3 powerful capital maintenance concepts

3 powerful capital maintenance concepts – There are three (or two a matter of definition) concepts of capital: a financial concept of capital (nominal maintenance and purchasing power maintenance) and a physical concept of capital. Under the financial concept, capital is defined as the net assets or equity of the enterprise, while under the physical concept, capital is defined as the productive capacity of the enterprise expressed in some physical units of measurement, as for example units of output per day.

The selection of the appropriate concept of capital by an enterprise should be based on the needs of the users of its financial statements. So, the financial concept of capital should be and mostly is used by the financial statement users who are primarily concerned with the maintenance of nominal invested capital or the purchasing power of invested capital expressed in monetary units of measurement. The physical capital concept is on the other hand used when the maintenance of the physical productive capacity is the main concern.

The choice of capital maintenance concept has following consequences: 3 powerful capital maintenance concepts

  1. The financial capital maintenance concept does not require the use of a particular basis of measurement, and is dependent solely on the nominal value of the underlying financial capital seeking to be maintained. 3 powerful capital maintenance concepts
  2. The general purchasing power financial capital maintenance concept also does not require the use of a particular basis of measurement, and is dependent solely on the purchasing power of the underlying financial capital seeking to be maintained. 3 powerful capital maintenance concepts
  3. The physical capital maintenance concept requires the adoption of the current cost basis of measurement. 3 powerful capital maintenance concepts

– 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. 3 powerful capital maintenance concepts

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 EUR 1,500,000 at the beginning of the year and EUR 2,000,000 at the end of the year in monetary units.

Assuming no capital transactions during the year, EUR 500,000 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. 3 powerful capital maintenance concepts

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. 3 powerful capital maintenance concepts

– 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. 3 powerful capital maintenance concepts 3 powerful capital maintenance concepts

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. 3 powerful capital maintenance concepts

Taking the earlier example, if it assumed that the rate of inflation was 10 per cent during the year, the initial EUR 1,500,000 capital is adjusted in terms of inflation. That is, in the terms of inflation the capital that needs to be maintained in tact is EUR 1,650,000, and income will be EUR 350,0001 which can be distributed without hurting the purchasing power of the capital of the firm. 3 powerful capital maintenance concepts

This approach suggests that the company 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. 3 powerful capital maintenance concepts

Reflecting holding gains in the income statement may indicate: 3 powerful capital maintenance concepts
1. The success of the firm in buying inventories and equipment at prices which have subsequently increased, and 3 powerful capital maintenance concepts
2. A surrogate of an increase in the exit value or the present value from selling or using the assets in question. 3 powerful capital maintenance concepts

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.

– Physical 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. 3 powerful capital maintenance concepts

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. 3 powerful capital maintenance concepts

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 EUR 1,000 of 100 units of stock costing EUR 800 if their replacement cost was EUR 1,000. 3 powerful capital maintenance concepts 3 powerful capital maintenance concepts

In this situation, an outlay of EUR 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. 3 powerful capital maintenance concepts

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 (at a minimum) 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 discussion regarding the meaning of maintaining physical productive capacity or operating capability. 3 powerful capital maintenance concepts

The issues in capital maintenance

The main difference between the three models lies in the treatment of the effects of changes in the prices of assets and liabilities of the enterprise. The main problem of capital maintenance in accounting lies in the determination of the difference in value between the invested resources at the beginning of the accounting period and their value stated in the balance sheet at the end of the accounting period, i.e. profit or loss. 3 powerful capital maintenance concepts

The main requirement for the profit or loss to be calculated as a difference between the available resources and the resources at the beginning of the accounting period is that they have the same unit of measurement, i.e. unit of account. 3 powerful capital maintenance concepts

If the available resources are not measured according to the same fair value valuation bases, the profit or loss resulting from their difference is expressed in different units of measurement (as for example if the inputs were valued in USD and the outputs in EUR). 3 powerful capital maintenance concepts

The following table illustrates the current complexity of valuation bases: 3 powerful capital maintenance concepts

Overview of valuation bases

Assets

Valuation bases

Liabilities

Valuation bases

Property plant and equipment

(Historical) cost model with accumulating depreciation, Revaluation model (Fair value) with accumulating depreciation, Value in use, Impairment (Fair value less costs of disposals)

Long-term borrowings

Amortised costs using effective interest rate method, FVPL

Investment property

(Historical) cost model with accumulating depreciation, Fair value with accumulating depreciation, Impairment (Fair value less costs of disposals)

Lease liabilities

Initial measurement: present value of lease payments

Subsequent measurement: increase initial liability with interest, decrease with lease payments and in/decrease with remeasurements of reassessments or lease modification or revisions of in-substance fixed lease payments

Goodwill

Allocated cost with accumulating depreciation, Impairment, Initial cost is balance of consideration transferred less identified assets and assumed liabilities.

Liabilities for share-based payments

Face value and intrinsic value of vested share appreciation rights) in a cash-settled share-based payment transaction

Intangible assets

Allocated cost with accumulating amortisation , Impairment, Initial cost based on fair value calculations

Post employment benefits

Net defined benefit liability at an actuarial valuation method, attributed to periods of service and based on actuarial assumptions or Defined contribution plans with periodical contributions (i.e. Trade payables)

Investments in financial instruments

Cost (uncommon), FVPL, FVOCI (with or without recycling to PNL), Amortised costs using effective interest rate method

Deferred tax liabilities

Face value

Retirement benefit plan investments (IAS 26)

Fair value through profit or loss or through other comprehensive income (with or without recycling)

Trade and other payables

FVPL (= in substance Face value)

Plan assets

Fair value through profit or loss or through other comprehensive income (with or without recycling)

Liabilities at FVPL

FVPL

Inventories

(Historical) cost, FIFO, Weighted average cost formula, Impairment (Obsolescence, Net realisable value)

Bank overdrafts

Face value

Trading portfolio commodities

FVPL, Amortised costs using effective interest rate method (uncommon)

Current tax payable

Face value

Trade receivables

FVPL (= in substance Face value), Impairment (Expected credit losses)

Other accrued expenses

Face value

Other assets

Face value

Cash and cash equivalents

Face value

Fair value measurement

The fair value is a market value, and not a specific value for the enterprise, so the fair value has to be constructed under the assumption that it is a price which market participants would accept. On that basis fair value measurement under IFRSs is based on some necessary conditions. 3 powerful capital maintenance concepts

Fair value measurement requires an entity to determine: 3 powerful capital maintenance concepts

  1. the particular asset or liability being measured; 3 powerful capital maintenance concepts
  2. for a non-financial asset, the highest and best use of the asset and whether the asset is used in combination with other assets or on a stand-alone basis;
  3. the market in which an orderly transaction would take place for the asset or liability; and 3 powerful capital maintenance concepts
  4. the appropriate valuation technique(s) to use when measuring fair value. The valuation technique(s) used should maximise the use of relevant observable inputs and minimise unobservable inputs. Those inputs should be consistent with the inputs a market participant would use when pricing the asset or liability.

Valuation is not a straightforward but a rather complex procedure, including estimates and assumptions, which make it rather subjective and obviously not immune to managerial interpretations. The main advantage of the above valuation model/technique is its usability, and its main disadvantage is the lack of objectivity inherent to the entity’s own assumptions about the unobservable inputs.

Capital Maintenance and Fair Value

The concept of capital maintenance requires a certain portion of capital enlargement (or depletion) to be recognised as profit (or loss). The financial capital maintenance concept defines as profit every increase of capital over and above the nominal invested value. 3 powerful capital maintenance concepts

Contrary to that, the fair value system is sensitive to market price changes, except those which are a result of inflation, or price changes of specific groups of assets. Some standards (IAS 16 and IAS 40) require the effects of asset revaluation to be recognised through other comprehensive income instead of being recognised in profit or loss. The depreciation of the revalued assets results in the decreased amount of reported profit. 3 powerful capital maintenance concepts

This is a feeble attempt to separate the financial result resulting from business activity from the financial result resulting from external circumstances such as: inflation, relative sector price changes, etc. It is questionable whether such a separation is ultimately possible and appropriate as these variables are one of the main forces of economic development.

They may for example be expressed as differences between the book value of an asset (however it may be measured) and its market price. The relationship between the book value of an asset and its market price is important for the investment decisions but also for the decisions on takeovers and company valuations.

Fair value is today either compulsory or an alternative valuation method in IFRSs. At present, the valuation according to the fair value method as regulated in IFRS 13 Fair value measurement, is currently the most precisely defined valuation technique. It is also the closest one to the concept of economic value. 3 powerful capital maintenance concepts

According to the IFRS 13, the fair value is determined primarily according to the market inputs if available or according to the estimate of the present value of future economic benefits included in the contracts, as also the risks of the cash flow amounts and maturities being different from expected. 3 powerful capital maintenance concepts

Nevertheless, such valuation techniques still do not take into account the change of the unit of measurement from the beginning till the end of the accounting period because of the change in external circumstances. This can cause unwanted and unexpected changes in the financial statements of the enterprise. 3 powerful capital maintenance concepts

The two concepts of capital are basically a mix of in-use and in-exchange values. When combined with the valuation techniques used to measure the elements of the financial statements, which are a rather “colourful” combination of market, income, and cost approaches, the problem of objective profit or loss determination still remains an open issue.

3 powerful capital maintenance concepts

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