Question

Explain financial capital maintenance and physical (operating) capital maintenance concepts and identify where holding gains are recorded under these capital maintenance concepts.

Answer 1

Capital maintenance is an accounting concept which states that the company’s income will only be recognized after it has fully recovered its cost. Capital maintenance is achieved if amount of capital at the end of a period is unchanged from that at the beginning of the period.

Financial Capital Maintenance

If the amount of net assets at the end of the period is more than amount at beginning of the period, the profit is earned as per financial capital maintenance. Inflows and outflows of the owners are excluded from this profit. Financial Capital Maintenance is measured either in nominal monetary units or constant purchasing power units. As per Financial Capital Maintenance company earns profits if the closing net assets exceed the opening net assets.

Under the financial capital maintenance concept, holding gains are reflected as income of the given period.

Physical Capital Maintenance

Physical Capital Maintenance focuses on the ability of business to sustain cash flows in the future by maintaining access to income-generating assets in use. It is not concerned with the cost of actual maintenance required on tangible items, such as plant, machinery, etc. As per Physical Capital Maintenance company earns profits if its operating capacity at the end of the period is more than capacity at the beginning of the period, excluding any owners' contributions.

Under the Physical Capital Maintenance, holding gains are shown in the shareholders’ equity section of the balance sheet as capital maintenance adjustments.