Top 3 Concepts of Capital Maintenance in an Enterprise

The following points highlight the top three concepts of capital maintenance in an enterprise. The concepts are: 1. Financial Capital Maintenance 2. General Purchasing Power Financial Capital Maintenance 3. Physical or Operating Capital Maintenance.

Concept # 1. Financial Capital Maintenance:

Financial or money capital maintenance pertains to the original cash invested by the shareholders in the business enterprise. According to this concept periodic income should be measured after recovering or maintaining the shareholders’ equity intact.

Income under this concept is the difference between opening and closing shareholders’ equity. It is this amount which may be distributed as income without encroaching upon the financial capital of the firm. For instance, the capital of a firm is Rs. 1,50,000 at the beginning of the year and Rs. 2,00,000 at the end of the year in monetary units.

Assuming no capital transactions during the year, Rs. 50,000 will be the income which can be distributed and still the firm will be well off at the end of the year as at the beginning. The financial capital maintenance concept is reflected in conventional or historical cost accounting.

Financial capital maintenance concept assumes a constant (stable) unit of measurement to determine the income by comparing the end-of-the-year capital with the beginning capital. Changes in the price levels during the period is not recognised. Because of this and other underlying principles, income measurement under this concept may not prove to be reliable and useful for decision-making purposes.

Concept # 2. General Purchasing Power Financial Capital Maintenance:

This concept aims at maintaining the purchasing power of the financial capital by continuously updating the historical cost of assets for changes in the value of money. This concept attempts to show to shareholders that their company has kept pace with general inflationary pressures during the accounting period, by measuring income in such a way as to take account changes in the price-levels.

It intends to maintain the Shareholders’ capital in terms of monetary units of constant purchasing power. It reflects the proprietorship view of the enterprise which demands that the objective of profit measurement should focus on the wealth of equity shareholders.

Taking the earlier example, if it assumed that the rate of inflation was 10 per cent during the year, the initial Rs. 1,50,000 capital is adjusted in terms of inflation. That is, in the terms of inflation the capital that needs to be maintained in tact is Rs. 1,65,000, and income will be Rs. 35,000 which can be distributed without encroaching the capital of the firm.

This approach suggests that the accountant should be aware of the measurement- unit problem that arises in a period of unstable general price-level conditions.

Instead of comparing the capital in units of money, it is preferable to compare beginning and ending capital, measured in units of the same purchasing power. The main drawback of financial capital maintenance concept is that the resulting bottom-line income figure includes holding gains as a component of periodic income.

Reflecting holding gains in the income statement may indicate:

(i) The success of the firm in buying inventories and equipment at prices which have subsequently increased, and

(ii) A surrogate of an increase in the exit value or the present value from selling or using the assets in question.

On the other hand, inclusion of such holding gains may raise two serious problems. First, the reported income figure, if distributed as dividends, could impair the firm’s ability to maintain its current level of operations. Such holding gains can only be available for distribution if the company is liquidated.

In the absence of evidence to the contrary, the firm is assumed to be going concern and, as such, any holding gains should not be considered income that can be distributed as dividends.

The second criticism of the bottom-line income measure is that it may not be useful to investors interested in normal operating results as a basis for predicting future normal operating income. An enterprise that maintains its net assets (capital) at a fixed amount of money in periods of inflation or deflation does not remain equally well-off in terms of purchasing power.

Concept # 3. Physical or Operating Capital Maintenance:

Physical or operating capital concept is expressed in terms of maintaining operating capability that is, maintaining the capacity of an enterprise to provide a given physical level of operations. The level of operations may be indicated by the quantity of goods and services of specified quality produced in a fixed period of time.

Financial capital maintenance concept— money capital and purchasing power concept both—views the capital of the enterprise from the standpoint of the shareholders as owners. In other words, it recognises the proprietorship concept of the enterprise while measuring income and capital, and applies valuation system which are in conformity with this concept.

On the other hand, the physical or operating capacity maintenance concept views capital as a physical phenomenon in terms of the capacity to produce goods or services and considers the problem of capital maintenance from the perspective of the enterprise itself and thus it reflects the entity concept of the enterprise.

Operating capacity concept provides that the income should be measured after productive (physical) capacity of the enterprise has been maintained intact, i.e., after provision has been made for replacing the physical resources exhausted in the course of business operations. Such income can be distributed without impairing the firm’s ability to maintain its operating level.

This income is also known as “sustainable” income implying that the firm can sustain such income as long as the firm insures the maintenance of its present physical operating capacity. This view is based on the following rationale. Firms produce certain goods or services.

To ensure a firm’s ability to produce such goods and services, at least at its present operating levels, it is necessary for the firm to maintain its prevailing physical operating capacity. This implies that income should represent the maximum dividend that could be paid without impairing the productive capacity of the firm.

The operating capability concept implies that in times of rising prices increased fund will be required to maintain assets. These funds might not be available if profit is determined without recognition of the rising costs of assets consumed in operations. For example, profit would not be earned on the sale for Rs. 1,000 of 100 units of stock costing Rs. 800 if their replacement cost was Rs. 1,000.

In this situation, an outlay of Rs. 1,000 would be required in order to maintain the operating capability of the business in terms of 100 units of stock. In other words, the increase in the cost of the stock necessitates the investment of additional funds in the business in order to maintain it as an operating unit.

The operating capability concept does not imply that the firm should necessarily replace assets with identical items. Business enterprises, being dynamic, may extend, contract, or change their activities in whichever way desired. The concept simply means that the operating capability should be maintained at the same level at the end of a period as it was at the beginning.

The operating capability concept considers the problem of capital maintenance from the perspective of the enterprise itself. This concept emphasises current cost accounting. However, there is a difference of opinion regarding the meaning of maintaining physical productive capacity or operating capability.

At-least three different interpretations are suggested:

(a) Maintaining identical or similar physical assets that the firm presently owns.

(b) Maintaining the capacity to produce the same volume of goods and services.

(c) Maintaining the capacity to produce the same value of goods and services.

The second interpretation implies technological improvements and in this respect is superior to the first interpretation, which essentially assumes the firm will maintain and replace its identical assets, an untenable assumption in light of technological improvements.

The third interpretation not only reflects technological changes but also the impact of changes on the selling prices of outputs. Although this might be a highly refined approach, it may well be difficult to implement.

On the balance sheet, the physical capacity maintenance concept requires the valuation of the physical assets of the firm at their current cost or lower recovery value (i.e., the higher of present value or net realisable value).

To compute income that preserves the physical capital intact, the holding gains and losses resulting from increases or decreases in the current costs of the productive capacity of the firm are treated as “capital maintenance adjustments.”

Once the necessary capital maintenance adjustments are made, the difference between beginning and ending capital would represent (assuming the ending capital is greater, and in the absence of any capital transactions by the owners) the amount that could be distributed while maintaining the physical capital of the firm intact.

In the income statement, the income of the period, under the physical capital maintenance approach, is measured by matching the realised revenues with the current cost of the assets sold or consumed.

Such a direct comparison, however, is only possible under a stable monetary situation. When changes in the general level of prices occur, the respective monetary measures of the physical capital amounts must be restated in units of the same purchasing power.

The basic difference between the financial and physical capital maintenance concept using current (replacement) cost is in the treatment of “holding gains and losses.” Under the financial capital maintenance concept, holding gains are reflected as income of the given period, whereas the concept of physical capital maintenance holding gains are shown in the shareholders’ equity section of the balance sheet as “capital maintenance adjustments.”

The physical capital maintenance concept is useful as a basis for providing information that would assist users in predicting the amounts, timing, and risks associated with future cash flows that could be expected from the firm. Information that enables users to assess whether an enterprise has maintained, increased or decreased its operating capability may be helpful for Understanding enterprise performance and predicting future cash flows; in particular, it may help users to understand past changes and to predict future changes in the volume of activity.

Also, the physical capacity maintenance concept is consistent with the going concern assumption—by maintaining the firm’s ability to continue its normal operations—and the enterprise theory of the firm.

Example:

During the year ended 31st December 2008 a company, a Rs. 40,000 equity financed company acquired an asset at a cost of Rs. 40,000. By 31 December 2008 its replacement cost had risen to Rs. 60,000. It was sold on 31st December 2009 for Rs. 1,00,000 and at the time of sale, its replacement cost was Rs. 65,000.

For the purpose of measuring historical cost profit, the profit arising from the sale of the asset (assuming no depreciation) would accrue in the year ended 31 December 2009 and would be calculated as follows:

HC profit = Revenue – Historical cost

= Rs. 1,00,000 – Rs. 40,000

= Rs. 60,000

For the purpose of measuring replacement cost profit three distinct gains are recognized which occur as follows:

(а) A holding gain in the year ended 31 December 2008 measured as the difference between the replacement cost at 31 December 2008 and the acquisition cost during the year, that is Rs. 60,000 – Rs. 40,000 = Rs. 20,000.

(b) A holding gain in the year ended 31 December 2009 measured as the difference between the replacement cost at 31 December 2008 and the replacement cost on the date of sale, that is Rs. 65,000 – Rs. 60,000 = Rs. 5,000/-.

(c) An operating gain resulting directly from the activity of selling measured as the difference between the realized sale price and the replacement cost at the date of sale, that is Rs. 1,00,000 – Rs. 65,000 = Rs. 35,000.

These differing timings of profit recognition may be compared as follows:

It is clear from this example that the difference between historical and replacement cost relate to the timing of reported gains and losses since the total gain over the two periods is Rs. 60,000 in each case.

Furthermore, the replacement cost concept provides more detailed information than the historical cost profit for performance evaluation. Two arguments for the separation of profit into holding and operating gains have been suggested. First, the two profit categories may be used to evaluate different aspects of management activity. Secondly, they permit better inter-period and inter-firm comparisons.

Holding gains on assets which have not been sold are termed ‘unrealized’, after sale they are said to be ‘realized.’ When the concept of maintenance of operating capability is applied no part of the holding gain can be regarded as profit. This should be credited to a capital maintenance reserve, designated current cost reserve by UK’s SSAP 16.

Assuming all of the Rs. 35,000 operating profit was distributed as dividends the condensed balance sheet of the company at 31st December 2009 would appear as follows:

If the balance sheet of the company is prepared on a historical cost basis, and assuming the Rs. 60000 profit was all distributed as dividends the position would appear as follows:

This example shows clearly how under the financial maintenance concept capital may be distributed to shareholder to the detriment of the long-term viability of the business. General or Current purchasing power accounting is not designed to differentiate between operating profits and holding gains.

However, it may be used to compute real gain or loss, i.e., the surplus or shortfall between the replacement cost value and what this would have been if it had behaved like prices in general. Taking the above example assume the retail price index at 31st December 2009 has increased by 10 per cent since company bought the asset in question.

Real gain is calculated as follows:

This shows that the company has beaten the general index to make a real gain of Rs. 21,000. In maintenance of general purchasing power financial capital, real holding gains form part of profit; the gain exceeds that needed to maintain the purchase which resulted in the gain. Therefore, under this concept of capital maintenance Rs. 56000 (Rs. 21000 + Rs. 35000) would be available for distribution as dividends.

If the company did take this step the balance sheet based on maintenance of current purchasing power financial capital at 31st December 2009 would appear as follows: