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Capital maintenance

Two approaches to measuring income are commonly discussed in the

accounting literature: the transaction approach and the capital maintenance
approach. Under the transaction approach, income is calculated by analyzing the
effects of revenue and expense transactions during a period. Any change in the
value of the enterprise that is not a result of a transaction is not reflected in the
enterprise's net income. Income from continuing operations under current
GAAP is based on the transaction approach.

Under the capital maintenance approach, however, net income is defined

as 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 maintenance
approach 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 the
firm has either been restored to its original level (called 'capital recovery') or is
maintained at a predetermined level. It is necessary, therefore, to determine the
value of capital before the amount of profit can be computed. Capital
maintenance (paid from the capital funds budget) is the work performed using a
systematic management process to plan and budget for known cyclical repair
and replacement requirements that extend the life and retain the usable
condition 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 the
work is performed the deferred maintenance backlog is reduced. The concepts
of capital give rise to the following concepts of capital maintenance:

1. The financial capital maintenance concept is that the capital of a

company is only maintained if the financial or monetary amount of its net assets
at the end of a financial period is equal to or exceeds the financial or monetary
amount of its net assets at the beginning of the period, excluding any
distributions to, or contributions from, the owners.
2. The physical capital maintenance concept is that the physical capital is
only 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 any
distributions to, or contributions from, owners during the financial period.
The concept of capital maintenance is concerned with how an enterprise
defines the capital that it seeks to maintain. It provides the linkage between the
concepts 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 inflows
of 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 amount
that remains after expenses (including capital maintenance adjustments, where
appropriate) have been deducted from income. If expenses exceed income the
residual amount is a net loss.

The physical capital maintenance concept requires the adoption of the

current 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 financial
capital that the enterprise is seeking to maintain.

The principal difference between the two concepts of capital maintenance is

the 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 has
as 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 defined

in terms of nominal monetary units, profit represents the increase in nominal
money 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 are
disposed of in an exchange transaction. When the concept of financial capital
maintenance is defined in terms of constant purchasing power units, profit
represents the increase in invested purchasing power over the period. Thus, only
that part of the increase in the prices of assets that exceeds the increase in the
general level of prices is regarded as profit. The rest of the increase is treated as
a capital maintenance adjustment and, hence, as part of equity.

Under the concept of physical capital maintenance when capital is defined in

terms of the physical productive capacity, profit represents the increase in that
capital 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 capital
maintenance adjustments that are part of equity and not as profit.
The selection of the measurement bases and concept of capital maintenance
will determine the accounting model used in the preparation of the financial
statements. Different accounting models exhibit different degrees of relevance
and reliability and, as in other areas, management must seek a balance between
relevance and reliability. This framework is applicable to a range of accounting
models and provides guidance on preparing and presenting the financial
statements constructed under the chosen model. At the present time, it is not the
intention of the Board of IASC to prescribe a particular model other than in
exceptional circumstances, such as for those enterprises reporting in the
currency of a hyperinflationary economy. This intention will, however, be
reviewed in the light of world developments.

Accounting has not yet advanced to a state of being able to value a business
(or a business's assets). As such, many transactions and events are reported
based upon the historical cost principle (in contrast to fair value). This
principle holds that it is better to maintain accountability over certain financial
statement elements at amounts that are objective and verifiable, rather than
opening the door to random adjustments for value changes that may not be
supportable. For example, land is initially recorded in the accounting records at
its purchase price. That historical cost will not be adjusted even if the fair value
is perceived as increasing. While this enhances the "reliability" of reported
data, it can also pose a limitation on its "relevance."

The FASB defines “fair value” as “the price at which an asset or liability could
be exchanged in a current transaction between knowledgeable, unrelated willing
parties” (FASB, 2004a).4 As the FASB notes, “the objective of a fair value
measurement is to estimate an exchange price for the asset or liability being
measured in the absence of an actual transaction for that asset or liability.”
Implicit in this objective is the notion that fair value is well defined so that an
asset or liability’s exchange price fully captures its value. That is, the price at
which an asset can be exchanged between two entities does not depend on the
entities engaged in the exchange and this price also equals the value-in-use to
any entity. For example, the value of a swap derivative to a bank equals the
price at which it can purchase or sell that derivative, and the swap's value does
not depend on the existing assets and liabilities on the bank’s balance sheet. For
such a bank, Barth and Landsman (1995) notes that this is a strong assumption
to make particularly if many of its assets and liabilities cannot readily be traded.
I will return to the implications of this problem when discussing implementation
of marking-to-market issues below. Fair value is an exit value (the price
received to sell an asset) and transaction costs are not included (hence the
substitution of ‘price’ for ‘amount’). Moreover, the reference to a market rather
than a transaction between parties emphasizes the requirement that the measure
be non entity specific, i.e. it should be based on a hypothetical best market price
rather than the price actually paid or that would be actually obtained by the
reporting entity. More recently, standard setters have preferred to use the term
fair value, meaning a current market value.