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Money illusion

June 30, 2011 in Uncategorized

Money illusion

  

 

Definition: Money illusion is the mistaken belief that money is stable in real value over time.

 

Money illusion is primarily evident in low inflation countries. In hyperinflationary countries there is absolutely no money illusion as far as the hyperinflationary national currency is concerned. Everyone knows as a fact that the local hyperinflationary currency loses value day by day and even hour by hour. In low inflationary countries people are vaguely aware that money loses value over a long period of time. Money in a low inflationary economy is often used as if its real value is completely stable over the short term. That is money illusion.

 

Money illusion is evident everywhere in low inflationary economies. TV presenters reporting on historical events regularly quote Historical Cost values as the most natural thing to do. “Marble Arch was built for 10 000 Pounds” the TV reporter states with sincere knowledge that his audience is being well entertained with correct facts and figures. It is a figure very difficult to instantaneously value today. 10 000 British Pounds was the original cost in historical terms but we live today and absolutely no–one can immediately imagine what the construction cost of Marble Arch was in current terms. It is the same as saying that something cost one Pound 300 years ago. It is impossible to immediately value it now. We live now and not 300 years in the past. We don’t know what some–one bought for a Pound 300 years ago. People in the United Kingdom know what a person can buy for one Pound now – and the Pound’s value changes month after month within the UKeconomy as indicated by the monthly change in the CPI.

 

Companies report an unending stream of information about their performance and results. Sales increased by 5 per cent over last year’s figures, for example. Are these historical cost comparisons or real value comparisons? It is more never than hardly ever stated.

 

Money illusion is very, very common in our low inflationary economies. Another example: The BBC ran a program about the fantastic E–Type Jaguar. The presenter stated that one of the many reasons why the E–type Jag – the best car ever, according to the presenter – was such a success, was its original nominal price of 2 500 Pounds at the time of its first introduction into the market. Towards the end of the program it is then stated that a number of years later these same original E–Type Jags sold at a nominal price at that time of 25 000 Pounds. It is thus implied to be 10 times more than the original price of 2 500 Pounds. In nominal terms, yes. We all agree. Certainly not in real terms and we are interested in real values. Nominal profits – however fantastic they may look – are misleading the longer the time period and the higher the rate of inflation or hyperinflation in the transaction currency during the time period involved.

 

In this example we are all led to believe that the E–Type Jag was sold at a real value 10 times its original real value. It is notorious money illusion at work. The real value in a sale like that certainly would not be 10 times the original real value once the original nominal price is adjusted for the effect of the stable measuring unit assumption – the assumption that money is stable in real value over time – as related to the British Pound over the years in question.

Nicolaas Smith

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

Deflation

June 28, 2011 in Uncategorized

Deflation

Deflation is a sustained absolute annual decrease in the general price level of goods and services. Deflation happens when the annual inflation rate falls below zero percent (a negative annual inflation rate), resulting in an increase in the real value of money and all other monetary items. Deflation allows one to buy more goods with the same amount of money. This should not be confused with disinflation, a slow–down in the annual inflation rate (i.e. when annual inflation decreases, but still remains positive). Disinflation is a decrease in the annual rate of increase in the general price level. Annual inflation erodes the real value of money and other monetary items over time; conversely, annual deflation increases the real value of money and other monetary items in a national or regional economy over a period of time.

Inflation and deflation are both undesirable economic processes. As far as the understanding of inflation and deflation allows us at the moment, it can be stated that whatever level of deflation – however low – is to be avoided completely. A low level of inflation in an economy with financial capital maintenance in units of constant purchasing power (CIPPA) as the fundamental model of accounting implementing IFRS, is the best practice: a low level of inflation (best practice is currently regarded as 2% annual inflation) to limit the erosion of real value in money and other monetary items; IFRS for the correct valuation of variable real value non–monetary items and, thirdly, financial capital maintenance in units of constant purchasing power (CIPPA) as authorized in IFRS for automatically maintaining the existing constant real values of existing constant real value non–monetary items constant forever during low inflation and deflation in all entities that at least break even – ceteris paribus – without the requirement for extra capital or extra retained profits simply to maintain the existing constant real value of existing constant real value non–monetary items (e.g. equity) constant. Net monetary losses and gains are calculated and accounted in the income statement during low inflation and deflation when CIPPA is implemented: basically, the cost of inflation is accounted as a loss and deducted from profit before tax. Reducing the holding of monetary items (cash and other monetary items) over time would reduce the net monetary loss to a minimum during low inflation.

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

Nicolaas Smith

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

Net monetary gains and losses

June 27, 2011 in Uncategorized

Net monetary gains and losses

 

  

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

 

 

Net monetary gains and losses are calculated and accounted during hyperinflation as required by IAS 29 Financial Reporting in Hyperinflationary Economies. The calculation and accounting of net monetary gains and losses have also been authorized in IFRS with the measurement of financial capital maintenance in units of constant purchasing power in the original Framework (1989), Par 104 (a) during low inflation and deflation, i.e. under the Constant Item Purchasing Power Accounting model. Net monetary gains and losses are not required to be computed under the traditional Historical Cost Accounting model although it can be done.

 

 

“Computing the gains or losses from holding monetary items can be done and the information disclosed when the books are maintained on a historical–cost basis.”

 

 

Harvey Kapnick, Chairman of Arthur Anderson & Company, Value based accounting: Evolution or revolution, Saxe Lecture, 1976, Page 6.

 

 

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

 

 

Net monetary gains and losses are constant real value non–monetary items once they are accounted in the income statement. All items accounted in the income statement are constant real value non–monetary items.

 

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

 

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

 

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

 

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

Nicolaas Smith

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

test

June 25, 2011 in Uncategorized

Inflation is always and everywhere a monetary phenomenon

Milton Friedman, A monetary history of the United States 1867 – 1960 (1963)

Inflation is a sustained annual increase in the general price level of goods and services in an economy. Prices are generally quoted in terms of money. During inflation each unit of the monetary unit buys fewer goods and services; consequently, annual inflation only erodes the real value of each monetary medium of exchange unit evenly over time. Inflation has no effect on the real value of non–monetary items.

Inflation erodes real value evenly in money and other monetary items over time. There are, consequently, hidden monetary costs to some and hidden monetary benefits to others from this erosion in purchasing power in monetary items that are assets to some while – a the same time – liabilities to others; e.g. the capital amount of a loan. The debtor (in the case of a monetary loan) gains during inflation since he, she or it (a company) has to pay back the nominal value of the loan, the real value of which is being eroded by inflation. The debtor (of a monetary loan) pays back less real value during inflation. The creditor (in the case of a monetary loan) loses out because he, she or it receives the nominal value of the loan back, but, the real value paid back is lower as a result of inflation. Efficient lenders recover this loss in real value by charging interest at a rate they hope will be higher than the actual inflation rate during the period of the loan.

An increase in the general price level (inflation) erodes the real value of money and other monetary items with an underlying monetary nature, e.g. the capital values of bonds and loans. However, inflation has no effect on the real value of variable real value non–monetary items (e.g. property, plant, equipment, cars, gold, inventories, finished goods, foreign exchange, etc.) and constant real value non–monetary items (e.g. issued share capital, retained profits, capital reserves, other shareholder equity items, salaries, wages, rentals, pensions, trade debtors, trade creditors, taxes payable, taxes receivable, deferred tax assets, deferred tax liabilities, dividends payable, dividends receivable, etc.).

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

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

Nicolaas Smith

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

CIPPA update: June 2011

June 24, 2011 in Uncategorized

CIPPA update: June 2011

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

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

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

The reason capital maintenance in units of constant purchasing power never went ahead was because non-monetary items were not yet split in variable and constant items in 1986. I identified the split in 2005 and it was peer reviewed (three times) and published in SAICA´s journal Accountancy SA in September, 2007: ” Financial Statements, Inflation & the Audit Report: Accountancy SA article – Sept 2007

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

A lot of that is still to come.

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

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

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

Then practical implementation.

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

I have absolutely no doubt that this will happen. Even if the book is not published now in SA, then I will simply find out (I am not an academic at an academic institution) which peer reviewed journal is the number one accounting journal, find out how to write an acceptable article and have it published. I know they will publish the article.  I will do this for some other top accounting journals and then submit the proposal

Nicolaas Smith

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

Money makes the world go round

June 22, 2011 in Uncategorized

Money makes the world go round

Money is the greatest economic invention of all time. Money did not exist and was not discovered. Money was invented over a long period of time.

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

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

Bank notes and coins are physical tokens of money. Money is a monetary item which is used as a monetary medium of exchange and serves at the same time as a monetary store of value and as the monetary unit of account for the accounting of economic activity in a country or a monetary union. All three basic economic items – monetary items, variable real value non–monetary items and constant real value non–monetary items – are valued in terms of money. The European Monetary Union uses the Euro as its monetary unit. The US Dollar is the monetary unit most widely traded internationally. The Rand Common Monetary Area which includes South Africa, Namibia, Swaziland and Lesotho employs the Rand as the common monetary unit and monetary unit of account.

An earlier form of money was commodity money; e.g. gold, silver and copper coins. Today money is generally fiat money created by government fiat or decree.

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

Money is the only unit of measure that is not a stable value under all circumstances. Money is only perfectly stable in real value at zero per cent annual inflation. This has never been achieved over a sustainable period of time. All other units of measure are fundamentally stable units of measure, e.g. inch, centimetre, ounce, gram, kilogram, pound, etc.

Nicolaas Smith

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

CIPPA increases a company’s net asset value

June 21, 2011 in Uncategorized

CIPPA increases a company’s net asset value 

 

A company’s capital is synonymous with its Net Assets or Shareholders Equity under a financial concept of capital such as invested money or invested purchasing power. The Net Asset Value is equal to Assets minus Liabilities. A listed company can have a market capitalization below, equal to or above its net asset value.

 

The intrinsic value of a company is its actual value based on an underlying perception of its true value including all aspects of the business, in terms of both tangible and intangible factors.

 

 Most often intrinsic worth is estimated by analyzing a company’s fundamentals.

Intrinsic value is the actual value of company, as opposed to its market price or book value (net asset value). The intrinsic value includes other variables such as brand names, trademarks and copyrights that are often difficult to calculate and sometimes not accurately reflected in the market price. One way to look at it is that the market capitalization is the price (i.e. what investors are willing to pay for the company) and intrinsic value is the value (i.e. what the company is really worth). Different investors use different techniques to calculate intrinsic value.

 

There is no single, universally accepted way to obtain this figure.

 

The intrinsic value of most companies will not simply increase at the moment of changeover to CIPPA with a change in accounting policy from the traditional Historical Cost Accounting model to measuring financial capital maintenance in units of constant purchasing power during low inflation and deflation because CIPPA only increases the net asset value of most companies over time in the future as compared to continuing with the traditional HCA model.

 

This is the case for those companies which do not have 100% of the updated original real values of all contributions to Shareholders´ Equity invested during low inflation in revaluable fixed assets with an equivalent updated fair value (revalued or with unrecorded holding gains) in order not to erode Shareholders Equity’s original real value under the traditional Historical Cost Accounting model implemented by most companies.

 

Example

 

Historical Cost Accounting

 

Opening balances

 

Capital                       1000

Retained Earnings        1000

Equity                        2000

Liabilities                        0

                                2000

 

Fixed Assets             1000

Trade Debtors           1000

Assets                     2000

 

Net Asset Value = Assets – Liabilities = Equity

 

                           = [Fixed Assets + Trade Debtors] – Liabilities = [Capital + Retained Earnings]

 

                           = [1000 + 1000] – 0 = [1000 + 1000]

                          

                           = 2000

 

Assumptions: 10% inflation during the next financial year.

 

                        Fixed Assets revalued at a rate equal to the inflation rate (only to simplify the example)

                       No other changes

 

At the end of the financial year:

 

Capital                          1000

Revaluation Reserve         100

Retained Earnings           1000

Equity                           2100

Liabilities                           0

                                   2100

 

Fixed Assets                 1100

Trade Debtors               1000

Assets                         2100

 

Net Asset Value = Assets – Liabilities = Equity

 

                           = [Fixed Assets + Trade Debtors] – Liabilities = [Capital + Retained Earnings]

 

                           = [1100 + 1000] – 0 = [1100 + 1000]

 

                           = 2100

 

Constant Item Purchasing Power Accounting

 

Opening balances are the same.

 

Assumptions are the same.

 

At the end of the financial year:

 

Capital                       1100

Retained Earnings        1100

Equity                        2200

Liabilities                        0

                                2200

 

Fixed Assets             1100

Trade Debtors           1100

Assets                     2200

 

Net Asset Value = Assets – Liabilities = Equity

 

                           = [Fixed Assets + Trade Debtors] – Liabilities = [Capital + Retained Earnings]

 

                          = [1100 + 1100] – 0 = [1100 + 1100]

 

                           = 2200

 

CIPPA increases the future net asset value of most companies compared to continuing with the current HCA model.

 

This will increase the net asset value of most companies listed on stock exchanges and most unlisted companies in the world economy.

 

When entities change the way they value constant real value non–monetary items from valuation in nominal monetary units to valuation in units of constant purchasing power they generally increase the net asset values of their companies. This increases the intrinsic and market values of companies.

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

HCA is not an appropriate accounting policy

June 18, 2011 in Uncategorized

HCA is not an appropriate accounting policy

Auditors state in the audit report that the directors´ responsibility for the financial statements includes selecting and applying appropriate accounting policies. The audit report also normally states under the Auditors´ Responsibility that an audit includes evaluating the appropriateness of accounting policies used in a company. So, both the directors and the auditors have a responsibility with regards to the appropriateness of accounting policies for a company.

The implementation of the very erosive stable measuring unit assumption which is based on a fallacy and financial capital maintenance in nominal monetary units per se which is a fallacy during inflation and deflation means that the use of the HCA model is – in principle – not an appropriate accounting policy for companies during inflation and deflation.

The IASB, on the one hand, agrees that the stable measuring unit assumption and financial capital maintenance in nominal monetary units per se are not appropriate accounting policies in hyperinflationary economies.

IAS 29 Financial Reporting in Hyperinflationary Economies states that:

“In a hyperinflationary economy, reporting of operating results and financial position in the local currency without restatement is not useful. Money loses purchasing power at such a rate that comparison of amounts from transactions and other events that have occurred at different times, even within the same accounting period, is misleading.” IAS 29 Par 2

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

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

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

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

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

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

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

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

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

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

and

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

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

Nicolaas Smith

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

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

June 17, 2011 in Uncategorized

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

Audited annual financial statements provided by companies which prepare them using the traditional Historical Cost Accounting model, i.e., when the board of directors choose to measure financial capital maintenance in nominal monetary units during low inflation and deflation instead of in units of constant purchasing power in terms of the IASB´ original Framework (1989), Par 104 (a), are compliant with IFRS, but, do not – in principle – fairly present the financial position of the companies.

The SA Companies Act, No 71 of 2008, Article 29.1 (b), for example, states:

If a company provides any financial statements, including any annual financial statements, to any person for any reason, those statements must –

(b) present fairly the state of affairs and business of the company, and explain the transactions and financial position of the business of the company;”

Audited financial statements prepared in terms of the HCA model do not – in principle – fairly present the financial position of companies during low inflation when the directors do not:

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

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

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

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

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

(6) state the change in the updated constant real non-monetary value of Shareholders´ Equity if the directors should decide – as they are freely allowed to do at any time – to measure financial capital maintenance in units of constant purchasing power which would automatically maintain the constant purchasing power of Shareholders´ equity constant forever in entities that at least break even during inflation and deflation – ceteris paribus – instead of in nominal monetary units also authorized in IFRS in the original Framework (1989), Par 104 (a);

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

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

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

Nicolaas Smith

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

Three concepts of capital maintenance under IFRS

June 16, 2011 in Uncategorized

Three concepts of capital maintenance under IFRS

The board of directors has to implement the current cost measurement basis, in terms of Par 4.61, if the entity chooses a physical concept of capital.

The Conceptual Framework (2010) does not, on the other hand, prescribe a specific measurement basis when the board of directors chooses one of the two financial capital maintenance concepts. The board of directors is given a choice between the Constant Item Purchasing Power Accounting model and the Historical Cost Accounting model in the Conceptual Framework (2010), Par 4.59 (a) which states:

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

The board of directors has to choose. The board of directors is not forced by IFRS to choose the Historical Cost Accounting model. It is a free choice made by the board of directors on behalf of the company and the company’s shareholders. The board is also free to choose financial capital maintenance in units of constant purchasing power (CIPPA) during low inflation and deflation – any time the entity wants to.

In terms of Par 4.61, the “selection” of the measurement basis (it is thus a free choice) of financial capital maintenance depends on what type of financial capital the company wants to maintain. There is thus more than one type of financial capital in terms of the Conceptual Framework (2010), Par 4.61. If there is more than one type of financial capital, then there is, logically, more than one type of financial capital maintenance concept too.

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

• (A) Physical capital

• (B) Nominal financial capital

• (C) Constant purchasing power financial capital

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

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

(2) Financial capital maintenance in nominal monetary units (Historical Cost Acounting): authorized by IFRS but not prescribed – optional during low inflation and deflation. See Par 4.59 (a)

(3) Financial capital maintenance in units of constant purchasing power (CIPPA): authorized by IFRS but not prescribed – optional during low inflation and deflation. See Par 4.59 (a). Prescribed in IAS 29 during hyperinflation.

The board of directors chooses, in terms of Par 4.59 (a), to measure financial capital maintenance in units of constant purchasing power (the CIPPA model) or in nominal monetary units (the HCA model). Most boards choose HCA – at the moment.

The main difference, according to the original Framework Par 107, between the physical and financial concepts of capital is the way changes in the prices of assets and liabilities are treated. According to Par 107, a company’s capital has been maintained when the entity has as much equity at the close of the accounting period as it had at the start of the period. Any value at the end of the period more that what is required for capital maintenance is profit. As stated before: this is only true and correct per se in real value terms, i.e. under financial capital maintenance in units of constant purchasing power (CIPPA) during low inflation and deflation. Financial capital maintenance in nominal monetary units per se is a fallacy during inflation and deflation.

In terms of them original Framework (1989), Par 108, the increase in nominal monetary capital during the accounting period is the profit for the period when capital is defined in terms of nominal monetary units under the financial capital maintenance concept. This is obviously not correct in real terms. Hidden or unrecognised gains in asset prices during the accounting period (so–called holding gains) are in principle profits according to Par 108. These holding gains are normally only recognised when the items are sold some time in the future. This confirms the concept put forward in this book that financial capital maintenance in nominal monetary units is only possible during inflation and deflation when 100% of the updated original real value of all contributions to shareholders´ equity is invested in revaluable fixed assets (revalued or not).

In the case of defining the financial capital maintenance concept in terms of units of constant purchasing power, the increase in invested purchasing power during the accounting period represents profit. This means that profit is only the part of asset price increases which is greater than the annual inflation rate according to the original Framework (1989), Par 108.

According to Par 110, the choice of capital maintenance concept and measurement bases will indicate the accounting model implemented in the preparation of the financial reports. The Framework applies to various different accounting models. It is a guide in the preparation and presentation of the financial reports presented in terms of the chosen accounting model. The IASB does not intend to stipulate a specific accounting model during non–hyperinflationary periods. It does however authorize both the HCA model and the CIPPA model as alternative options during low inflation and deflation in the original Framework (1989) Par 104 (a). It does, however, specifically require the Constant Purchasing Power Accounting (CPPA) inflation accounting model as defined in IAS 29 during hyperinflation – which is an exceptional circumstance – under which all non–monetary items (variable and constant real value non–monetary items) are updated by means of the period–end CPI. The IASB also specifically requires the implementation of the Current Cost Accounting model when companies choose the physical capital maintenance concept. According to the original Framework (1989), Par 110, world developments in accounting will determine whether the IASB will change its policy in this regard.

Nicolaas Smith

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