Question

How does inflation impact the capital maintenance of a company during a period?

Briefly explain how the financial capital maintenance concept and the operating capital maintenance concepts are used to address the issue.

Answer 1

Capital maintenance:-

A company achieves capital maintenance when the amount of its capital at the end of a period is unchanged from that at the beginning of the period. Any excess amount above this represents the company's profit.

Impact of Inflation on the capital maintenance:-

A high rate of inflation especially inflation that has occurred over a short period of time can impact a company's ability to accurately determine if it has achieved capital maintenance. The value of a company's net assets may increase along with the increase in prices. However, this increase could misrepresent the true value of the company's assets. For this reason, during inflationary times a company may need to adjust the value of its net assets in order to determine if it has achieved capital maintenance.he 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 hyper inflationary environment.

financial capital maintenance:-

According to financial capital maintenance, a company earns a profit only if the amount of its net assets at the end of a period exceeds the amount at the beginning of the period.

This concept attempts to show to shareholders that their company has kept pace with general inflationary pressures during the accounting period, by measuring income in such a way as to take account changes in the price-levels.This approach suggests that the accountant should be aware of the measurement- unit problem that arises in a period of unstable general price-level conditions.The criticism of the bottom-line income measure is that it may not be useful to investors interested in normal operating results as a basis for predicting future normal operating income. An enterprise that maintains its net assets (capital) at a fixed amount of money in periods of inflation or deflation does not remain equally well-off in terms of purchasing power.

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.

Physical or Operating Capital Maintenance:-

Physical or operating capital concept is expressed in terms of maintaining operating capability that is, maintaining the capacity of an enterprise to provide a given physical level of operations.

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.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.