Capital Maintenance - Explained
What is Capital Maintenance?
Written by Jason Gordon
Updated at September 15th, 2021
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Table of Contents
What is Capital Maintenance?How is Capital Maintenance Used?Financial Capital MaintenancePhysical Capital MaintenanceCapital Maintenance and InflationAcademic Research on Capital MaintenanceWhat is Capital Maintenance?
Capital maintenance is a concept that maintains that profit can only be accounted for when there is proper maintenance of capital and when costs have been fully recovered or restored. Capital maintenance is otherwise called Capital recovery, it is a concept that places importance on the recover pf costs and efficient management of a company's capital. It is an accounting concept that when the closing amount or capital of a company at the end of a fiscal year is the same as the amount of capital the company has at the beginning of the accounting period, capital maintenance has been achieved.
Back to: ACCOUNTING, TAX, & REPORTING
How is Capital Maintenance Used?
Capital maintenance is when a company's capital at the beginning of an accounting period is the same as the capital at the end of an accounting period. This shows that the company maintained its assets and capital for the period and there is a full recovery of all costs. Hence, to calculate the profit of a company, the capital of a company must be restored to its initial level and an additional monetary amount or net assets recorded at the end of a period. It is the excess amount that is calculated as the company's profit.
Financial Capital Maintenance
There are two main subsections of capital maintenance, these are;
- Financial capital maintenance, and
- Physical capital maintenance.
Financial capital maintenance deals with the actual funds that a company has. When the funds are adequately maintained in such a way that the amount recorded at the end of an accounting period is more than the amount recorded at the beginning of the period, profit is recorded. The International Financial Reporting Standards (IFRS) when calculating profit earned through financial capital maintenance excludes contributions and distributions. The Financial capital maintenance measures profit using net assets, excess net assets translate to profit.
Physical Capital Maintenance
The ability and effectiveness of a business to maintain cash flows, including managing assets that generate revenue for the business are known as physical capital maintenance. Unlike financial money maintenance, physical money maintenance is not concerned with the actual funds or money of a firm, rather, it pays attention to how well the business maintains its income-generating assets. Physical capital maintenance also excludes contributions and distributions when determining the profit earned by a firm at the end of an accounting period.
Capital Maintenance and Inflation
Whether directly or indirectly, inflation has effects on capital maintenance. Inflation affects the value of net assets of a company, despite that the assets have not changed in appearance, condition or mode of operation. During inflationary periods, there is a high tendency that a company would record low value of net assets, it is, therefore, essential that the adjusted values of the assets are recorded.
Academic Research on Capital Maintenance
- Depreciation of housingcapital,maintenance, and house price inflation: Estimates from a repeat sales model, Harding, J. P., Rosenthal, S. S., & Sirmans, C. F. (2007). Depreciation of housing capital, maintenance, and house price inflation: Estimates from a repeat sales model.Journal of urban Economics,61(2), 193-217.
- Capital maintenanceand investment: complements or substitutes?, Boucekkine, R., & Ruiz-Tamarit, R. (2003). Capital maintenance and investment: complements or substitutes?.Journal of Economics,78(1), 1-28. This paper studies the properties of demand for capital maintenance services and its interaction with investment under variable capital utilization rate and adjustment costs. The depreciation rate varies with the maintenance effort and the utilization rate of capital. We show that the properties of the demand functions for maintenance services and capital goods depend closely on the sign of the cross derivative of the depreciation function, i.e., on whether the marginal efficiency of maintenance decreases or increases when the rate of capital utilization rises. In our model, it is impossible to reconcile some unquestionable empirical facts and some minimal regularity conditions on the demand function for maintenance services if this cross derivative is positive. In all cases, investment and maintenance are gross complements.
- Capital maintenance, price changes, and profit determination, Gynther, R. S. (1970). Capital maintenance, price changes, and profit determination.The Accounting Review,45(4), 712-730.
- A statistical theory of expenditures incapital maintenanceand repair, Bitros, G. C. (1976). A statistical theory of expenditures in capital maintenance and repair.Journal of Political Economy,84(5), 917-936. This study introduces an econometric model to explain the determinants of expenditures in capital maintenance and repair and, indirectly, to question the assumption implicit in most investment studies that such expenditures do not "matter" in the process of capital accumulation. The model is estimated by a consistent-systems technique, with data pertaining to the rolling stock of class-I line-haul railways in the United States from 1944-70. The empirical results indicate that maintenance expenditures are determined by gross additions to and retirements from the rolling stock as well as by the cost of funds and the rate of utilization. Moreover, in light of the uncovered rade-offs between maintenance expenditures and gross investment, the paper concludes that in estimating investment models, a proxy for maintenance expenditures should be included among the independent variables.
- Capital maintenanceand the concept of income, Break, G. F. (1954). Capital maintenance and the concept of income.Journal of Political Economy,62(1), 48-62.
- Acapital maintenanceapproach to income measurement, Revsine, L. (1981). A capital maintenance approach to income measurement.Accounting Review, 383-389. This paper uses a simple example to isolate the underlying capital maintenance concepts that are associated with historical cost income and four widely discussed inflation accounting alternatives. The approach illustrates that each of these concepts conforms to Hicks' classical income definition and thus demonstrates why discussions of "true" inflation-adjusted income are oversimplified.