What Is Capital Maintenance? Everything You Need to Know
Capital maintenance refers to the principle that the company income is fully recognized after the capital has been maintained and all costs have been recovered.3 min read
2. Capital Maintenance and Inflation
3. Capital Maintenance for Nonprofit Organizations
"What is capital maintenance?" is a question that those involved in business accounting functions can answer. Capital maintenance is a concept used in accounting to refer to the principle that the income of a company is only fully recognized after being sure that capital has been maintained and all costs have been recovered.
Your company will achieve capital maintenance if, at the end of a period, the capital that a company has remains unchanged. At this point, any excess will be considered company profit. Capital maintenance can also be referred to as capital recovery and basically means that the company only generates a profit once all of the costs associated with its operations during the accounting period selected have been fully recuperated.
The concept was used to create the distinction between a company's return on capital as well as its return of capital.
To effectively calculate profit, you must first know all of the business's financial and capital assets that it possesses at the beginning of the defined period. There are two primary subsections of capital maintenance:
- Financial capital maintenance
- Physical capital maintenance
According to the IFRS, or International Financial Reporting Standards, financial capital maintenance is defined as the profit that is earned once the amount exceeds the net assets by the end of the period of time selected. This calculation will exclude any of the amounts that have flowed in to or out from the owners, such as distributions and contributions.
When determining these amounts, you can measure them by either monetary measures or constant purchasing power units. In regards to financial capital, you only need to be concerned with actual funds that the company has at the start of the determined accounting period. It does not include the value of other capital assets the company may have.
This means that certain items will be excluded from physical capital maintenance, such as the costs that are associated with maintenance of tangible items such as equipment. Physical capital maintenance will instead focus on the company's ability to sustain its financial capital such as cash flow. This is done by maintaining the income-generating assets in the business to maintain the company's cash flow.
While physical capital maintenance does not always have a specific definition, one of the components that make up physical capital maintenance involves replacement costs, which means that income can only occur after all the costs of replacing the capital of a company has been replaced.
By the definition set forth by the IFRS, profit is earned by the company only in the event that the productive and operating capacity of the business meets or exceeds its capacity that it started with at the beginning of the period chosen.
Capital Maintenance and Inflation
Inflation can skew the values of a company's net assets even when the underlying asset has not undergone any changes in its condition or quantity. If your business is operating in an environment that is considered hyperinflationary, you may need to adjust the values based on the rate of inflation to obtain a proper calculation.
With the definition of the capital maintenance concept, the business will not be considered profitable until it has maintained or increased the number of its assets during the period of accounting being reflected. Therefore, adjusting for inflation on your assets is essential for accurately representing this figure. Often times, though, inflation is not accounted for as controllers will not also work it into their calculations. Your assets can increase from selling stock to shareholders and can decrease from the payment of the dividends to the shareholders as well.
Capital Maintenance for Nonprofit Organizations
The concept of capital maintenance may have a more severe impact in regards to nonprofit organizations. Certain state laws may have donor agreements that require the endowment balances not to be lost. This means that endowment balances will often have to be replenished from different sources if the organization has an accounting period where the earnings of the organization or the invested funds become negative. When this occurs, it can cause a significant drop in the availability of funds to meet the operational needs.
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