Concepts of Capital and Capital Maintenance

Concepts of Capital | Concepts of Capital Maintenance and the Determination of Profit

Concepts of Capital

102

A financial concept of capital is adopted by most entities in preparing their financial statements.  Under a financial concept of capital, such as invested money or invested purchasing power, capital is synonymous with the net assets or equity of the entity.  Under a physical concept of capital, such as operating capability, capital is regarded as the productive capacity of the entity based on, for example, units of output per day.

103

The selection of the appropriate concept of capital by an entity should be based on the needs of the users of its financial statements.  Thus, a financial concept of capital should be adopted if the users of financial statements are primarily concerned with the maintenance of nominal invested capital or the purchasing power of invested capital.  If, however, the main concern of users is with the operating capability of the entity, a physical concept of capital should be used.  The concept chosen indicates the goal to be attained in determining profit, even though there may be some measurement difficulties in making the concept operational.

Concepts of Capital Maintenance and the Determination of Profit

104

The concepts of capital in paragraph 102 give rise to the following concepts of capital maintenance.

(a) Financial capital maintenance Under this concept, a profit is earned only if the financial (or money) amount of the net assets at the end of the period exceeds the financial (or money) amount of net assets at the beginning of the period, after excluding any distributions to, and contributions from, owners during the period. Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power.

(b) Physical capital maintenance Under this concept, a profit is earned only if the physical productive capacity (or operating capability) of the entity (or the resources or funds needed to achieve that capacity) at the end of the period exceeds the physical productive capacity at the beginning of the period, after excluding any distributions to, and contributions from, owners during the period.

105

The concept of capital maintenance is concerned with how an entity 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 entity’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.

106

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 entity is seeking to maintain.

107

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 entity.  In general terms, an entity 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.

108

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 recognised 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.

109

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 entity are viewed as changes in the measurement of the physical productive capacity of the entity.  Hence, they are treated as capital maintenance adjustments that are part of equity and not as profit.

110

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 AASB to prescribe a particular model other than in exceptional circumstances, such as for those entities reporting in the currency of a hyperinflationary economy.  This intention will, however, be reviewed in the light of world developments.