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Valuation of constant items during hyperinflation

June 22, 2012 in Uncategorized

Valuation of constant items during hyperinflation

The stable measuring unit assumption is applied in the valuation of constant real value non–monetary items, e.g., salaries, wages, rentals, equity, trade debtors, trade creditors, taxes payable, etc. during hyperinflation when these items are not updated at all or not fully updated during hyperinflation; i.e., when the HCA model is implemented during hyperinflation as mistakenly approved in IAS 29 and mistakenly supported by Big Four accounting firms like PricewaterhouseCoopers (PricewaterhouseCoopers 2006).

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

It is clear from the above quotes that IFRS approve and PricewaterhouseCoopers support the implementation of the Historical Cost Accounting model and the very erosive stable measuring unit assumption during hyperinflation. That is a fundamental mistake during hyperinflation. HCA should be banned by law during hyperinflation.

Certain (not all) income statement items, e.g., salaries, wages, rentals, etc. are measured as a generally accepted accounting practice in units of constant purchasing power on an annual basis (they are updated annually – not monthly) as part of the traditional Historical Cost Accounting model during low inflation. The Framework states that various measurement bases are used in conjunction in the HCA model during inflation, hyperinflation and deflation.

A constant real value non–monetary item´s legal existence is determined by contract or statute (company law, commercial law, etc.). However, these constant real value non–monetary items are – in practice – treated as monetary items (cash) during the period that they are not measured in units of constant purchasing power in terms of the daily US Dollar or other daily hard currency parallel rate or a daily index rate during hyperinflation.

Salaries, wages, rentals, trade debtors, trade creditors, all other non–monetary payables, all other non–monetary receivables, etc. are not required in IAS 29 to be measured at the date of payment in terms of the period–end monthly published CPI. That is, obviously, not practically possible when the period–end monthly CPI is normally only available one or two months after the month to which it relates during hyperinflation. What is required in IAS 29 is that these constant real value non–monetary items´ nominal Historical Cost or Current Cost values – after payment or after the liability for the payment has been accounted – in HC or CC financial statements at the end of the accounting period be restated in terms of the period–end monthly CPI in order – simply –to make the HC or CC financial statements more useful during hyperinflation. The practical implementation of IAS 29 thus generally does not result in financial capital maintenance in units of constant purchasing power during hyperinflation. That explains the complete failure of IAS 29 when it was implemented during hyperinflation in Zimbabwe. It did not manage to keep the Zimbabwe real economy relatively stable like daily measurement in terms of the daily index supplied by various governments during 30 years of very high and hyperinflation in Brazil did. The complete failure of IAS 29 in Zimbabweseems to make absolutely no difference to the IASB´s confidence in this failed standard.

When there is no CPI published as happened towards the end of severe hyperinflation in Zimbabwe, values measured in terms the CPI cannot be determined. It was impossible to implement IAS 29 during severe hyperinflation in Zimbabwe.

TheZimbabwe government last published an official Zimbabwedollar inflation index in July 2008. This, combined with the complexities of not having a stable currency due to the phenomenon described above, meant that there were severe limitations to accurate financial reporting in the period from August 2008. During this period the Instituteof Chartered Accountants in Zimbabwe set up a technical subcommittee to address these challenges, as it was impossible to apply IAS 29 “Financial Reporting in Hyperinflationary Economies” without a general price index, or IAS 21 “Exchange Rates” without a single spot rate.

Whiley 2010

However, these constant items´ legal or contractual values (labour contracts, company registrations) do not disappear even when the accounting items – temporarily –cannot be valued. The companies act and labour laws governing labour contracts, etc. are still valid during hyperinflation, severe hyperinflation, monetary meltdown and thereafter. The accounting concept that the constant purchasing power of capital is equal to the real value of net assets always applies. Their legal or contractual constant real non–monetary values still exist even after monetary meltdown of only the local currency. They are valued in terms of IAS 1 in the opening balance sheet after monetary meltdown applying the principle that the constant purchasing power of capital is equal to the real value of net assets.

The IASB authorized an addition to IAS 1 in 2011 to allow for the fair value valuation of non–monetary items in the opening balance sheet of companies applying IFRS after severe hyperinflation and a monetary meltdown. Inflation and hyperinflation have no effect on the real value of non–monetary items. All non–monetary items (constant and variable items) were still there to be fair–valued and included in the opening balance sheets of companies after the monetary meltdown in Zimbabwe in 2008.

No exchangeability with any relatively stable foreign currency means no exchange rate which means no hyperinflation (no prices being set in the local currency) and vice versa: no exchange rate with any relatively stable foreign currency means no exchangeability which means no hyperinflation (no prices being set in the local currency). No prices being set in the local currency means monetary meltdown: the total money supply (only local currency money and only other monetary items stated in the local currency) has no value. This does not include any non-monetary item, variable or constant real value non-monetary item.

Nicolaas Smith

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

Non–monetary real value does not disappear with a monetary meltdown

June 21, 2012 in Uncategorized

Non–monetary real value does not disappear with a monetary meltdown

Only ZimDollars and other monetary items (loans, etc.) expressed in the ZimDollar had no value after the monetary meltdown. The real values of all non–monetary items (variable and constant real value non–monetary items) still existed after the monetary meltdown while the real value of ZimDollar money and monetary items terminated. All non–monetary items (constant and variable items) still had economic real values despite the lack of a CPI and despite the monetary meltdown of the ZimDollar.

Variable items, e.g., finished goods for sale, are generally valued in terms of the daily US Dollar parallel rate during hyperinflation. A variable item is sold at a lower price when a seller does not know the current street rate and sells it at the previous level of the parallel rate. This unnecessary real loss is not caused by the implementation of the stable measuring unit assumption. The seller did not assume the local hyperinflationary currency was stable in real value. The seller was simply not properly informed regarding the current level of the daily US Dollar parallel rate at the time of the sale.

Finished goods and all other variable real value non–monetary items still exist after monetary meltdown. They are then priced / valued / measured at fair value in terms of IAS 1 in the opening balance sheet in the new relatively stable currency adopted as the functional currency after monetary meltdown.

Valuation of constant items during hyperinflation

The stable measuring unit assumption is applied in the valuation of constant real value non–monetary items, e.g., salaries, wages, rentals, equity, trade debtors, trade creditors, taxes payable, etc. during hyperinflation when these items are not updated at all or not fully updated during hyperinflation; i.e., when the HCA model is implemented during hyperinflation as mistakenly approved in IAS 29 and mistakenly supported by Big Four accounting firms like PricewaterhouseCoopers (PricewaterhouseCoopers 2006).

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

It is clear from the above quotes that IFRS approve and PricewaterhouseCoopers support the implementation of the Historical Cost Accounting model and the very erosive stable measuring unit assumption during hyperinflation. That is a fundamental mistake during hyperinflation. HCA should be banned by law during hyperinflation.

Certain (not all) income statement items, e.g., salaries, wages, rentals, etc. are measured as a generally accepted accounting practice in units of constant purchasing power on an annual basis (they are updated annually – not monthly) as part of the traditional Historical Cost Accounting model during low inflation. The Framework states that various measurement bases are used in conjunction in the HCA model during inflation, hyperinflation and deflation.

A constant real value non–monetary item´s legal existence is determined by contract or statute (company law, commercial law, etc.). However, these constant real value non–monetary items are – in practice – treated as monetary items (cash) during the period that they are not measured in units of constant purchasing power in terms of the daily US Dollar or other daily hard currency parallel rate or a daily index rate during hyperinflation.

Salaries, wages, rentals, trade debtors, trade creditors, all other non–monetary payables, all other non–monetary receivables, etc. are not required in IAS 29 to be measured at the date of payment in terms of the period–end monthly published CPI. That is, obviously, not practically possible when the period–end monthly CPI is normally only available one or two months after the month to which it relates during hyperinflation. What is required in IAS 29 is that these constant real value non–monetary items´ nominal Historical Cost or Current Cost values – after payment or after the liability for the payment has been accounted – in HC or CC financial statements at the end of the accounting period be restated in terms of the period–end monthly CPI in order – simply –to make the HC or CC financial statements more useful during hyperinflation. The practical implementation of IAS 29 thus generally does not result in financial capital maintenance in units of constant purchasing power during hyperinflation. That explains the complete failure of IAS 29 when it was implemented during hyperinflation in Zimbabwe. It did not manage to keep the Zimbabwe real economy relatively stable like daily measurement in terms of the daily index supplied by various governments during 30 years of very high and hyperinflation in Brazildid. The complete failure of IAS 29 in Zimbabwe seems to make absolutely no difference to the IASB´s confidence in this failed standard.

When there is no CPI published as happened towards the end of severe hyperinflation in Zimbabwe, values measured in terms the CPI cannot be determined. It was impossible to implement IAS 29 during severe hyperinflation in Zimbabwe.

TheZimbabwe government last published an official Zimbabwedollar inflation index in July 2008. This, combined with the complexities of not having a stable currency due to the phenomenon described above, meant that there were severe limitations to accurate financial reporting in the period from August 2008. During this period the Instituteof Chartered Accountants in Zimbabweset up a technical subcommittee to address these challenges, as it was impossible to apply IAS 29

“Financial Reporting in Hyperinflationary Economies” without a general price index, or IAS 21 “Exchange Rates” without a single spot rate.

Whiley 2010

However, these constant items´ legal or contractual values (labour contracts, company registrations) do not disappear even when the accounting items – temporarily –cannot be valued. The companies act and labour laws governing labour contracts, etc. are still valid during hyperinflation, severe hyperinflation, monetary meltdown and thereafter. The accounting concept that the constant purchasing power of capital is equal to the real value of net assets always applies. Their legal or contractual constant real non–monetary values still exist even after monetary meltdown of only the local currency. They are valued in terms of IAS 1 in the opening balance sheet after monetary meltdown applying the principle that the constant purchasing power of capital is equal to the real value of net assets.

The IASB authorized an addition to IAS 1 in 2011 to allow for the fair value valuation of non–monetary items in the opening balance sheet of companies applying IFRS after severe hyperinflation and a monetary meltdown. Inflation and hyperinflation have no effect on the real value of non–monetary items. All non–monetary items (constant and variable items) were still there to be fair–valued and included in the opening balance sheets of companies after the monetary meltdown in Zimbabwe in 2008.

No exchangeability with any relatively stable foreign currency means no exchange rate which means no hyperinflation (no prices being set in the local currency) and vice versa: no exchange rate with any relatively stable foreign currency means no exchangeability which means no hyperinflation (no prices being set in the local currency). No prices being set in the local currency means monetary meltdown: the total money supply (only local currency money and only other monetary items stated in the local currency) has no value. This does not include any non-monetary item, variable or constant real value non-monetary item.

Nicolaas Smith

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

Hyperinflation has no effect on the real value of non–monetary items

June 20, 2012 in Uncategorized

Hyperinflation has no effect on the real value of non–monetary items

Hyperinflation only erodes the real value of the monetary unit extremely rapidly. Hyperinflation has no effect on the real value of non–monetary items. All non–monetary items (variable and constant real value non–monetary items) maintain their real values during hyperinflation when they are measured in units of constant purchasing power daily in terms of a daily parallel rate (a black market or street rate) normally the daily official or unofficial US Dollar or other unofficial hard currency parallel exchange rate or an official Brazilian–style daily URV non–monetary index normally almost totally based on the daily US Dollar exchange rate as Brazil did during 30 years of very high and hyperinflation.

The stable measuring unit assumption (HCA) – not hyperinflation – unknowingly, unnecessarily and unintentionally erodes the real value of constant real value non–monetary items not maintained constant as fast as hyperinflation erodes the real value of the local currency and other monetary items, e.g., loans stated in the local currency, because all economic items (monetary, variable and constant items) in the hyperinflationary economy are measured in terms of the hyperinflationary monetary unit. A monetary meltdown erodes all real value only in the monetary economy; i.e., in the local currency money supply.

Hyperinflation is not always stopped with first a period of severe hyperinflation in the final stage and then a complete monetary meltdown. Hyperinflation was successfully overcome by various countries, e.g., Turkey,Brazil and Angola, without dollarization or a monetary meltdown.

Brazil actually grew their non–monetary economy in real value during 30 years of very high and hyperinflation of up to 2000 per cent per annum from 1964 to 1994 and never had severe hyperinflation followed by a complete monetary meltdown at the end. Brazilstopped its hyperinflation with the Real Plan in 1994. Brazil managed to have years of positive Gross Domestic Product growth during those 30 years of very high and hyperinflation because the various governments during those three decades supplied the population with a daily non–monetary index based almost entirely on the daily US Dollar exchange rate with their monetary unit. It was used to update most non–monetary items (variable and constant real value non–monetary items), e.g., goods, services, equity, trade debtors, trade creditors, salaries payable, wages payable, taxes payable, etc., in the hyperinflationary economy daily.

Brazil would not have been able to maintain its non–monetary or real economy relatively stable with actual real GDP growth during hyperinflation if it had applied restatement of HC or CC financial statements in terms of the period–end monthly published CPI as required in IAS 29 Financial Reporting in Hyperinflationary Economies during that period. IAS 29 does not require continuous daily measurement of all non–monetary items in terms of a daily index during hyperinflation. IAS 29 does not require continuous daily updating of all non-monetary items in terms of the US Dollar parallel rate or a Brazilian–style URVdaily index rate. IAS 29 simply requires restatement of Historical Cost and Current Cost financial statements during hyperinflation applying the monthly Consumer Price Index at the end of the reporting period (monthly, quarterly, six monthly or annual) – generally available a month or two months after the current month – to make these financial statements more useful. It is not the intention of IAS 29 to, and in its current form it cannot, stop the continuous daily rapid erosion of the real value of constant real value non–monetary items never maintained constant as Brazil did for 30 years of high and hyperinflation generating positive economic growth.

This daily very rapid erosion of constant real value non-monetary items never maintained constant is caused, not by hyperinflation, but, by the implementation of the stable measuring unit assumption (HCA) during hyperinflation. Applying the monthly CPI a month or two months after the current month is very ineffective during hyperinflation as far as the constant real non–monetary value of salaries, wages, rentals, equity, trade debtors, trade creditors, etc., positive economic growth, economic stability in the real or non–monetary economy, the maintenance of internal demand and the continuous daily maintenance of the real value of all non–monetary items during hyperinflation are concerned. All non–monetary items (variable and constant items) have to be updated daily in terms of the parallel US Dollar rate or a Brazilian–style URV daily index rate in order to maintain the real economy relatively stable during hyperinflation in the local currency monetary unit. That would be financial capital maintenance in units of constant purchasing power (CIPPA) during hyperinflation.

When the stable measuring unit assumption is implemented under HCA or financial capital maintenance in nominal monetary units also originally authorized in IFRS in the Framework (1989), Par. 104 (a), it is assumed, in practice, that there was, is and never ever will be inflation, deflation or hyperinflation as far as the valuation of constant real value non–monetary items are concerned. It
is assumed, in principle, that money was, is and will always in the future be perfectly stable at all levels of inflation, hyperinflation and deflation.

Various accounting authorities are requesting a fundamental review of IAS 29. See IFRS X Capital Maintenance in Units of Constant PurchasingPower.

David Mosso state:

Neither IFRS 29 nor FAS 89 is complete in the sense of a single authoritative standard.

Mosso 2011

Severe hyperinflation is defined by the IASB as a period at the end of completely uncontrolled hyperinflation when exchangeability between the hyperinflationary monetary unit and most relatively stable foreign currencies does not exist. The wording of the IASB definition thus confirms that at least one exchangeability has to exist for prices to be established in the hyperinflationary monetary unit; i.e., for severe hyperinflation to exist. Severe hyperinflation is only present when there is still exchangeability with at least one relatively stable foreign currency in order for prices to continue to be set in the hyperinflationary monetary unit in terms of this final exchangeability. The one exchange rate that lasted till the end of severe hyperinflation in Zimbabwewas the Old Mutual Implied Rate (OMIR).

The ratio of the Old Mutual share price in Harare to that in London equals the Zimbabwe dollar/sterling exchange rate.

Hanke and Kwok 2009: 8

Hyperinflation (severe or not) stops the moment exchangeability between the local hyperinflationary currency and all foreign currencies does not exist.

Zimbabwe’s hyperinflation came to an abrupt halt. The trigger was an intervention by the Reserve Bank of Zimbabwe. On November 20, 2008, the Reserve Bank’s governor, Dr. Gideon Gono, stated that the entire economy was “being priced via the Old Mutual rate whose share price movements had no relationship with economic fundamentals, let alone actual corporate performance of Old Mutual itself” (Gono 2008: 7–8). In consequence, the Reserve Bank issued regulations that forced the Zimbabwe Stock Exchange to shut down. This event rapidly cascaded into a termination of all forms of non–cash foreign exchange trading and an accelerated death spiral for the Zimbabwedollar. Within weeks the entire economy spontaneously “dollarized” and prices stabilized.

Hanke and Kwok 2009: 9–10

There was severe hyperinflation in Zimbabwewhile there was exchangeability (prices could still be set in the ZimDollar) with at least one relatively stable foreign currency – the British Pound in this case as it was made possible via the OMIR. When this last exchangeability stopped it was not possible to set prices in the ZimDollar anymore and severe hyperinflation stopped: no exchangeability means no hyperinflation. That was a monetary meltdown. The entire ZimDollar money supply had no value as from that date on.

Nicolaas Smith

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

Monetary meltdown

June 18, 2012 in Uncategorized

Monetary meltdown

A monetary meltdown takes place when a hyperinflationary local currency monetary unit stops having exchangeability with all foreign currencies, normally after first a period of hyperinflation and then a period of severe hyperinflation. It happened in Zimbabwe on 20November 2008.

The monetary economy (the total real value of the fiat money supply) can disappear completely from one day to the next. It happened three times during three months towards the end of hyperinflation in Yugoslavia. It happened at the end of hyperinflation in Zimbabwe in 2008, terminating severe hyperinflation in that country. Zimbabwedid not try hyperinflation again like Yugoslavia which has the distinction of having wiped out the real value of its entire monetary economy three times in three months. In Zimbabwethe economy dollarized spontaneously after a decision by the Reserve Bank of Zimbabwe to close the Zimbabwe Stock Exchange. That stopped the Old Mutual Implied Rate being the final exchange rate of the Zimbabwe Dollar with a foreign currency: the British Pound.

The Zimbabwean economy dollarized spontaneously after that because it was a sufficiently open economy right next to the stable South African, Botswana and other stable economies in the Southern Africaregion. Those stable economies supplied the Zimbabwean economy with essential goods and services during and after hyperinflation. Zimbabwe then had the opportunity to slowly recover from total monetary meltdown and the devastating effect of implementing the very erosive stable measuring unit assumption – the Historical Cost Accounting model – during hyperinflation as supported by the IASB and Big Four accounting firms like PricewaterhouseCoopers.. The implementation of the HCA model during hyperinflation is mistakenly accepted in International Financial Reporting Standards and mistakenly supported by Big Four accounting firms like PricewaterhouseCoopers. Zimbabwe spontaneously adopted a multi–currency dollarization model using the US Dollar, the Euro, the South African Rand, the British Pound and the Botswana Pula as relatively stable foreign currencies in the Zimbabwean economy in 2008.

The variable real value non–monetary item economy (fixed assets, land, property, plant, equipment, inventory, etc.) cannot disappear completely from the one day to the next because of wrong monetary policies. ‘Inflation is always and everywhere a monetary phenomenon.’ Inflation and hyperinflation have no effect on the real value of non–monetary items. After monetary meltdown in Zimbabwethe fixed assets, land, properties, plant, equipment, raw materials, finished goods, etc., were still there. The variable item economy can be destroyed by natural disasters like earth quakes and tsunamis and by man–made events like war, but not by hyperinflation.

The constant item economy (owners´ equity, trade debtors, trade creditors, salaries, wages, rentals, etc.) also cannot be eroded by inflation and hyperinflation because inflation and hyperinflation have no effect on the real value of non–monetary items – both variable and constant real value non–monetary items. However, the very erosive stable measuring unit assumption (i.e., the HCA model or financial capital maintenance in nominal monetary units during inflation and hyperinflation) erodes the constant real non–monetary value of constant items not maintained constant during inflation and hyperinflation, e.g., trade debtors, trade creditors, salaries, wages, rentals, that portion of shareholder´s equity never maintained constant by the real value of net assets under HCA, all other non–monetary payables and receivables, etc., at a rate equal to the annual rate of inflation or hyperinflation.

Severe hyperinflation is the final stage of a devastating hyperinflationary spiral only in the local currency monetary unit with a continuously super–increasing rate of hyperinflation reaching millions per cent per annum when exchangeability of the hyperinflationary monetary unit becomes limited to very few or just one single relatively stable foreign currency.

Hyperinflation and severe hyperinflation need exchangeability with at least on foreign currency. With no exchangeability there is no local currency and no hyperinflation, in this case, no severe hyperinflation.

The real value of the entire money supply can be eliminated like in the case of the Zimbabwe Dollar on 20 November, 2008, not as a result of hyperinflation, but as a result of a monetary meltdown after a period of severe hyperinflation.

As of 14 November 2008, Zimbabwe’s annual inflation rate was 89.7 Sextillion p
er cent (89,700,000,000,000,000,000,000%).

Hanke 2010

In Zimbabwethe Zimbabwe Dollar finally had exchangeability only with the British Pound via the Old Mutual Implied Rate (OMIR) as derived from continued trade in Old Mutual shares on the Zimbabwe Stock Exchange even during severe hyperinflation. A monetary meltdown took place in Zimbabwe on 20 November, 2008 when the ZSE was closed by government regulation and the Zimbabwe Dollar stopped having exchangeability with the British Pound (the last foreign currency it had exchangeability with) via the OMIR.

Nicolaas Smith

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

Valuing monetary items during hyperinflation

June 15, 2012 in Uncategorized

Valuing monetary items during hyperinflation

 

Monetary items are valued at their nominal monetary HC values during the
current accounting period under HCA during hyperinflation too. The real value
of money and other monetary items is eroded at the rate of hyperinflation which
can be anything from 100 per cent per over three years (i.e., 26 per cent per
annum for three years in a row) to 89.7 Sextillion per cent
(89,700,000,000,000,000,000,000 per cent) in the case of Zimbabwe in 2008.
(Hanke 2010)

 

Net monetary losses and gains have to be calculated and accounted during
hyperinflation as required by IAS 29 Financial Reporting in Hyperinflationary Economies
under HCA. IAS 29 is an extension to and not a departure from HCA. This is in
total contradiction to what is done during low inflation under HCA.

 

The net monetary loss or gain from holding net monetary item assets or
net monetary item liabilities has to be calculated and accounted during
hyperinflation under HCA in terms of IAS 29, but not during low inflation of up
to, for example, 15 per cent per annum.

 

Hyperinflation is defined by the IASB as 100 per cent cumulative
inflation over three years. That is 26 per cent annual inflation for three
years in a row. At 26 per cent annual inflation for three years in a row
companies have to calculate and account the cost of hyperinflation and write it
off against profit, but, not at 15 per cent or 6 per cent inflation. At 22 per
cent annual inflation for three years or 81.6 per cent cumulative inflation
over three years an economy would not be in hyperinflation. However, 81.6 per cent
of the real value of the monetary unit, all other monetary items as well as the
real value of all constant items not maintained constant (treated as monetary
items) of  listed and unlisted companies
would be wiped out over the short period of three years. The economy would not
be in hyperinflation and the HCA model would be implemented.

 

SA, for example, had been going along at 12 per cent average annual
inflation or 40 per cent cumulative inflation over three years for at least the
last 15 years before 2000, continuously implementing the HCA model.

 

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

                         

Valuing monetary items during deflation

June 14, 2012 in Uncategorized

Valuing monetary items during deflation

The whole money supply would be deflation-adjusted daily under complete coordination and perfect financial capital maintenance in units of constant purchasing power during deflation. It is highly unlikely that this would happen right from the start in any economy which decides to abandon the HCA model while it is in deflation and adopt financial capital maintenance in units of constant purchasing power (CIPPA). Monetary items not deflation-adjusted daily in bank and ledger accounts would continue to be valued in nominal monetary units and the net monetary gain or loss would be calculated and accounted under financial capital maintenance in units of constant purchasing power (CIPPA).

Monetary items not deflation-adjusted daily are valued in nominal monetary units under the HCA model during deflation. Their real values thus increase daily. The net monetary gain or loss is not calculated under HCA during deflation.

Not all inflation-indexed government bonds become deflation-indexed bonds when the economy changes over from inflation to deflation. USTreasury Inflation-Protected Securities (TIPS) and most euro-denominated sovereign inflation-indexed bonds, for example, contain a clause that states that when the nominal value of the capital amount adjusted for deflation is less than the original nominal amount, the original amount would be repaid. These bonds would thus be nominal bonds and the capital amounts would gain in real value during deflation.

The presence of this guarantee, which is beneficial for the investor in the event of deflation, is mainly due to accounting considerations: in a lot of countries, bonds must have a minimum redemption price:

Comité de Normalisation Obligataire 2011: 15 CNO_Indexed_Bonds_-Final_15.7.2011-2-2.pdf

This normally does not apply to the coupon payments. They stay the same in real value during inflation and deflation, i.e., they would be lower in nominal value during deflation, but the same in real value.

Some countries´ government inflation-indexed bonds do not contain the above clause and thus become capital deflation-indexed bonds during deflation, i.e., they are real constant real value bonds. Their capital amounts and their coupon payments would be constant in real value during inflation and deflation.

The UK, Canada and Japan, do not guarantee a minimum redemption price for their indexed issues.

Comité de Normalisation Obligataire 2011: 15 CNO_Indexed_Bonds_-Final_15.7.2011-2-2.pdf

Nicolaas Smith

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

Measurement during low inflation

June 13, 2012 in Uncategorized

Measurement during low inflation

Monetary items are normally not inflation–adjusted daily under HCA during low inflation although Chile inflation-adjusts between 20 and 25 per cent of its broad M3 money supply daily (2011) and most countries issue government inflation-indexed bonds which totalled about USD 2.9 trillion at the end of 2009. Inflation thus erodes the real value of most money and other monetary items evenly throughout the world´s monetary economy under the HC paradigm. Money and other monetary items would only maintain their real values perfectly stable, excluding complete daily 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.

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 results in the erosion of the real value of the Rand at a rate of three to six per cent per annum. That is the erosion of about R66 to R132 billion in real value in the SA monetary economy per annum (March 2012). 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, nominal government bonds, etc.) throughout the SA monetary economy. Inflation has no effect on any non–monetary item in the SA or any other economy.

Monetary items not inflation-indexed daily are valued at their current depreciated generally lower real values by being accounted during the current accounting period at their original nominal HC values during inflation. Monetary items´ real values are eroded by inflation over time. Being valued at their original nominal values during inflation means that monetary items are automatically being valued by the continuous economic process of inflation over time. Monetary items´ real values thus change daily in the internal economy as indicated by the Daily CPI or a monetized daily indexed unit of account, but their nominal values stay the same over time under HCA. Under HCA this change in real value is not calculated and not accounted. The net monetary loss or gain is not calculated and accounted during low inflation.

This obviously means that monetary items are always correctly valued during the current financial period in any current account: at its current real value as determined by the Daily CPI or monetized daily indexed unit of account. Money and other monetary items´ real values consequently generally decrease to a lower real value daily as indicated by the Daily CPI in low inflationary economies. Their nominal values stay the same under HCA when they are not inflation-adjusted daily.

There are net monetary losses and gains whenever the entire or any part of the money supply is not inflation–indexed on a daily basis. It is however a Generally Accepted Accounting Practice compliant with IFRS not to calculate net monetary losses and gains under HCA except during hyperinflation as required by IAS 29. By implementing 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 during low and high inflation and deflation. It is thus generally assumed under HCA that money is, in practice, perfectly stable for the purpose of valuing current period monetary items during low inflation in the accounting records. Daily infltion-indexed monetary items are valued and accounted at the values as determined in the contracts under which they are being inflation-adjusted daily, i.e. their nominal values increase daily while their real values stay the same during inflation.

There is no stable measuring unit assumption under financial capital maintenance in units of constant purchasing power (CIPPA). All monetary items (the whole money supply) would be inflation
–indexed on a daily basis in terms of the Daily CPI with complete coordination in a perfect implementation of financial capital maintenance in units of constant purchasing power which is highly unlikely in the near future (2012). It would be the best solution, but it is doubtful that any country would have an accounting authority and a central bank with the necessary understanding of the implementation and benefits of financial capital maintenance in units of constant purchasing power in terms of a Daily CPI to implement the best solution right from the start. This would remove the entire cost of inflation (not actual inflation in money and other monetary items) from the economy.

The concept of net monetary losses and gains would be extinct under inflation-adjusting the entire money supply and complete coordination.

Chile is the country closest to achieving this, still implementing the HCA model. Chile inflation-indexes 20 to 25 per cent of its broad M3 money supply (2011) on a daily basis by means of the Unidad de Fomento. The rest of Chile´s money supply is subject to the erosion of the real value monetary items by inflation. All constant items in Chile´s constant item economy economy never maintained constant are also still subject to the erosion of their real values by the implementation of the stable measuring unit assumption.

The stable measuring unit assumption does not erode the about R132 billion (March 2012) in real value of the Rand and other monetary items in the SA monetary economy: six per cent annual inflation does that.

Net monetary gains and losses are constant real value non–monetary items (income statement gains and losses) once they are accounted and have to be inflation–adjusted – measured in units of constant purchasing power –thereafter under financial capital maintenance in units of constant purchasing power (CIPPA).

Nicolaas Smith

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

Valuing monetary items

June 12, 2012 in Uncategorized

Valuing monetary items

Measurement is determining the particular basis on which monetary items are to be valued and accounted on a daily basis in the functional currency – the legal unit of account for accounting purposes – in an economy under all levels of inflation and deflation. The functional currency is the currency of the primary economic environment in which an entity operates. The functional currency is normally the national (or monetary union) monetary unit which is legal tender in the economy. In dollarized economies the adopted hard currency is the functional currency for accounting purposes.

Entities implement financial capital maintenance in nominal monetary units when they prepare their financial reports in terms of the HCA model. The stable measuring unit assumption is applied to some – not all – items under HCA. It is applied to all monetary items not inflation-adjusted on a daily basis under HCA.

Monetary items are thus generally not inflation–adjusted under HCA. The Chilean banking system is partially indexed daily using the Unidad de Fomento. Some monetary items are also inflation–adjusted daily in other economies, e.g., TIPS in the USeconomy, where HCA is the generally accepted accounting model.

Under CIPPA, i.e., financial capital maintenance in units of constant purchasing power in terms of a Daily CPI during inflation and deflation, there is no stable measuring unit assumption. All monetary items would thus be inflation–adjusted on a daily basis in terms of the Daily CPI or monetized daily indexed unit of account. Historical monetary items as well as current financial period monetary items would be inflation–adjusted daily. This would require inflation–indexing of all monetary items in the banking system. Complete coordination in the economy would eliminate the total cost of inflation (not actual inflation) from the monetary economy. Chile is the country closest to achieving this. HCA is the generally accepted accounting model in Chile(2012).

Chile may be closer than all other economies to eliminating the cost of inflation (not inflation) from the country´s monetary economy with the generally accepted monetary practice of inflation–adjusting a significant part of their money supply in terms of the Unidad de Fomentowhich is a monetized daily indexed unit of account, but the stable measuring unit assumption (not inflation) is still eroding the real values of constant items never maintained constant in the country´s constant item economy because Chile is still implementing the HCA model in 2012. Chile is thus still bearing the full cost of the stable measuring unit assumption in its constant item economy. Fully coordinated financial capital maintenance in units of constant purchasing power (CIPPA) in terms of the UF on a daily basis would eliminate this cost completely from their economy too.

Nicolaas Smith

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

Functions of money

June 11, 2012 in Uncategorized

Functions of money

Money performs the following three functions:

1 Unstable medium of exchange

2 Unstable store of value

3 Unstable unit of account

Unstable medium of exchange

Money has the basic function that it is an unstable medium of exchange. It overcomes the inconveniences of a barter economy where there must be a double coincidence of wants before a trade can take place. For a trade to take place in a barter economy one person must want exactly what the other person has to offer, at the exact time and place where it is offered.

In a monetary economy the real value of goods and services are measured in terms of unstable money, the unstable monetary medium of exchange, which is generally accepted to buy any other good or service. Without this function or attribute the invention cannot be money.

We use payment with unstable money instead of barter to exchange real values in our economies in the transactions we enter into when we buy and sell goods, services, ideas, rights and any kind of property whether physical, virtual or intellectual. Unstable money is the lifeblood of an economy even though it is continuously changing in real value. The creation and exchange of real value in an economy would be severely restricted without unstable money since it would be a barter economy.

Unstable store of value

Unstable money is an unstable store of real value. Unstable money is a depreciating store of value during inflation and an appreciating store of value during deflation.

Unstable money has to maintain most of its real value over the short term in order to be accepted as an unstable medium of exchange. It would not solve barter’s double coincidence of wants problem if it could not be stored over time and still remain valuable in exchange.

The fact that inflation is eroding the real value of unstable money means it is a store of depreciating real value during inflation. Money was a store of value right from the start. The first types of money consisted of gold and silver coins. The metals from which the coins were made had an actual real value in themselves and these coins could be melted down and the metal could be sold in its bullion form when the bullion price was above the coin price. Next money was not made of precious metals but money consisted of bank notes, the real value of which was full
y backed by gold. Today depreciating or appreciating fiat money´s real value is backed by all the underlying value systems in an economy while the actual bank notes and coins are simply physical tokens of money since the materials the notes and coins are made of have almost no intrinsic value. Although the store of value function (legal tender) and permanently fixed nominal values of depreciating or appreciating bank notes and bank coins are legally defined, fiat money´s real value is in fact determined by all the underlying values systems in an economy. The daily change in fiat money´s depreciating or appreciating real value is indicated by the change in the Daily CPI.

The abuse of money’s store of value function led to inflation.

Money in the form of bank notes and coins and in the form of virtual real values in bank and credit card accounts are liquid media of exchange; i.e., they are readily available. It is normally easy to obtain cash on demand in banks in most economies under normal economic conditions. A property, e.g., a well–located plot of land with a well–maintained and well–equipped building, which is a variable real value non–monetary item, is also a store of value. It is however quite an illiquid store of value. The real value is not immediately available in easily transportable and divisible cash. Money’s high liquidity makes it more desirable as a store of value in comparison with other stores of value like gold, property, marketable securities, bonds, etc. Money is obviously not the best store of value in an inflationary economy where its real value is continuously being eroded by inflation. Money is normally available in convenient small denominations which facilitate everyday small purchases. As such, money is very user friendly. It is easily transportable especially with electronic transfer facilities (2012).

Inflation actually manifests itself in money’s store of value function since inflation always and everywhere erodes the real value of only money and other monetary items. Inflation does not manifest itself in money’s medium of exchange function in the case of spot transactions since (a) the exchange is made between money and the other item considered to be equal in real value to the money amount at the moment of exchange and also since (b) inflation only happens over time. Inflation also does not manifest itself in money’s unit of account function (the stable measuring unit assumption manifests itself in money´s unit of account function) which vindicates the fact that inflation can only erode the real value of money and other monetary items; i.e., inflation has no effect on the real value of non–monetary items. Money is always a medium of exchange of equal real value at the moment of exchange. Free market prices are adjusted in the market in a price setting process that takes the decreasing real value of money during inflation or the increasing real value of money during deflation into account (amongst many other factors) so that economic items – the product or service or right and the amount of money- of equal real value are exchanged at the moment of exchange.

Depreciating money has a constantly decreasing real value during inflation. Depreciating ‘bank money’deposits have the same attributes as depreciating money with the single exception that they are not physical depreciating bank notes and bank coins but accounted depreciating monetary items. The depreciating money represented by depreciating bank money also has a depreciating store of value function during inflation. Money and other monetary items appreciate in real value during deflation.

Unstable unit of account

Unstable money’s third function is that it is the unstable unit of account in the economy. It is a monetary standard of measure of the real value of economic items to facilitate exchange without barter in order to overcome the double coincidence of wants problem. Inflation erodes the real value of money and deflation increases the real value of money. Money has never been perfectly stable in real value over an extended period of time. However, money illusion makes people believe that money maintains its real value stable over the short to medium term. Money is the only standard unit of measure that is not a fundamentally stable or fixed unit of account. All other standards of measure are perfectly stable units.

Accounting transformed money illusion into a Generally Accepted Accounting Practice with the very destructive stable measuring unit assumption, also called 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 reports.’

Walgenbach, Dittrich and Hanson 1973: 429

The very erosive stable measuring unit assumption is based on the fallacy that changes in the general purchasing power (real value) of unstable money are not sufficiently important to require adjustments to the basic financial reports; i.e., not sufficiently important to require financial capital maintenance in units of constant purchasing power during inflation and deflation.

In an inflationary economy depreciating money is used as a depreciating monetary unit of account to value and account economic activity. It is very tempting to state that it is very clear that you cannot have a unit of account in the economy that is not stable – not fixed – in real value for accounting purposes. However, we have been doing exactly that since the start of inflation in the economy; i.e., for about the last 3000 years. Accounting has been trying to overcome this problem for the last 3000 years by simply assuming money is perfectly stable in real value duirng inflation and deflation. However, a fact will eventually prevail over an assumption regarding it. The assumption in Historical Cost Accounting is that changes in the purchasing power of money are not sufficiently important to require financial capital maintenance in units of constant purchasing power during inflation and deflation. In practice that means that unstable money is assumed to be perfectly stable in real value during inflation and deflation. The fact is that money is not perfectly stable in real value during inflation and deflation. Financial capital maintenance in units of constant purchasign power during inflation and deflation implements this fact instead of the stable measuring unit assumption under Historical Cost Accounting. The stable measuring unit assumption is not implemented under financial capital maintenance in units of constant purchasing power (CIPPA). The problem stems from the difficulty in achieving zero inflation on a permanently sustainable basis – never achieved to date (2012) – and the difficulty in defining a universal unit of real value – also never achieved to date.

The only remedy to eliminate the erosion of real value in constant real value non-monetary items never maintained constant during inflation and deflation under HCA – besides permanently sustainable zero inflation – would be to change over to financial capital maintenance in units of constant purchasing power; i.e., the measurement of all constant items in units of constant purchasing power in terms of a Daily Index during inflation and deflation (CIPPA).

The only remedy to eliminate the erosion of real value in money and other monetary items – besides permanently sustainable zero inflation – would be inflation-adjusting the entire money supply on a daily basis under complete co-ordination. Chileis already 20 to 25 per cent (2011) of the way there according to the Banco Central de Chile.

Nicolaas Smith

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

Consumer Price Index

June 8, 2012 in Uncategorized

Consumer Price Index

‘The consumer price index was first used in 1707. In 1925 it became institutionalized when the Second International Conference of Labour Statisticians, convened by the International Labour Organization, promulgated the first international standards of measurement.’

(Vink, Kirsten and Woerman, 2004)

The CPI is a non–monetary index value measuring changes in the weighted average of prices quoted in the unstable monetary unit of a typical basket of consumer goods and services. The annual per centage change in the CPI is used to measure inflation. It is a price index determined by measuring the price of a standard group of goods and services representing a typical market basket of a typical urban consumer. It measures the change in the weighted average price for a constant market basket of goods and services from one period to the next within the same area (city, region, or nation). It can be used to measure changes in the cost of living. It is a measure estimating the average price of consumer goods and services purchased by a typical urban household.

The daily change in the CPI would be used as a measure to calculate and account the erosion of real value caused by inflation in only monetary items under financial capital maintenance in units of constant purchasing power (CIPPA). The net monetary loss or gain resulting from holding either a net weighted average excess of monetary item assets or a net weighted average excess of monetary items liabilities during a specific period is not calculated and accounted under the traditional HCA model during low inflation and deflation. It is also calculated and accounted during hyperinflation as required by IAS 29.

The daily change in the CPI would be used to calculate the net constant item loss from holding an excess of constant item assets not maintained constant over constant item liabilities not maintained constant at all levels of inflation and deflation under financial capital maintenance in units of constant purchasing power (CIPPA). Likewise it would be used to calculate the net constant item gain from holding an excess of constant item liabilities not maintained constant over constant items assets not maintained constant at all levels of inflation and deflation under CIPPA.

The cost of the stable measuring unit assumption is – like the cost of inflation – not calculated and accounted under HCA during inflation and deflation. Most people mistakenly believe the erosion in, for example, companies´ capital and profits – in fact, never maintained constant by the real value of net assets because of the implementation of stable measuring unit assumption – is caused by inflation. However, inflation has no effect on the real value of non-monetary items and capital and retained profits are constant real value non-monetary items. Thus, the cost of the stable measuring unit assumption is mistakenly believed by most people to be the same as the cost of inflation. They do not know that it is caused by the stable measuring unit assumption. They are taught that the erosion of companies´ capital and retained profits is caused by inflation. Since the cost of inflation is not calculated and accounted under the HCA model, entities – mistakenly treating constant items like monetary items, e.g., in the case of trade debtors and trade creditors as well as mistakenly believing that the erosion of companies’ capital and retained profits is caused by inflation – are satisfied to do nothing about it because net monetary losses and gains are not calculated and accounted under HCA during low inflation and deflation. They see it as the central bank´s duty to lower inflation and lower this erosion. They believe it has nothing to do with the accounting profession.

There is no CPI in a barter economy since there is no money in such an economy. The Daily CPI is essential in practice to index the real value of constant items in the economy with continuous measurement of financial capital maintenance in units of constant purchasing power (CIPPA) being used as the fundamental model of accounting during inflation and deflation.

The nominal value of money stays the same over time while the change in the real value of money is indicated by the rate of inflation and deflation. The nominal value of a constant item changes inversely with the rate of daily inflation or deflation with measurement in units of constant purchasing power under CIPPA resulting in its real value remaining constant during inflation and deflation. The real value of money changes inversely with the rate of inflation and deflation.

The Daily CPI is the sine qua non under financial capital maintenance in units of constant purchasing power (CIPPA) in an inflationary and deflationary economy to correctly fix the problem created by the fact that money is the only global unit of account that is not a stable unit of measure: the monetary unit of account has no fundamental constant. Under the Historical Cost paradigm it is assumed that money was, is and will always be perfectly stable in all cases where the stable measuring unit assumption is applied.

It would be difficult to measure the erosion and creation of real value in monetary items correctly during inflation and deflation, respectively, and to correctly implement financial capital maintenance in units of constant purchasing power without the CPI. The CPI is calculated during hyperinflation, but, it is impossible to maintain the constant purchasing power of constant items constant in terms of the CPI that becomes available a month or more after a transaction or event during hyperinflation of hundreds of millions or more per cent per annum. The daily change in a parallel or daily index rate is used for that purpose during hyperinflation. See Brazil´s use of daily indexing during very high and hyperinflation from 1964 to 1994.

Financial capital maintenance in units of constant purchasing power in terms of the Daily CPI makes it relatively easy to fix this problem and to stop the erosion of hundreds of billions of US Dollars in real value in the world´s constant item economy each and every year during inflation.

Nicolaas Smith

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