The accounting framework argues that capital is maintained if the closing capital position of a business is greater than the opening capital position. If a business makes a loss, it destroys capital. If it breaks even or makes a profit, it maintains or increases capital, respectively.
Capital maintenance can be classified in two ways namely:
- financial capital maintenance
- physical capital maintenance
Both financial capital and physical capital maintenance should be adjusted to reflect the impact of new capital contributions by owners and capital distributions to owners during the financial year. The section below discusses in more detail both financial capital and physical capital maintenance.
Financial Capital Maintenance
According to the financial capital maintenance theory, a profit is earned only if the monetary amount of net assets at the end of a period exceeds the monetary amount of net assets at the start of a period. If the net assets of a business go down or if they decline during the year, then that business would have failed in maintaining its capital.
Businesses that maintain or increase capital are likely going to continue growing because they will have the capital resources to support them. Businesses that continuously fail to maintain capital will eventually go out of business because they will eventually become underfunded, therefore leading to failure to support objectives.
Financial capital can be measured in both nominal monetary amounts or in units of the current purchasing power as determined using the relevant price index. The nominal value denominated measure of capital assumes a constant dollar; that is, it assumes the value of the dollar at the beginning of a financial period is the same as the dollar at the end of the financial year.
The capital maintenance that is adjusted for the current purchasing power adjusts the closing capital position so that the impact of inflation and time value of money are reflected in the capital measure. Under the current purchasing power method, a business that maintains the par value or nominal value of capital would have lost capital because some value would have been lost through inflation.
Physical Capital Maintenance
Under the physical capital maintenance, a profit is only earned by a business if the physical operating capability of the business at the end of a financial period exceeds its physical operating capability at the start of the financial period.
According to the physical capital maintenance, making a financial profit alone is not enough in increasing or maintaining the business’ capital. A business should also increase its production capacity, or it should sell more products or services than the previous year if it is to increase its physical capital. If the business produces less or if it sells less than in the prior year, it is considered to have failed to maintain its physical capital.
The objective of managers or the business is to maintain or increase both the financial capital and physical capital. If a business has an opening capital and closing capital for a period which is the same, then capital would have been maintained. If capital has increased over a period, then a profit has been earned. If capital has reduced, then a loss would have been made.
Munya Mtetwa - Munya is an ACCA and IFA qualified accountant with over ten years financial management and accounting experience acquired in a plethora of ...
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