The IASB Conceptual Framework identifies two concepts of capital:
- a financial concept of capital
- a physical concept of capital
A financial concept of capital is one whereby capital is linked to the net assets or equity of a company.
A physical concept of capital is where capital is linked to the productive capacity of the entity.
1. Financial capital maintenance
A financial concept of capital is whereby the capital of the entity is linked t the net assets, which is the equity of the entity.
When a financial concept of capital is used, a profit is earned only if the financial amount of the net assets at the and of the period is greater than the net assets at the beginning of the period, adjusted of course for any distributions paid to the owners during the period, or any equity capital raised.
The main concern of the users of the financial statements is with the maintenance of the financial capital of the entity.
There are also two ways of looking at financial capital maintenance:
- money financial capital maintenance, and
- real financial capital maintenance
Under the money financial capital maintenance, the profit is measured if the closing net assets is greater than the opening net assets, and the net assets in both cases are measured at historical cost.
This method doesn’t take into consideration any inflation or the time value of money.
Therefore under the real financial capital maintenance, the entity makes a net profit if the closing net assets are greater than the opening net assets, and both of these figures are measured at current prices.
To do this we increase the opening net asset figure by the inflation rate.
2. Physical capital maintenance
A physical concept of capital is one where the capital of an entity is regarded as its production capacity, which could be based on its units of output.
When a physical concept of capital is used, a profit is earned only if the physical production capacity (or operating capability) of the entity at the end of the period is greater than the production capacity at the beginning of the period, adjusted for any distributions paid to the owners during the period, or any equity capital raised.
The main concern of users of its financial statements is with the maintenance of the operating capability of the entity.
A financial concept of capital should be used if the users of the financial statements are mostly concerned with the maintenance of their invested capital, or the purchasing power of the invested capital.
A physical concept of capital should be used if the users of the financial statements are mostly concerned with the operating capacity of the entity, and current value accounting.
NB. Profits will usually be higher when the financial concept of capital is used compared to the physical concept of capital. This is due to the inflation adjustment.
Exam Tip: worked out example
Let’s look at an example of the physical concept of capital in use.
Scenario:
- An entity is established on 1 January 20X1 with 20,000 ordinary shares at €1 each.
- It then buys €20,000 worth of stock, which is sells during the year for €25,000.
- There were no other transactions during the period.
- At the end of the year the purchase price of the stock increased on €23,000.
Answer:
- Using the physical maintenance concept, the profit for the reporting period is €2,000 (€25,000-23,000).
- If the financial capital maintenance concept is used, the profit for the year is €5,000, but if the company paid out the €5,000 profit to shareholders, it would be unable to buy the same stock again as the purchase price has risen.
- To keep the operating capability of the entity the same, profit is measured as sales less the replacement cost of the goods sold.
Real life
Most entities use the financial capital maintenance concept, as it is the easiest to apply because it uses actual prices paid for goods, rather than making adjustments.
Both capital maintenance concepts provide useful information.
Investors prefer to use the financial capital maintenance concepts as they are focused on increasing and maximizing the returns they get on their investments.
Staff and management may prefer to use the physical capital maintenance concept as it allows them to assess the entity’s ability to maintain its operating capacity.
This is useful for manufacturing businesses in particular where management may need to ensure the business can keep producing the same volume of goods.