Meaning of Capital Maintenance
The Conceptual Framework for Financial Reporting explains the concepts of capital and capital maintenance. Capital maintenance determines how an entity defines the capital that it intends to maintain while measuring its profit.
The concept is important for determining whether an entity has actually earned a profit during a particular accounting period. Under the Conceptual Framework, capital maintenance is broadly based on two approaches: Financial Capital Maintenance and Physical Capital Maintenance.
Financial Capital Maintenance
Under the Financial Capital Maintenance concept, profit is considered to have been earned only when the financial amount of the entity’s net assets at the end of the accounting period exceeds the financial amount of net assets at the beginning of the period.
This concept focuses on maintaining the financial value of capital. Therefore, an increase in the financial amount of net assets over the accounting period indicates that the entity has earned a profit.
In simple terms, the financial capital of the entity at the end of the period is compared with its financial capital at the beginning of the period. Profit arises only when the closing financial amount of net assets is higher than the opening amount.
Physical Capital Maintenance
Under the Physical Capital Maintenance concept, profit is considered to have been earned only when the physical productive capacity of the entity at the end of the accounting period exceeds its physical productive capacity at the beginning of the period.
This concept focuses on maintaining the entity’s ability to produce goods or provide services. Therefore, the measurement of profit is based on changes in the physical productive capacity of the entity rather than only on changes in the financial amount of its net assets.
Profit is recognized only after the entity has maintained its opening productive capacity and the closing productive capacity exceeds the capacity available at the beginning of the period.
Difference Between Financial and Physical Capital Maintenance
The main difference between the two concepts lies in the meaning of capital being maintained. Financial Capital Maintenance focuses on the financial amount of net assets, whereas Physical Capital Maintenance focuses on the physical productive capacity of the entity.
Under financial capital maintenance, profit is determined by comparing the financial value of net assets at the beginning and end of the period. Under physical capital maintenance, profit is determined by comparing the productive capacity of the entity at the beginning and end of the period.
Key Points
The capital maintenance concept determines how an entity defines the capital it seeks to maintain while measuring profit.
Under Financial Capital Maintenance, profit is earned only when the financial amount of net assets at the end of the period exceeds the amount at the beginning of the period.
Under Physical Capital Maintenance, profit is earned only when the physical productive capacity at the end of the period exceeds the productive capacity at the beginning of the period.
For examination purposes, remember: Financial Capital Maintenance focuses on net assets, while Physical Capital Maintenance focuses on productive capacity.