What is 'Capital Maintenance'
Capital maintenance is an accounting concept based on the principle that income is only recognized after capital has been maintained or there has been a full recovery of costs. Capital maintenance has been reached if the amount of a company's capital at the end of a period is unchanged from that at the beginning of the period, with any excess amount treated as profit.
BREAKING DOWN 'Capital Maintenance'Also referred to as capital recovery, capital maintenance means that a profit is only generated once the costs associated with operations during the selected accounting period have been fully recuperated. As capital maintenance is mainly concerned with an enterprise's definition of the capital sought to be maintained by it, the concept distinguishes between the enterprise's return on capital and its return of capital.
To calculate the profit, the total value of the business's financial and other capital assets at the beginning of the period must be known. The two basic subsections of capital maintenance are financial capital maintenance and physical capital maintenance.
Financial Capital Maintenance
According to International Financial Reporting Standards (IFRS), under the definition of financial capital maintenance, a profit is earned only if the amount of net assets at the end of a period exceeds the amount at the beginning of the period, excluding any inflows from or outflows to owners, such as contributions and distributions. It can be measured either in nominal monetary units or constant purchasing power units.
Financial capital maintenance is only concerned with the actual funds available at the start and the end of a specified accounting cycle and does not include the value of other capital assets.
Physical Capital Maintenance
Physical capital maintenance is not concerned with the cost associated with the actual maintenance required on tangible items, such as equipment. Instead, it focuses on a business's ability to sustain cash flows into the future by maintaining access to income-generating assets in use within the business's infrastructure.
The definition of physical capital maintenance, according to the IFRS, implies that a profit is earned only if the enterprise's productive or operating capacity at the end of a period exceeds the capacity at the beginning of the period, excluding any owners' contributions or distributions.
Capital Maintenance and Inflation
Inflation has the ability to skew the value of net assets even when the underlying asset has not changed in quantity or condition. For businesses operating in a hyperinflationary environment, adjusting values to reflect the rate of inflation properly may be required.