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Capital Maintenance

Capital Maintenance

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Published by Pj Sorn

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Published by: Pj Sorn on Jul 05, 2010
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06/08/2013

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Capital maintenance
Two approaches to measuring income are commonly discussed in theaccounting literature: the transaction approach and the capital maintenanceapproach. Under the transaction approach, income is calculated by analyzing theeffects of revenue and expense transactions during a period. Any change in thevalue of the enterprise that is not a result of a transaction is not reflected in theenterprise's net income. Income from continuing operations under currentGAAP is based on the transaction approach.
Under the capital maintenance approach
, however, net income is definedas the difference between the net assets (assets minus liabilities) at the beginning of a period and net assets at the end of the period, excluding owners'contributions and distributions during the period. The capital maintenanceapproach captures all changes in the value of the enterprise during a period,regardless of whether the change resulted from a transaction.Accounting concept that a profit can be realized only after capital of thefirm has either been restored to its original level (called 'capital recovery') or ismaintained at a predetermined level. It is necessary, therefore, to determine thevalue of capital before the amount of profit can be computed. Capitalmaintenance (paid from the capital funds budget) is the work performed using asystematic management process to plan and budget for known cyclical repair and replacement requirements that extend the life and retain the usablecondition of facilities and systems. This includes what is commonly known as“deferred maintenance”: work that has been deferred on a planned or unplanned basis to a future budget cycle or postponed until funds are available; when thework is performed the deferred maintenance backlog is reduced. The conceptsof capital give rise to the following
concepts of capital maintenance
:
1.
The
 financial capital maintenance concept 
is that the capital of acompany is only maintained if the financial or monetary amount of its net assetsat the end of a financial period is equal to or exceeds the financial or monetaryamount of its net assets at the beginning of the period, excluding anydistributions to, or contributions from, the owners.
2.
The
 physical capital maintenance concept 
is that the physical capital isonly maintained if the physical productive or operating capacity, or the funds or resources required to achieve this capacity, is equal to or exceeds the physical productive capacity at the beginning of the period, after excluding anydistributions to, or contributions from, owners during the financial period.
 
The concept of capital maintenance is concerned with how an enterprisedefines the capital that it seeks to maintain. It provides the linkage between theconcepts of capital and the concepts of profit because it provides the point of reference by which profit is measured; it is a prerequisite for distinguishing between an enterprise's return on capital and its return of capital; only inflowsof assets in excess of amounts needed to maintain capital may be regarded as profit and therefore as a return on capital. Hence, profit is the residual amountthat remains after expenses (including capital maintenance adjustments, whereappropriate) have been deducted from income. If expenses exceed income theresidual amount is a net loss.The physical capital maintenance concept requires the adoption of thecurrent cost basis of measurement. The financial capital maintenance concept,however, does not require the use of a particular basis of measurement.Selection of the basis under this concept is dependent on the type of financialcapital that the enterprise is seeking to maintain.The principal difference between the two concepts of capital maintenance isthe treatment of the effects of changes in the prices of assets and liabilities of the enterprise. In general terms, an enterprise has maintained its capital if it hasas much capital at the end of the period as it had at the beginning of the period.Any amount over and above that required to maintain the capital at the beginning of the period is profit.Under the concept of financial capital maintenance where capital is definedin terms of nominal monetary units, profit represents the increase in nominalmoney capital over the period. Thus, increases in the prices of assets held over the period, conventionally referred to as holding gains, are, conceptually, profits. They may not be recognized as such, however, until the assets aredisposed of in an exchange transaction. When the concept of financial capitalmaintenance is defined in terms of constant purchasing power units, profitrepresents the increase in invested purchasing power over the period. Thus, onlythat part of the increase in the prices of assets that exceeds the increase in thegeneral level of prices is regarded as profit. The rest of the increase is treated asa capital maintenance adjustment and, hence, as part of equity.Under the concept of physical capital maintenance when capital is defined interms of the physical productive capacity, profit represents the increase in thatcapital over the period. All price changes affecting the assets and liabilities of the enterprise are viewed as changes in the measurement of the physical productive capacity of the enterprise; hence, they are treated as capitalmaintenance adjustments that are part of equity and not as profit.
 
The selection of the measurement bases and concept of capital maintenancewill determine the accounting model used in the preparation of the financialstatements. Different accounting models exhibit different degrees of relevanceand reliability and, as in other areas, management must seek a balance betweenrelevance and reliability. This framework is applicable to a range of accountingmodels and provides guidance on preparing and presenting the financialstatements constructed under the chosen model. At the present time, it is not theintention of the Board of IASC to prescribe a particular model other than inexceptional circumstances, such as for those enterprises reporting in thecurrency of a hyperinflationary economy. This intention will, however, bereviewed in the light of world developments.

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