What is capital maintenance?
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Capital maintenance is a principle that states profit should not be recorded until its cost or capital has been maintained. In other words, profit should not be recognized unless net assets have been maintained.
Capital maintenance states that profit recognized is the increase in the value of net assets. However, there are two exceptions to it:
It is important because:
Capital maintenance is of two types:
It is measured by the value of assets at the beginning and end of the financial year.
It is measured by the production capacity at the beginning and end of the financial year.
Capital maintenance is concerned with keeping proper account balances of assets and not the physical assets.
Inflation is the increase in the economic value of goods due to the lower purchasing power and not an actual increase in the value of assets. So, if the value of an asset is increased due to inflation it does not depict the right picture for the company.
Hence, if the value of assets increases due to inflation, companies need to adjust the value of assets to assess if capital maintenance has occurred.