Concepts of Capital and Capital maintenance

A financial concept of capital is adopted by most entities in preparing their financial statements. Under a financial concept of capital, such as invested money or invested purchasing power, capital is synonymous with the net assets or equity of the entity. Under a physical concept of capital, such as operating capability, capital is regarded as the productive capacity of the entity based on, for example, units of output per day.

The selection of the appropriate concept of capital by an entity should be based on the needs of the users of its financial statements. Thus, a financial concept of capital should be adopted if the users of financial statements are primarily concerned with the maintenance of nominal invested capital or the purchasing power of invested capital.

If, however, the main concern of users is with the operating capability of the entity, a physical concept of capital should be used. The concept chosen indicates the goal to be attained in determining profit, even though there may be some measurement difficulties in making the concept operational.

Concepts of capital maintenance and the determination of profit

The capital maintenance concept states that the business net worth is said to have been maintained if net assets at the end of the period are equal to or more than net assets at the beginning of the accounting period keeping aside any withdrawal during the said period. In other words, it states that the company must book net income only when it has recovered its capital or the cost, i.e., an adequate amount of capital has been maintained.

Financial capital maintenance. Under this concept a profit is earned only if the financial (or money) amount of the net assets at the end of the period exceeds the financial (or money) amount of net assets at the beginning of the period, after excluding any distributions to, and contributions from, owners during the period. Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power.

All the inflows such as the sale of stock to shareholders, the addition of capital from owners, and payment of dividends to shareholders payment of bonus to shareholders are excluded. The two measurement units of financial capital maintenance theory are constant purchasing power units and nominal monetary units.

Financial capital maintenance is affected only by the entire amount of funds available at the starting of the year and the funds available at the end of the year. Therefore, this concept is least concerned with any other capital assets transaction undertaken during the financial year.

Physical capital maintenance. Under this concept a profit is earned only if the physical productive capacity (or operating capability) of the entity (or the resources or funds needed to achieve that capacity) at the end of the period exceeds the physical productive capacity at the beginning of the period, after excluding any distributions to, and contributions from, owners during the period.

This method books profit only when the physical production capacity of the business at the end of the year is more than or equal to the physical production capacity of the business at the beginning of the year except any amount adjusted towards any amount paid to owners during the year or any amount raised by the owner. The main use of this method is for checking and maintaining the operational business capacity.

Capital Maintenance and Inflation

Inflation is the increase in any product/service cost or decrease in purchasing capacity. When the inflation rate is high, which has occurred in a short duration of time can affect the business’s ability to determine if it has achieved capital maintenance or not accurately. Due to inflation, the purchase price of assets gets increased accordingly, the value of the company’s net assets also increases. But the increase due to this inflation misrepresents the original value of the company’s assets.

Capital maintenance is distorted at the time of inflation as the pressure of inflation will increase the net assets even if their original value is unchanged. Due to this reason, at the time of inflammation, the companies must adjust the value of their assets to determine whether they have achieved capital maintenance. This is very important if the business operates in a hyperinflationary  economy.