The capital maintenance concept states that a profit should not be realized until a business in the least maintains its value of net assets during an accounting cycle (usually a year).
The concept regards profit as an increase in the value of net assets during a given period.
The concept looks at profit (income) from Sir John Hicks’s perspective.
John Hicks’s definition of income (profit) is, the maximum value which a man can consume during a week , and still expect to be as well off at the end of the week as he was at the beginning.
Approaches to capital maintenance examine how the maintenance of wealth (capital maintenance) can be measured.
What are the capital maintenance approaches using historical costs?
1.Money capital maintenance.
The money capital maintenance is a suitable approach to capital maintenance when there is no change in prices.
This traditional approach says that a business that has net assets (capital) of $30,000 on 1st January must have $50,000 in net assets (capital) to be considered well off at the end of the period.
The approach measures an increase in the value at the end of the period provided, there were no share capital issued, withdrawn or dividends paid.
2. Real capital maintenance.
The focus of this concept is the maintenance of the purchasing power of shareholders’ equity when changes in general prices affect the business.
The concept pays attention to changes in the purchasing power of money, measured by retail price index.
3. Maintenance of specific purchasing power of the capital of the equity.
This concept uses a price index associated with specific prices affecting the business.
An example can be used to clearly illustrate the differences:
If a business that had net assets of $50,000 on 1st January and $59,000 on 31st December of the same year would have three different profits from the three measures.
- The general rate of inflation was 12 percent (measured by the retail price index).
2. The specific rate of price increase for the business’s goods was 17 percent.
|Money maintenance of capital ($)||Real capital maintenance ($)||Maintenance of specific purchasing power ($)|
|Net assets (capital), 31st December.||59,000||59,000||59,000|
|Less: net assets on 1st January:|
|A. Money maintenance||50,000||–||–|
|B. Real capital ($50,000 x 12%)||–||56,000||–|
|C. Specific purchasing power maintenance ($50,000 x 17%)||–||–||58,500|
A. The traditional system gives a profit of $9,000,
B. Real capital recognizes a fall in the purchasing power of money due to changes in prices in general.
C. The profit of $500 is an indication that goods which were bought for $50,000 at the beginning of year was bought $58,500 on 31st December of the same year.