hyperinflationary Economies. Measurement in units of constant purchasing power is not automatically thought of as affecting the fundamental constant real non-monetary values of existing constant real value non-monetary items (e.g. salaries, wages, rentals, shareholders´ equity, trade debtors, trade creditors, taxes payable, taxes receivable, etc.) in a double entry accounting model although that is what is done with world wide annual measurement in units of constant purchasing power of salaries, wages, rentals, etc. The two processes are seen as different processes – when, in principle, they are not.

Under Constant Item Purchasing Power Accounting financial capital maintenance is measured in units of constant purchasing power as authorized in IFRS. Only constant real value non-monetary items (not variable real value non-monetary items) are measured in units of constant purchasing power in terms of the monthly CPI. CIPPA automatically maintains the existing constant real value of all constant items constant for an indefinite period of time in all entities that at least break even during low inflation and deflation, 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.

Money illusion

May 16, 2011 in Uncategorized

Money illusion

This is the result of money illusion. People make the mistake of thinking that money is stable in real value over time in a low inflationary environment. Inflation always and everywhere erodes the real value of money and other monetary items over time. It is thus impossible for money to be stable in real value during inflation. On the other hand, inflation has no effect on the real value of non–monetary items over time.

The monetary unit of measure in accounting is the base money unit of the most relevant currency. Money is not stable in real value during inflation. This means that the monetary unit of measure in accounting is not a stable unit of measure during inflation and deflation. Money, i.e., the unstable monetary unit of measure or unstable monetary unit of account is the only generally accepted unit of measure that is not an absolute value. Money does not contain a fundamental constant. All other generally accepted units of measure of time, distance, velocity, mass, momentum, energy, weight, etc are absolute values, e.g. second, minute, hour, metre, yard, litre, kilogram, pound, mile, kilometre, inch, centimetre, gallon, ounce, etc.

Nicolaas Smith

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

No split of non-monetary items under the HCA model

May 14, 2011 in Uncategorized

No split of non-monetary items under the HCA model

The world only goes round by misunderstanding. Charles Baudelaire

It is generally accepted under the current Historical Cost paradigm that the economy is divided in two parts: the monetary economy and the non–monetary or real economy. It is also generally accepted that there are only two basic economic items in the economy: monetary items and non–monetary items. Monetary items are money held and items with an underlying monetary nature. Non–monetary items are all items that are not monetary items.

No distinction is generally made between the valuation of variable real value non–monetary items, e.g. property, plant, equipment, inventory, etc, valued at Historical Cost under the Historical Cost Accounting model and constant real value non–monetary items, e.g. Issued Share capital, Retained Earnings, other items in Shareholders´ Equity and most items in the income statement (excluding items like salaries, wages, rentals, etc. valued in units of constant purchasing power) also valued at Historical Cost under the HCA model.

This is the result of the fact that the economy is based on the Historical Cost paradigm. Historical Cost is the traditional measurement basis in accounting. It is thus generally accepted for entities to choose to implement the very erosive stable measuring unit assumption (based on a fallacy) and measure financial capital maintenance in nominal monetary units (another complete fallacy) as authorized by the IFRS in the Framework (1989), Par 104 (a) during low inflationary periods.

  

One of the basic principles in accounting is “The Measuring Unit principle:

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

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

However, non–monetary items are not all fundamentally the same. Non–monetary items are, in fact, subdivided into variable real value non–monetary items and constant real value non–monetary items. The three fundamentally different basic economic items are monetary items, variable real value non–monetary items and constant real value non–monetary items although it is generally accepted under the HC paradigm that there are only two basic economic items, namely, monetary and non–monetary items.

All non–monetary items stated at HC, whether they are variable real value non–monetary HC items (e.g. land and buildings stated at HC) or constant real value non–monetary HC items (e.g. shareholders´ equity stated at HC) are regarded to be fundamentally the same, namely, simply non–monetary items when the very erosive stable measuring unit assumption is implemented as part of the traditional HCA model during low inflationary periods.

Nicolaas Smith

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

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May 14, 2011 in Uncategorized

Price–level accounting does not prevail for balance sheet constant items during low inflation

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. 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 real value non–monetary items salaries, wages, rentals, etc are concerned since they are updated 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; i.e. they are not updated monthly in terms of the CPI.

In terms of the Historical Cost Accounting model the stable measuring unit assumption is implemented under which balance sheet constant real value non–monetary items are valued at historical cost, i.e. in nominal monetary units thus eroding the existing constant real value of these constant real value non–monetary items when their existing constant real non–monetary values are never maintained as a result of insufficient revaluable fixed assets (revalued or not) under the HC paradigm 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 real value non–monetary items and constant real value non–monetary items) in their non–monetary or real economy with daily indexation 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. Brazil stopped daily indexation during hyperinflation which is, in principle, continuous financial capital maintenance in units of constant purchasing power during hyperinflation. They should have changed from daily indexation of all non-monetary items (variable and constant real value non-monetary items) during hyperinflation to financial capital maintenance in units of constant purchasing power (CIPPA) during low inflation where under only constant items (not variable items) are measured in units of constant purchasing power by applying the monthly CPI.

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

As quoted in FAS 33 p. 29.
Shareholder’s equity forms part of an entity’s financial resources.

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

Shareholders´ equity is a financial resource with a constant real non–monetary value expressed in terms of an unstable monetary unit of measure under the HCA model. The IASB statement in the Framework (1989), Par 104 (a) that “financial capital maintenance can be measured in nominal monetary units” is clearly a fallacy since it is impossible to maintain the existing constant real non–monetary value of capital constant “in nominal monetary units” during inflation and deflation.

There is no substance in the claim that the existence and value of economic resources, for example shareholders´ equity items, exists 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, 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 does affect the economy. That is generally known and a fact.

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

Nicolaas Smith

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