In accounting, the capital maintenance approach refers to the measurement of a company's

financial performance based on the idea of maintaining the company’s capital. There are two
main types of capital maintenance approaches: the financial capital maintenance approach and
the physical capital maintenance approach. Here's a breakdown of both:

1. Financial Capital Maintenance Approach:

 Definition: This approach focuses on maintaining the monetary value of capital. Profit is
considered to be the increase in financial capital during a period, after deducting any
distributions (like dividends).

 Measurement: Under this approach, capital is maintained by ensuring that the net asset
value at the end of the period exceeds the net asset value at the start of the period after
accounting for any distributions. The focus here is primarily on financial performance.

 Example: If a company starts the year with net assets of $500,000 and ends with net
assets of $550,000 after not paying any dividends, the company has maintained its
financial capital. Net assets = Total Assets – Total Liabilities

Example Scenario:

Imagine Company ABC started the year with the following financial data:

 Beginning Net Assets: $500,000

 Ending Net Assets: $550,000

 Dividends Paid: $50,000

Computation Steps:

1. Determine the Net Assets at Beginning and End of the Period:

o Beginning Net Assets: $500,000

o Ending Net Assets: $550,000

2. Adjust for Distributions: Calculate the financial capital maintenance requirement,

o Adjusted Ending Net Assets = Ending Net Assets + Dividends Paid

o Adjusted Ending Net Assets = $550,000 + $50,000

o Adjusted Ending Net Assets = $600,000

3. Calculate Profit for the Period:

o To find out whether the financial capital was maintained, compare Adjusted
Ending Net Assets with Beginning Net Assets:

o Profit = Adjusted Ending Net Assets - Beginning Net Assets

o Profit = $600,000 - $500,000

o Profit = $100,000

Conclusion:
Under the financial capital maintenance approach, Company ABC recognized a profit of $100,000
for the period. This profit indicates that the company not only maintained its financial capital but
also increased it over the period, after accounting for the dividends paid.

This approach emphasizes the importance of net asset values and demonstrates how financial
outcomes relate to capital maintenance as defined by changes in financial position after
distributions to shareholders.

2. Physical Capital Maintenance Approach:

 Definition: This approach emphasizes maintaining the physical capacity and operational
capability of the company. Profit is determined based on whether a company can
continue to operate at its normal capacity without reducing its ability to produce goods
and services.

 Measurement: Under the physical maintenance approach, the capital is maintained if the
organization can sustain its physical resources—meaning that the quantity and quality of
productive capacity remain intact.

 Example: If a factory has the same capacity to produce widgets at the end of the period
as at the beginning, considering depreciation of machinery and equipment to measure
capital maintenance, it would be viewed as maintaining its physical capital.

Key Differences:

 Focus: Financial capital maintenance emphasizes financial figures and monetary value,
while physical capital maintenance focuses on sustaining operational capacity.

 Profit Recognition: Under financial capital maintenance, profit can be recognized even if
physical assets have deteriorated, as long as the financial capital exceeds its prior value. In
contrast, with physical capital maintenance, profit is only recognized if the physical
capabilities of the business are preserved.

Each approach serves different purposes and provides varying perspectives on financial
performance and capital maintenance, allowing stakeholders to assess the company's well-being
based on their specific interests and requirements.

example to illustrate the computation of the financial capital maintenance approach:

Example Scenario:

Imagine Company XYZ operates a manufacturing facility with the following information for the
year:

 Beginning Physical Capacity (Units Produced): 10,000 units

 Ending Physical Capacity (Units Produced): 10,500 units

 Beginning Net Assets (Financial Value): $700,000

 Ending Net Assets (Financial Value): $800,000

 Depreciation Expense: $50,000

 Dividends Paid: $30,000

1. Determine Beginning and Ending Physical Capacity:

o Beginning Physical Capacity: 10,000 units

o Ending Physical Capacity: 10,500 units

2. Assess Physical Capacity Maintenance:

o If the ending physical capacity is greater than the beginning capacity, the physical
capital has been maintained and expanded.

o In this case, physical capacity has increased (by 500 units), indicating that the
physical capital has been maintained and even enhanced.

3. Verify Asset Depreciation:

o Calculate the impact of depreciation on physical capital:

o Beginning Net Assets (Financial Value): $700,000

o Depreciation Expense: $50,000

This means that the actual economic consumption of the physical assets must also be considered.

4. Net Assets Comparison:

o Evaluate the Adjustment of Financial Assets considering physical maintenance:

o Ending Net Assets (Financial Value): $800,000

o To determine how much of the increase in financial capital is due to maintaining

o Adjusted Ending Net Assets = Ending Net Assets + Depreciation Expense

o Adjusted Ending Net Assets = $800,000 + $50,000 = $850,000

5. Calculate Profit for the Period:

o Profit = Adjusted Ending Net Assets - Beginning Net Assets

o Profit = $850,000 - $700,000

o Profit = $150,000

Conclusion:

Under the physical capital maintenance approach, Company XYZ recognizes a profit of $150,000
for the period. This profit confirms that the company not only maintained its physical operating
capacity but also expanded it while accounting for depreciation.

The approach emphasizes that profits are linked to the maintenance of physical capacity, hence, a
true representation of sustainable performance from a physical standpoint.