Concepts of capital-

A financial concept of capital is adopted by most entities in preparing their financial

statements. Under a financial concept of capital, such as invested money or invested
8.1 purchasing power, capital is synonymous with the net assets or equity of the entity.
Under a physical concept of capital, such as operating capability, capital is regarded as
the productive capacity of the entity based on, for example, units of output per day.

The selection of the appropriate concept of capital by an entity should be based on the
needs of the users of its financial statements. Thus, a financial concept of capital should
be adopted if the users of financial statements are primarily concerned with the
maintenance of nominal invested capital or the purchasing power of invested capital. If,
8.2
however, the main concern of users is with the operating capability of the entity, a
physical concept of capital should be used. The concept chosen indicates the goal to be
attained in determining profit, even though there may be some measurement difficulties
in making the concept operational.

Concepts of capital maintenance and the determination of

profit-
The concepts of capital in paragraph 8.1 give rise to the following concepts of capital
maintenance:

Financial capital maintenance. Under this concept a profit is earned only if the
financial (or money) amount of the net assets at the end of the period exceeds the
financial (or money) amount of net assets at the beginning of the period, after
(a)
excluding any distributions to, and contributions from, owners during the period.
8.3 Financial capital maintenance can be measured in either nominal monetary units or
units of constant purchasing power.
Physical capital maintenance. Under this concept a profit is earned only if the
physical productive capacity (or operating capability) of the entity (or the resources or
(b
funds needed to achieve that capacity) at the end of the period exceeds the physical
)
productive capacity at the beginning of the period, after excluding any distributions to,
and contributions from, owners during the period.

The concept of capital maintenance is concerned with how an entity defines the capital
that it seeks to maintain. It provides the linkage between the concepts of capital and the
concepts of profit because it provides the point of reference by which profit is measured;
it is a prerequisite for distinguishing between an entity’s return on capital and its return of
8.4 capital; only inflows of assets in excess of amounts needed to maintain capital may be
regarded as profit and therefore as a return on capital. Hence, profit is the residual
amount that remains after expenses (including capital maintenance adjustments, where
appropriate) have been deducted from income. If expenses exceed income the residual
amount is a loss.
 The physical capital maintenance concept requires the adoption of the current cost basis
of measurement. The financial capital maintenance concept, however, does not require
8.5
the use of a particular basis of measurement. Selection of the basis under this concept is
dependent on the type of financial capital that the entity is seeking to maintain.

The principal difference between the two concepts of capital maintenance is the
treatment of the effects of changes in the prices of assets and liabilities of the entity. In
8.6 general terms, an entity has maintained its capital if it has as much capital at the end of
the period as it had at the beginning of the period. Any amount over and above that
required to maintain the capital at the beginning of the period is profit.

Under the concept of financial capital maintenance where capital is defined in terms of
nominal monetary units, profit represents the increase in nominal money capital over the
period. Thus, increases in the prices of assets held over the period, conventionally
referred to as holding gains, are, conceptually, profits. They may not be recognised as
such, however, until the assets are disposed of in an exchange transaction. When the
8.7
concept of financial capital maintenance is defined in terms of constant purchasing
power units, profit represents the increase in invested purchasing power over the period.
Thus, only that part of the increase in the prices of assets that exceeds the increase in
the general level of prices is regarded as profit. The rest of the increase is treated as a
capital maintenance adjustment and, hence, as part of equity.

Under the concept of physical capital maintenance when capital is defined in terms of the
physical productive capacity, profit represents the increase in that capital over the period.
8.8 All price changes affecting the assets and liabilities of the entity are viewed as changes
in the measurement of the physical productive capacity of the entity; hence, they are
treated as capital maintenance adjustments that are part of equity and not as profit.

The selection of the measurement bases and concept of capital maintenance will
determine the accounting model used in the preparation of the financial statements.
Different accounting models exhibit different degrees of relevance and reliability and, as
in other areas, management must seek a balance between relevance and reliability.
This Conceptual Framework is applicable to a range of accounting models and provides
8.9
guidance on preparing and presenting the financial statements constructed under the
chosen model. At the present time, it is not the intention of the Board to prescribe a
particular model other than in exceptional circumstances, such as for those entities
reporting in the currency of a hyperinflationary economy. This intention will, however, be
reviewed in the light of world developments.

Capital maintenance adjustments-

8.10 The revaluation or restatement of assets and liabilities gives rise to increases or
decreases in equity. While these increases or decreases meet the definition of income
and expenses, they are not included in the income statement under certain concepts of
capital maintenance. Instead these items are included in equity as capital maintenance
adjustments or revaluation reserves.