In the previous blog, we discussed Measurement of Financial Statement Elements and learned how assets and liabilities are valued. But now a very important question arises:
What is real profit?
Is profit simply the difference between income and expenses? Or should we first make sure that the capital of the business is protected?
This is where the concept of Capital Maintenance becomes important. Before a business can say it has made a profit, it must first ensure that its capital is intact.
Let us understand this concept in a clear and practical way.
What is Capital?
In accounting, capital refers to the net assets of a business.
“Capital = Assets – Liabilities”
It represents what belongs to the owners of the business.
If capital reduces, it means the business is becoming weaker. If capital increases, the business is becoming stronger.
So before declaring profit, a business must check:
“Has my capital been maintained?”
Meaning of Capital Maintenance
Capital maintenance means that the business should not treat an increase in asset values caused only by price changes as profit.
In simple words:
“A business should earn enough to keep its capital at the same level before distributing profits.”
Only after maintaining capital can profits be distributed to owners.
Why Capital Maintenance is Important
Suppose a trader started with ₹10 lakh. After one year, his assets are worth ₹12 lakh. Does that mean profit is ₹2 lakh?
Not necessarily.
If prices of goods have increased, the trader may need ₹12 lakh just to replace the same stock. In that case, he has not really earned any profit.
Capital maintenance helps us identify real profit, not just paper profit.
Relationship Between Capital and Profit
Profit is calculated only after capital is maintained.
In simple terms:
“Profit = Increase in capital after maintaining capital intact”
So profit depends on:
- How assets and liabilities are valued
- Which capital maintenance concept is used
Types of Capital Maintenance
The framework recognises three types of capital maintenance:
- Financial Capital Maintenance at Historical Cost
- Financial Capital Maintenance at Current Purchasing Power
- Physical Capital Maintenance at Current Cost
Let us understand them one by one.
1. Financial Capital Maintenance at Historical Cost
Under this method:
- Capital is measured using historical cost of assets and liabilities
- Capital is considered maintained if closing capital is equal to or more than opening capital
Example
- A trader starts with ₹12,000.
- He buys goods, sells them, and ends with ₹12,000 again after drawings.
Since closing capital equals opening capital, capital is maintained. Profit = Zero.
This method ignores inflation.
2. Financial Capital Maintenance at Current Purchasing Power
This method considers the effect of inflation.
Opening capital is adjusted according to price index.
Example
- Opening capital = ₹12,000
- Price index at start = 100
- Price index at end = 120
Adjusted capital = 12,000 × 120 / 100 = ₹14,400
If closing capital is ₹12,000, then real capital has fallen.
So: Profit = ₹12,000 – ₹14,400 = (–₹2,400) loss
This shows that inflation has reduced purchasing power.
3. Physical Capital Maintenance at Current Cost
This method focuses on the ability to replace assets.
If a business started with 6,000 units of goods, it must be able to buy 6,000 units again at current prices to maintain capital.
Example
- Opening stock = 6,000 units @ ₹2 = ₹12,000
- Closing price per unit = ₹2.50
Required capital = 6,000 × 2.50 = ₹15,000
If closing funds are ₹12,000, capital is not maintained.
Loss = ₹3,000
Which Method is Best?
Each method has a different purpose:
| Method | Focus |
| Historical cost | Legal capital |
| Current purchasing power | Inflation |
| Physical capital | Replacement of assets |
Modern accounting prefers current value-based methods for better realism.
Determination of Profit
Profit is not simply: Income – Expenses
It depends on how capital is measured and maintained.
True profit = Increase in capital after capital maintenance
So different measurement bases give different profits.
Conclusion
Capital maintenance ensures that a business does not distribute money that it actually needs to stay in business.
It helps in determining real profit instead of illusory profit.
Together with measurement concepts, capital maintenance forms the backbone of meaningful financial reporting.
In the next blog, we will solve practical problems, MCQs, and scenario-based questions to strengthen our understanding of the Financial Statement Framework.
Frequently Asked Questions (FAQs)
1. What is capital maintenance in accounting?
It is the concept of ensuring that a business maintains its capital before treating any increase as profit.
2. Why is capital maintenance important?
It helps determine the real profit of a business and prevents distribution of capital as profit.
3. What are the types of capital maintenance?
Financial capital maintenance at historical cost, financial capital maintenance at current purchasing power, and physical capital maintenance at current cost.
4. How does inflation affect profit?
Inflation increases asset values. Without adjusting for it, profits may appear higher than they actually are.
5. What is physical capital maintenance?
It ensures that a business can replace its assets at current prices before declaring profit.
6. How is profit determined under capital maintenance?
Profit is the increase in capital after ensuring capital has been maintained.
7. Which capital maintenance method is best?
Each method has a different purpose. Physical and purchasing power methods give more realistic results in inflationary conditions.
