Knowing the nature of the financial system allows one to assess the application of accounting standards in faithfully representing the events, interactions, and conditions of life. From there, and not beforehand, one is able to assess the laws of taxation. This article will look at the accounting, Part 1, and at the taxation, Part 2.
When operating on a stable unit of account each idea below discussed was valid. Due to the unstable unit of account today, being all fiat currency, the once sound accounting processes break down and become detrimental to the private individual, and to society. It is not the instability of the fiat currency alone that causes detriment. It is, for the purposes here, that the accounting has not changed to adapt from once stable currency to now annually changing volumes of currency. As such, as individuals and as a society we have deviated from assessing truth. This is the plain issue that one ought to be aware of.
Accounting – Theory
In the words of the International Financial Reporting Standards (IFRS), to which Australia aligns, “Financial reports represent economic phenomena in words and numbers. To be useful, financial information must not only represent relevant phenomena, but it must also faithfully represent the substance of the phenomena that it purports to represent.”1
The IFRS are here recognising an immortal truth of human endeavour:
- Humans will interact.
- Interactions organised in some way result in the surest attainment of goals.
- That accurate organised information allows better decisions to be made than does inaccurate organised information.
In training financial statement auditors, it is taught that one must gain comfort that the application of the accounting standards provide a true representation of the underlying economic situation. Mautz and Sharaf explain, “Although the auditor borrows GAAP [or International Accounting Standards] from the field of accounting, he does so with full recognition that he may have to reject their application in some cases. To the extent that the standards are satisfactory in bringing about a realistic portrayal of the facts of business activity and conditions he is grateful for them; to the extent that they fail, he must draw upon his knowledge of the goals and develop solutions which his experience and judgement tell him are constructively useful.”2
This is the precise thought process required in order to analyse the accounting and taxation treatment under the current economic environment of rapid credit creation; being a different economic environment from when many of these standards and laws were first created.
Accounting – Application
The Australian financial system has created new currency, by M3, at greater than 10% CAGR (compound annual growth rate) over the past 50 years3.
With every creation of new currency:
- Existing assets lose purchasing power, having to compete with new currency to buy market-place goods and services (an outflow of economic resources from an entity)
- Existing liabilities become easier to pay, requiring fewer economic resources to pay them (an inflow of economic resources to an entity).
The value of the loss or gain can be reliably measured. It is the rate at which the new currency was created, i.e. the percentage increase in total currency, applied to the fair market value of the asset or liability at opening. The accounting profession do not currently post journals to capture these income and expense events. As such, they are missing in analysis of entities and from assessment of laws of taxation.
A simplified example to explore the idea further. All figures are in AUD.
Running a business:
Consider a business who at 30 June 2019 had assets of 3m (including land and property worth 1m), debt of 2m and equity of 1m. During the year their EBT and NPAT were both nil, and at 30 June 2020, not from lack of trying, their balance sheet remains with assets of 3m, debt of 2m and equity of 1m. During this period, the financial system created 10% new AUD, being the long-run average.
At 30 June 2020, the debt of 2m can’t buy as much in the marketplace as a year ago, however, it also takes fewer sales of assets or services to repay. Thankfully, their land and property rose during the year to 1.1m. Turning that increase into tangible purchasing power seems impossible for these owners. Their maintenance costs increased, so did insurance and rates as well as the value of all land surrounding their land. They can’t purchase additional land using the gain. They observe an unrealised capital gain has arisen which, should they sell, would be taxed.
From the business’s perspective, the debt reducing in economic value is an inflow of economic resources to the entity. The value of this inflow is 10%, being the rate of change of the currency supply, multiplied by 2m, equalling $200,000. The assets, which are unable to buy as much today as one year ago, represent an outflow of economic resources from the entity, with a value of 10% of 3m, being $300,000. The true loss for this entity this period was $100,000 (also equal to 10% of opening equity). They have not recorded this in their reports. If this loss were booked, or known of during the year, the owners would have cut out some spending. They can’t afford to lose $100,000 each year. Breaking even seemed bearable to them, and good enough to try again next year.
They lament, this husband and wife, who’ve been in this position since 1970! They have been meticulous in their control of expenditure, not once entering a loss position in these 50 years and breaking even every year. They are one good year away from retiring. When they began, 1 July 1970, they had 3m of assets, 2m of debt, and their own contributed equity of 1m. “You should have seen the acreage we had back then! 3m sure bought a lot in 1970”, they say. Over the years they sold land to fund the business and paid themselves enough to cover the necessary costs of bringing up their family. Their 1.1m land owned today was the smallest in their portfolio in 1970. They paid $13,500 for it.
This business’s accounts have zero retained losses, in other words, the accounts tell us that this business has not made a loss, and that the owners are in the same position as they began in 1970. No profit and no loss. Ask yourself, are they in the same position of wealth as in 1970? In the words of the IFRS: Does their, “financial report represent economic phenomena in words and numbers?” Has the accounting, “faithfully represent[ed] the substance of the phenomena”? Indeed, are the reports “useful” at all? I see little use in them. Not if the aim is to improve your lot in life, nor if it be to report accurately on the performance of the capital at play. The data is in no way a faithful representation of the economic reality of the situation.
We do not ask you to unseat your directors […] but rather to carry on as you are now doing, with only one exception. We ask that you carry on your affairs as at present, except that you be honest – honest not only with others but with yourselves. […] Let us acknowledge the truth. Humanity is not suffering from unavoidable circumstances over which it has no control, but from the results of deliberate and dishonest actions of its own creation and invention.4 – Vincent C. Vickers, retired Governor of the Bank of England
Accurate accounting would require the IASB or AASB to review in a complete, thorough, and systematic manner the phenomenon in all situations of impact. It is not the purpose of this article to explore Statements of Accounting Concepts (SACs). Both these projects can be done, valid journals exist and they can be audited.
The tendency may later be for entities to overstate their losses by this method. This motivation is no different to many situations where estimates are in use. It will be a risk for auditors to add to their many risks that are assessed when auditing accounts. Additionally, a true-up journal could be performed on disposal of balance sheet items. If material errors are found, these can be corrected. Again, similar to what already occurs in the profession.
The purpose of this article is to state the case for the true and faithful representation of reality with reference to the stated aims of the internationally recognised Conceptual Framework for Financial Reporting. If you ask your accountant, auditor or governing bodies to look into this, you must take comfort that you have truth on your side.
- IFRS Conceptual Framework for Financial Reporting, March 2018 (current at May 2020).
- The philosophy of auditing by Robert K. Mautz and Hussein A. Sharaf (1961).
- Reserve Bank of Australia, monetary aggregates. Available from: <rba.gov.au/statistics/>.
- Economic tribulation by Vincent C. Vickers (1946).