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TIPS

August 31, 2011 in Uncategorized

TIPS

Treasury Inflation–Protected Securities (TIPS) are inflation–adjusted or inflation–indexed money loans to the US government. The U.S. Treasury started issuing TIPS in January 1997. The United Kingdom has been issuing inflation-indexed bonds since 1981 and Canada since 1991. The United States of America has thus been a relatively late starter in the inflation-indexed government bond market. Unlike normal nominal Treasury Bonds, these TIPS offer investors protection against inflation as well as the opportunity to gain from deflation, but, only as far as the capital amount of the loan is concerned. Both the semi-annual coupons (interest payments) and the capital repayments of TIPS are adjusted for changes in the Consumer Price Index during inflation. Only the capital amount of the loan is maintained fixed in nominal value during deflation allowing the investor to automatically gain from the creation of real value in money during a deflationary period. This is not possible with the interest paid on the loan. The interest paid is maintained constant in real value during inflation and deflation. There is thus no automatic gain in the real value of TIPS interest during deflation.

If at maturity the inflation-indexed capital amount is less than the par amount of the security (due to deflation), the final payment of the principal will not be less than the par amount of the security at issuance. In such a circumstance, the Treasury will pay an additional amount at maturity so that the additional amount plus the inflation-indexed capital amount will equal the par amount of the security on the date of original issuance

Nominal Treasury Bonds would gain from the fact that deflation creates real value in nominal monetary items in both the principal and in interest payments.

The coupon paid out is the fixed rate coupon times the compounded rate of inflation from the date of issue. The capital amount repaid is the par amount or the par amount times the compounded rate of inflation from the date of the issue, whichever is greater.

TIPS are inflation-indexed in terms of the US non-seasonally adjusted Consumer Price Index for All Urban Consumers (NSA CPI-U). The CPI-U for a particular calendar month is only published during the following calendar month. The inflation-indexed coupon and capital repayments are thus paid in terms of a TIPS Daily Consumer Price Index which is a lagged daily interpolation of the CPI-U with a two month lag. The CPI-U index value used for the calculation of the DCPI on the first day of a calendar month is the CPI-U of three months before.

The TIPS DCPI value calculated for any given day in a calendar month is the daily interpolation of the CPI-U index value (of three months before) used at the beginning of the calendar month and the CPI-U index value (of three months before) used at the beginning of the following calendar month.

A country which issues inflation-indexed government bonds and uses a one or two month lagged interpolated Daily Consumer Price Index to determine the daily price of these bonds can use the DCPI for the implementation of financial capital maintenance in units of constant purchasing power during inflation and deflation (CIPPA). A DCPI is not automatically a monetized daily indexed unit of account like the Unidad de Fomento in Chile. A DCPI is simply a lagged daily interpolation of the CPI.

See A TIPS Valuation Framework, Lehman Brothers, Fixed Income Research, US Interest Rate Strategy, 2006.

Nicolaas Smith

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

Historical Cost Illusion

August 30, 2011 in Uncategorized

Historical Cost illusion

The illusion that it is possible to measure financial capital maintenance in nominal monetary units per se during inflation and deflation.

The illusion that it is possible to maintain the real value of capital in nominal monetary units per se during inflation and deflation.

Financial capital maintenance in nominal monetary units per se during inflation and deflation is a fallacy. It is impossible to maintain the real value of capital in nominal monetary units per se during inflation and deflation. That is only possible

(1) under sustainable zero annual inflation which has never been achieved in the past and is not likely soon to be achieved in the future and

(2) in entities which always invest 100% of the updated original constant real value of shareholders ´ equity in revaluable fixed assets with an equivalent updated fair value (revalued or not). This mostly only applies to property companies, hotel, hospital and other property–intensive entities.

Financial capital maintenance in nominal monetary units was authorized in IFRS in the original Framework (1989), Par 104 (a). It was unnecessarily implemented by Chile when that country started compliance with IFRS in 2008.

Chilean companies maintained the real value of their capital constant in units of constant purchasing power in terms of the Unidad de Fomento which is a monetized daily indexed unit of account under the “correción monetaria” regime before 2008, and then stopped doing that to comply with IFRS.

FRS compliance very unfortunately stopped financial capital maintenance in units of constant purchasing power in Chile. Fortunately, IFRS compliance did not stop the Unidad de Fomento.

Financial capital maintenance in units of constant purchasing power is also authorized in IFRS in the exact same original Framework (1989), Par 104 (a) which states:

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

Chilean companies can thus go back to maintaining the real value of their capital in units of constant purchasing power as they did before 2008 and they will still comply with IFRS.

Financial capital maintenance in units of constant purchasing power (CIPPA) automatically maintains the constant purchasing power of capital constant forever in all entities that at least break even in real value during inflation and deflation – ceteris paribus – whether they own any revaluable fixed assets or not.

Nicolaas Smith

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

Chile´s fundamental accounting mistake

August 29, 2011 in Uncategorized

Chile´s fundamental accounting mistake

“Chilean companies maintained the real value of their capital constant in units of constant purchasing power under monetary correction´s regime, and then stopped doing that to comply with IFRS.”

In my opinion it was a serious mistake for Chilean companies to have stopped financial capital maintenance in units of constant purchasing power as from 2008 when it had been authorized in 1989 in the International Accounting Standard Board´s original Framework for the Preparation and Presentation of Financial Statements, Par 104 (a) which states:

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

The above paragraph is maintained in the IASB´s current Conceptual Framework (2010), Par 4.59 (a). The IASB and the US FASB have been working together over the last six years on a joint program to update the Conceptual Framework in IFRS. The FASB has informed me that the Capital Maintenance paragraphs would most probably stay the same.

I think I can explain why Chile unknowingly, unintentionally and unnecessarily abandoned financial capital maintenance in units of constant purchasing power in favour of financial capital maintenance in nominal monetary units in 2008.

The short explanation is that Chile simply wanted to comply with IFRS and that financial capital maintenance in nominal monetary units is the generally accepted capital maintenance concept world-wide during low inflation and deflation.

Chilean accounting authorities in 2008 accepted the general misconception that there are only two capital maintenance concepts authorized in IFRS, namely, physical and financial capital maintenance. The original Framework (1989) specifically states that there are two capital maintenance concepts. The original Framework (1989), Par 107 [now Conceptual Framework (2010) Par 4.62 ] states:

The principal difference between the two concepts of capital maintenance is the treatment of the effects of changes in the prices of assets and liabilities of the entity. (My underlinging and bold script.)

Various paragraphs of the Framework deal with only the two concepts. It is very clear that, according to the IASB, there are only two concepts of capital maintenance. It is however a fact that financial capital maintenance in units of constant purchasing power is fundamentally different from financial capital maintenance in nominal monetary units.

Thus: IFRS have authorized in 1989 what Chilean companies have been doing since 1967; namely, financial capital maintenance in units of constant purchasing power in terms of a daily index.

It was, consequently, not necessary for Chile to stop “correción monetaria” with the implementation of IFRS started in 2008.

The reason why Chile adopted financial capital maintenance in nominal monetary units in 2008 was because it was not generally accepted at that time that there are three concepts of capital maintenance, namely:

1) Physical capital maintenance;

2) Financial capital maintenance in nominal monetary units , and

3) Financial capital maintenance in units of constant purchasing power

Although

(I) it had been implemented in Brazil during 30 years from 1964 to 1994 in terms of a daily index supplied by the government ;

(II) it had been implemented in Chile from 1967 till 2008 in terms of the Unidad de Fomento published daily since 1977;

(III) it had been authorized in particular countries´ accounting codes, e.g. Portugal´s since 1989, and most importantly

(IV) it had been specifically authorized in IFRS in the original Framework, Par 104 (a) in 1989 [now the Conceptual Framework (2010), Par. 4.59 (a)],

the concept of financial capital maintenance in units of constant purchasing power was not generally accepted at all or even discussed or stated in accounting literature before 2008.

Today the three capital maintenance concepts are specifically stated in various articles on the internet; on Wikipedia, e.g. the IFRS article (51 000 views per month), the Constant Item Purchasing Power Accounting article (2200 views per month) and the Financial Capital article (9400 views per month). They were first stated on this blog in 2009.

Financial capital maintenance in nominal monetary units during inflation and deflation is a fallacy. It is impossible to maintain the real value of capital in nominal monetary units per se during inflation and deflation. That is only possible

(1) under sustainable zero annual inflation which has never been achieved in the past and is not likely soon to be achieved in the future and

(2) in entities which always invest 100% of the updated original constant real value of shareholders ´ equity in revaluable fixed assets with an equivalent updated fair value (revalued or not). This mostly only applies to hotel, hospital, property and other property-intensive entities.

As from 2008 the constant real non-monetary value of that portion of Chilean companies´ shareholders´ equity never covered by sufficient revaluable fixed assets as qualified above, is now being eroded (where it had not been eroded before under “correción monetaria”) at a rate equal to the annual rate of inflation – not by inflation as everyone still believes – but, by the stable measuring unit assumption as implemented under financial capital maintenance in nominal monetary units.

Constant real value currently being eroded by the implementation of the stable measuring unit assumption in the Chilean economy is at least equal to 4% (a rate equal to the annual rate of inflation) of the aggregate accumulated retained earnings of Chilean companies per annum. This amounts to the erosion of hundreds of billions of US Dollars in the world economy per annum.

In my opinion, unnecessarily stopping financial capital maintenance in units of constant purchasing power in Chile was a very serious and unfortunate mistake. It will have a very negative cumulative effect over time on the maintenance of the capital investment base in the Chilean economy. The recent financial crisis in the world economy high-lighted the danger of under-capitalized banks and companies caused by the erosion of these entities´ equity by the very erosive stable measuring unit assumption as implemented under financial capital maintenance in nominal monetary units.

Financial capital maintenance in units of constant purchasing power – properly implemented – automatically maintains the constant purchasing power of capital constant forever in all entities that at least break even in real value during inflation and deflation – ceteris paribus – whether they own any revaluable fixed assets or not. This is done by applying a Daily Index during low inflation; the very successful Unidad de Fomento in Chile´s case.

Financial capital maintenance in units of constant purchasing power in terms of the Unidad de Fomento published daily by the Banco Central de Chile since 1990 played a very important part in Chile´s economy over the years since the UF was started in 1967 and companies maintained their capital in units of constant purchasing power in terms of the UF.

It is very unfortunate when countries which actually had been implementing financial capital maintenance in units of constant purchasing power stop that, simply as a result of a general lack of appreciating the very erosive effect of the stable measuring unit assumption (which everyone mistakenly blames on inflation) in the economy – especially by the IASB and FASB.

Nicolaas Smith

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

Measurement of variable items – Part 2

August 26, 2011 in Uncategorized

Measurement of variable items – Part 2

Entities implement the HC model when they choose to measure financial capital maintenance in nominal monetary units in terms of the IASB´s Conceptual Framework (2010), Par 4.59 (a). They implement the HCA model which includes the very erosive stable measuring unit assumption. In so doing, the stable measuring unit assumption – and not inflation – is unknowingly, unintentionally and unnecessarily eroding the real value of constant items never maintained constant during low inflation.

The IASB only makes a distinction between monetary and non–monetary items. The stable measuring unit assumption allows the IASB to side–step the split between variable real value non–monetary items and constant real value non–monetary items.

Non–monetary items which “hold their values in terms of purchasing power” under HCA are variable items as well as the particular income statement constant items salaries, wages, rentals, etc. – the latter being valued in units of constant purchasing power on an annual (not monthly) basis during low inflation. Variable items hold their values in terms of purchasing power as a result of the ways in which they are valued in terms of IFRS in which their nominal values are adjusted to allow for the many factors that determine their values – including inflation. For example: fair value, market value, net realizable value, present value and recoverable value all adjust for inflation – in the real value of the monetary unit – as part of the specific valuation process.

Nicolaas Smith

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

Measurement of variable items in the financial statements

August 26, 2011 in Uncategorized

Measurement of variable items in the financial statements 

 

 

Measurement in the case of variable items is the process of determining the monetary amounts at which variable items are to be recognised, valued, carried and accounted on a daily basis in an economy under all levels of inflation and deflation. This involves the selection of particular bases of measurement.

Under CIPPA variable items are valued in terms of IFRS. Variable item revaluation losses and gains are treated in terms of IFRS. Variable items, when not valued daily in terms of IFRS, would be updated in terms of a Daily Index or a monetized daily indexed unit of account because there is no stable measuring unit assumption under financial capital maintenance in units of constant purchasing power.

Variable items in the non–monetary or real economy are valued at, for example, fair value or the lower of cost and net realizable value or recoverable value or market value or present value, etc. in terms of IFRS.

 

The real values of variable items exist independently of being valued at their original nominal Historical Cost values in terms of IFRS. Valuing a variable item at its original cost during its lifetime does not erode its real value because it would be valued at its current market value whenever it is finally exchanged or sold in the future. Any variable item valued at HC, when not being revalued, would be continuously updated in terms of a Daily Index since the stable measuring unit assumption is not applied under CIPPA.

Originally all items in financial statements – monetary, variable and constant real value non–monetary items – were valued at Historical Cost before there were any GAAPs, IASs or IFRSs, since money – the monetary unit of account – was generally assumed to be stable in real value over time: the infamous stable measuring unit assumption. Today, the traditional Historical Cost Accounting model maintains this very erosive and very economically destabilizing assumption for the valuation of all income statement items, all balance sheet constant items and certain variable items, e.g. inventories which are measured at the lower of cost and net realisable value

 Entities may also choose the historical cost model instead of the revaluation model for measurement of fixed assets after recognition. After recognition as a fixed asset, an item of property, plant and equipment may be carried at its historical cost less any accumulated depreciation and any accumulated impairment losses.

Nicolaas Smith

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

Difference between measurement in terms of the CPI and a Daily Index

August 25, 2011 in Uncategorized

Difference between measurement in terms of the CPI and a Daily Index

A Daily Index is required when financial capital maintenance in units of constant purchasing power (CIPPA) as authorized in IFRS in the original Framework (1989), Par 104 (a) as maintained in the current Conceptual Framework (2010), Par 4.59 (a) is implemented during inflation and deflation.

A Daily Index is simply a lagged daily interpolation of the CPI. It is a lagged and smoothed CPI. It is lagged because the CPI for a particular day may only become available 41 days later. That is impractical in daily business operations where, e.g. trade debtors and trade creditors may pay or be paid on any day.

It is smoothed because financial capital maintenance in units of constant purchasing power by means of measurement in terms of the CPI may result in sudden increases or decreases in the value of items on the monthly publication date of the CPI.

The DI is based on the CPI. It is basically measurement in terms of the CPI, just lagged and smoothed for practical purposes.

Nicolaas Smith

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

Money

August 24, 2011 in Uncategorized

Money

Money makes the world go round

John Kander, Fred Ebb

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

Money is not perfectly stable in real value during inflation and deflation. However, all historical cost accounting world–wide is done assuming it is stable in real value when the stable measuring unit assumption is implemented for the valuation of most – not all – constant items during low inflation and deflation. It is assumed, in principle, that money is perfectly stable when balance sheet constant items and all income statement items (excluding constant items like salaries, wages, rentals, transport fees, etc. which are measured in units of constant purchasing power on an annual basis) are valued in nominal monetary units when financial capital maintenance in nominal monetary units 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 zero annual inflation which has never been achieved on a sustainable basis 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, variable and constant items – are valued in terms of money within an economy.

An earlier form of money was commodity money; e.g. gold, silver and copper coins. Today money is 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 on a sustainable basis. 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.

The Unidad de Fomento and CIPPA

August 23, 2011 in Uncategorized

The Unidad de Fomento and CIPPA

The Unidad de Fomento is without a doubt an important contribution to the implementation of the financial capital maintenance in units of constant purchasing power concept as authorized in IFRS in the original Framework (1989), Par 104 (a) as maintained in the current 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“.

Financial capital maintenance in units of constant purchasing power (CIPPA) automatically maintains the constant purchasing power of capital constant forever in entities that at least break even in real terms during low inflation and deflation – ceteris paribus – whether they own any revaluable fixed assets or not. It thus is a very useful and very profitable accounting model authorized in IFRS especially during the current period of financial crises resulting from under-capitalized banks and companies. Using it instead of the Historical Cost Accounting model world-wide would stop the erosion of hundreds of billions of US Dollars per annum in the real value of constant real value non-monetary items never maintained constant in the world´s constant item economy. It would thus maintain hundreds of billions of US Dollars in the world economy per annum.

A Daily Index is required to implement it. The UF is a monetized daily indexed unit of account first calculated and published in 1967. It has been published daily since 1977. The Central Bank of Chile publishes it daily since 1990. It is based on a formula that can easily be used by all countries publishing a Consumer Price Index at very little cost. The formula is so simple that there is only one result when the formula is applied to any CPI from the beginning; i.e. from the starting value of 100. It is thus a perfect formula for a Daily Index which is simply a lagged daily interpolation of the CPI. Whoever calculates it will always get the same value. There is no doubt about its value.

A Daily Index is not automatically monetized like the UF. It does not need to be. The UF´s monetization is a result of its historical development in Chile.

The UF is a very important fully developed daily index. Its proven success can advance the acceptance of financial capital maintenance in units of constant purchasing power (CIPPA) as authorized in IFRS to a great extent.

Nicolaas Smith

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

Equity is equal to net assets

August 22, 2011 in Uncategorized

Equity is equal to net assets

The constant purchasing power of shareholders´ equity is equal to the real value of net assets fairly valued.

The fair value of fixed assets higher or lower than simply updating their nominal Historical Cost is reflected after revaluation in the revaluation reserve account in equity under financial capital maintenance in units of constant purchasing power during inflation, deflation and hyperinflation as originally authorized in International Financial Reporting Standards in the Framework for the Preparation and Presentation of Financial Statements (1989), Par. 104 (a) which states:

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

The revaluation reserve´s constant real non–monetary value is then automatically maintained constant with financial capital maintenance in units of constant purchasing power.

Under Constant Item Purchasing Power Accounting – CIPPA

Under CIPPA the existing constant real non–monetary value of equity is automatically maintained constant forever in terms of a Daily Index in all entities that at least break even during inflation and deflation – ceteris paribus – whether these entities own any revaluable fixed assets or not. CIPPA is not an inflation accounting model. Inflation accounting is only implemented during very high and hyperinflation. CIPPA is a basic accounting alternative to Historical Cost Accounting only implemented during low inflation and deflation.

Under Constant Purchasing Power Accounting – CPPA

Only capital maintenance in units of constant purchasing power in terms of the daily US Dollar or other hard currency parallel rate or a Brazilian–style daily index under CPPA automatically maintains the existing constant real value of shareholders´ equity constant for an indefinite period of time in all entities that at least break even during hyperinflation – all else being equal –whether these entities own any revaluable fixed assets or not. CPPA is an inflation accounting model where under all non–monetary items are valued in terms of the daily US Dollar or other hard currency parallel rate or a daily Brazilian-style index rate during hyperinflation. Variable items are updated daily and constant items are measured in units of constant purchasing power daily because there is no stable measuring unit assumption under CIPPA and CPPA.

Nicolaas Smith

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

Measurement of monetary items during low inflation

August 19, 2011 in Uncategorized

Measurement of monetary items during low inflation

Monetary items are normally not inflation–adjusted under HCA during low inflation. Inflation thus erodes the real value of only money and other monetary items evenly throughout the monetary economy in a country implementing the HCA model. Money and other monetary items only maintain their real values perfectly stable, excluding complete indexation of the total money supply, under permanently sustainable zero per cent annual inflation. This has never been achieved on a sustainable basis over an extended period of time. Chile is indexing a substantial part of the country´s money supply on a daily basis with the Unidad de Fomento, but, not yet 100%.

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. SARB

The SARB´s definition of price stability, in practice, results in the erosion of the real value of the Rand at a rate of 6% to 3% per annum. That is the erosion of about R120 billion to R60 billion per annum. Real value is eroded evenly in Rand bank notes and coins and other monetary items (loans, deposits, consumer credit, mortgage credit, monetary investments, car loans, government bonds, etc.) throughout the SA monetary economy. Inflation has no effect on any non–monetary item in the SA or any other economy.

Nicolaas Smith Copyright

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