What is Capital Maintenance?
Capital maintenance concept states that the business net worth is said to have maintained if net assets at the end of the period are equal to or more than net assets at the beginning of the accounting period keeping aside any withdrawal during the said period. In other words, it states that the company must book net income only when it has recovered its capital or the cost, i.e., an adequate amount of capital has been maintained.
Capital maintenance theory suggests that one must not book profits until there is a sufficient amount of capital maintained in net assetsNet AssetsThe net asset on the balance sheet is the amount by which your total assets exceed your total liabilities and is calculated by simply adding what you own (assets) and subtract it from whatever you owe (liabilities). It is commonly known as net worth (NW). during a financial period. In simple words, profit is the expansion of assets during the financial year except for the increase in cash from the sale of stocks to the shareholders and decrease in cash from the dividend payoutDividend PayoutThe dividend payout ratio is the ratio between the total amount of dividends paid (preferred and normal dividend) to the company's net income. Formula = Dividends/Net Income to its shareholdersShareholdersA shareholder is an individual or an institution that owns one or more shares of stock in a public or a private corporation and, therefore, are the legal owners of the company. The ownership percentage depends on the number of shares they hold against the company's total shares.. This theory is used to track the net assets changes that occurred before reviling the accounting year’s profit. It depicts the actual real change in the account balances for the financial year rather than window dressed booked profits.
Capital Maintenance Types
#1 – Financial Capital Maintenance
As per financial capital maintenance, the company will book profitBook ProfitBook Profit is the profit amount that a business earns from its operations & activities but has not been realized yet. It is not tracked by analysts or stakeholders & its calculation is relevant only to evaluate a Company’s tax liability. only if the amount of the net assets at the end of the financial year is more than the number of net assets at the beginning of the financial year. All the inflows such as the sale of stock to shareholders, the addition of capital from owners, etc. and payment of dividends to shareholders payment of bonus to shareholders are excluded. Constant purchasing power units and nominal monetary units are the two measurement units of financial capital maintenance theory.
Financial capital maintenance is affected only with the real amount of funds available at the starting of the year and with the funds available at the end of the year. This concept is least concerned with any other capital assets transaction undertaken during the financial year.
#2 – Physical Capital Maintenance
Under this method capital of the organization is considered as production capacity and is based on the output units. This method books profit only when the physical production capacity of the business at the end of the year is more than or equal to the physical production capacity of the business at the beginning of the year except any amount adjusted towards any amount paid to owners during the year or any amount raised by the owner. The main use of this method is for checking and maintaining the business operational capacity.
Capital Maintenance and Inflation
Inflation is the increase in the cost of any product/service or decrease in purchasing capacity. When the inflation rateInflation RateThe rate of inflation formula helps understand how much the price of goods and services in an economy has increased in a year. It is calculated by dividing the difference between two Consumer Price Indexes(CPI) by previous CPI and multiplying it by 100. is high, which has occurred in a short duration of time can affect the business ability to determine if it has achieved capital maintenance or not accurately. Due to the inflation purchase price of assets gets increased accordingly, the value of the net assets of the company also increases. But the increase due to this inflation misrepresents the original value of the company’s assets.
Capital maintenance is distorted at the time of inflation as the pressure of inflation will increase the net assets even if their original value is unchanged. Due to this reason, at the time of inflammation, the companies are required to adjust the value of their assets to determine whether they have achieved capital maintenance. This is very important if the business operating in a hyperinflationaryHyperinflationaryHyperinflation is an accelerated level of inflation that tends to quickly destroy the actual value of the local currency since there is a rise in the cost of all products and services. It forces people to lower their holdings in that particular currency to participate in stable foreign currencies. economy.
The prime objective of capital maintenance is to safeguard stakeholders’ interests like creditors and shareholders. With the statutory requirement of maintaining capital requirements, companies will ensure timely compliances to avoid any penal provisions or damage to its brand value. Maintenance of capital ensures the safety of shareholders and creditors invested funds. This will, in turn, affect a large number of potential vendors and investors who are actively looking for investing. Also, analyzing it will help business owners and managers evaluate their performance over time. The company is said to earn profits if its capital remains unchanged or has increased over a period of time.
- Shareholders Protection – As per the governing laws of the land, due to this provision under prevailing acts, protects shareholders against losing their capital erosion.
- Creditors Protection – It has an important role in creditors’ protection. Due to this rule, a barrier is created that restricts the company from withdrawing money to protect the creditors. This also suggests minimum funds that need to be introduced by the company to fulfill minimum capital requirements.
- Performance Analysis – This not only helps in ensuring the protection of shareholders, creditors’ rights but also helps management and business owner to compare and analyze its business performance over a period of time or with other companies. This analysis may further suggest suitable action points.
This has been a guide to What is Capital Maintenance & its concept. We also discuss its two types and impact along with importance. You can learn more about from the following articles –