Capital maintenance definition
/What is Capital Maintenance?
The capital maintenance concept states that a profit should not be recognized unless a business has at least maintained the amount of its net assets during an accounting period. Stated differently, this means that profit is essentially the increase in net assets during a period. This concept excludes the following cash inflows and outflows that impact net assets:
Increase in assets from the sale of stock to shareholders (increases cash)
Decrease in assets from the payment of dividends or other distributions to shareholders (decreases cash)
Technically, the capital maintenance concept means that the amount of net assets should be reviewed for changes before determining the profit generated during an accounting period. From a practical perspective, this is rarely done - controllers simply calculate the amount of profit and do not review for compliance with the capital maintenance concept at all.
Types of Capital Maintenance
There are two types of capital maintenance noted in the accounting literature, which are as follows:
Financial capital maintenance. This is the concept that an organization should not recognize a profit unless it has at least maintained its asset base during the reporting period.
Physical capital maintenance. This is the concept that an organization should maintain its physical assets at a level of productive capacity sufficient to meet its ongoing sales requirements. This is done by investing in an adequate amount of equipment maintenance on an ongoing basis.
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Impact of Inflation on Capital Maintenance
The capital maintenance concept can be skewed by inflation, since inflationary pressure will inevitably increase net assets, even if the underlying amount of assets has not changed. Thus, it is more accurate to adjust net assets for the effects of inflation in order to see if capital maintenance has occurred. This issue is especially important if a business operates in a hyperinflationary environment.
Impact of Capital Maintenance on Nonprofit Entities
The capital maintenance concept can have a more serious impact for nonprofit organizations. State law or donor agreements may require that endowment balances not be lost - which means that endowment balances must be replenished from other sources in periods when earnings on invested funds are negative. This can trigger a sharp downturn in the amount of funds available for operational needs, which in turn reduces the amount of services that a nonprofit can provide.