Concept of capital and capital maintenance?

Answer 1

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.

Principles

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 marketrather 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.