Capital Maintenance

What Is Capital Maintenance?

Capital maintenance, also known as capital recovery, is an accounting concept based on the principle that a company's income should only be recognized after it has fully recovered its costs or its capital has been maintained. A company achieves capital maintenance when the amount of its capital at the end of a period is unchanged from that at the beginning of the period. Any excess amount above this represents the company's profit.

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.

How Capital Maintenance Works

The capital maintenance concept means that a company only generates a profit once the costs associated with operations during a selected accounting period have been fully recuperated. To calculate the profit, the total value of the company's financial and other capital assets at the beginning of the period must be known.

Types of Capital Maintenance

Financial Capital Maintenance

According to financial capital maintenance, a company earns a profit only if the amount of its net assets at the end of a period exceeds the amount at the beginning of the period. This excludes any inflows from or outflows to the 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. The two ways of looking at financial capital maintenance are money financial capital maintenance and real financial capital maintenance.

Under money financial capital maintenance, profit is measured if the closing net assets exceed the opening net assets, with both measured at historical cost. The historical cost refers to the value of the assets at the time they were acquired by the company. Under real financial capital maintenance, profit is measured if the closing net assets exceed the opening net assets, with both measured at current prices.

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 implies that a company only earns a profit if its 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.

The Effect of Inflation on Capital Maintenance

A high rate of inflation — especially inflation that has occurred over a short period of time — can impact a company's ability to accurately determine if it has achieved capital maintenance. The value of a company's net assets may increase along with the increase in prices. However, this increase could misrepresent the true value of the company's assets. For this reason, during inflationary times a company may need to adjust the value of its net assets in order to determine if it has achieved capital maintenance.