Updated July 13, 2023
What is Capital Maintenance?
The term “capital maintenance” refers to the concept that states that the net worth of a business can be maintained only if the value of net assets at the end of the period is equal to or more than that at the beginning of the period without infusion or withdrawal of any capital during the period.
In other words, a company can recognize profit only when it has recovered its capital or cost and maintained the capital till the end of the given period. It is also popularly called Capital Recovery.
How Does Capital Maintenance Work?
The theory states that companies shouldn’t book profit until an adequate amount of capital maintains in net assets. Essentially, profit represents an expansion of assets during a period while excluding an increase in the capital due to the sale of additional equity stocks or a decrease in capital owing to dividend payout. This theory defies the window-dressed booked profits and describes the actual change in the account balances.
Types of Capital Maintenance
Capital maintenance can divide into two different types:
1. Financial Capital Maintenance
In this type, a company books profit only if the value of its net assets at the end of a period is equal to or more than the amount at the start of the period. It discounts any capital inflow (such as shareholder contributions) or outflow (such as dividend distributions). Typically, it measures either constant purchasing power units or nominal monetary units. In this, the focus is on actual funds available at the beginning and the end of a given accounting period and excludes the value of other capital assets.
2. Physical Capital Maintenance
In this type, the focus is on the ability of the business to sustain cash flows by developing income-generating assets within the business itself. It doesn’t include the costs of maintaining tangible items, such as equipment. As per physical capital maintenance, a company must recognize profit only if operating or productive capacity at the end of a period surpasses that at the start while excluding any contributions or distributions.
The main purpose is to protect the stakeholders, such as creditors, lenders, and shareholders. The statutory requirement of capital maintenance forces companies to comply with all regulatory obligations to avoid any damage to their brand value. Essentially, it ensures the safety of the stakeholders’ invested funds, which can be instrumental in attracting a large number of potential investors seeking lucrative investment opportunities.
It is a useful analysis tool that business owners and other interested participants can use to evaluate a company’s performance over time. This concept is essential for creditors and lenders to decide whether or not to extend funds to a company. Most companies run their businesses by leveraging funds from banks, and this is where it can help the lenders estimate the time that the borrower will take to repay based on the ability of the business to generate value.
Financial Capital Maintenance vs Physical Capital Maintenance
The underlying principle of financial and physical capital maintenance is the same. However, in the case of financial capital maintenance, profit measures either the dollar value of a company’s equity or the purchasing power of those dollars. On the other hand, in the case of physical capital maintenance, the focus is not on the value of equity but rather on the operating capability of the company’s assets. The subtle variation in focus is the only major difference between financial and physical capital maintenance.
Some of the major advantages are as follows:
- It helps the creditors protect their funds. Essentially, it creates a barrier such that there is a limit to the companies’ ability to withdraw money, which protects the creditors.
- It helps the management and the business owners analyze the business performance over a period of time and compare them with other companies.
Some of the key takeaways of the article are:
- An important accounting concept states that a company should recognize profit only if it has recovered its capital or costs in full such that the capital is maintained.
- The computation excludes any type of movement in asset value, such increase due to the sale of additional equity stocks or a decrease due to dividend payout.
- At the beginning of a period, the capital should consider the minimum funds needed to fulfill the requirements.
So, it can be seen that the concept of capital maintenance primarily revolves around how a company defines the capital that it intends to maintain. It links the concepts of capital to the concepts of profit by providing a point of reference for recognizing profit based on the change in capital. This accounting concept protects the stakeholders and helps the companies estimate their real value. In short, a concept is an important tool for anybody associated with any business.
This is a guide to Capital Maintenance. Here we also discuss the definitions, types, and working along with its impact and advantages. You may also have a look at the following articles to learn more –