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Thursday, 9 May 2013

Physical capital maintenance is very different from financial capital maintenance

Physical capital maintenance is very different from financial capital maintenance

Updated on 26-08-2014

In IFRS the Conceptual Framework (2010), Par. 4.59 (b) states the following:

 ‘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 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 (1) physical capital maintenance concept is a fundamentally (totally) different capital maintenance concept compared to the two financial capital maintenance concepts, namely (2) financial capital maintenance in nominal monetary units (traditional Historical Cost Accounting) and (3) financial capital maintenance in units of constant purchasing power in terms of a Daily CPI. The latter authorised at all levels of inflation (including hyperinflation) and deflation in IFRS in the Conceptual Framework, Par. 4.59 (a) which states "Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power" as an alternative to financial capital maintenance in nominal monetary units (i.e., as an alternative to HCA). 

Financial capital maintenance in units of constant purchasing power is required in terms of the monthly published CPI in IAS 29 Financial Reporting in Hyperinflationary Economies during hyperinflation. It has been implemented under IAS 29 in terms of the monthly published CPI which, unfortunately, does not result in actual capital maintenance in units of constant purchasing power. 

In fact, IAS 29 was implemented for the last 8 years in Zimbabwe´s hyperinflationary economy with no positive effect at all: a fact the IASB stubbornly refuses to admit. The IASB also irresponsibly refuses to update IAS 29 to require DAILY INDEXING in terms of the DAILY CPI although I have pointed out to them a number of times that it only works when the DAILY CPI is used. 

Capital maintenance in units of constant purchasing power was widely implemented with great success in the form of DAILY monetary correction or DAILY indexation in Latin America from the early 1960´s to the mid 1990´s and carried on in Chile till 2008).

(1), (2) and (3) are the three capital maintenance concepts authorised in IFRS.

The Conceptual Framework (2010), Par. 4.57 states:

‘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.’

So, it is all about ‘units of output per day. An entity must be using units of output per day as the measurement basis to maintain its physical capital.

Physical capital maintenance is not just another way or an additional way of looking at or presenting the two financial capital maintenance concepts.

Actual physical capital maintenance is not widely used in any economy. Prof. Rachel Baskerville from Victoria University in New Zealand states in her paper ‘100 Questions and Answers about IFRS’, Question 39:

‘It is equally possible for a company to adopt a concept of physical capital; i.e. the cycle of operation moves from assets/goods to dollar to goods/assets. Some public sector entities consider that their stewardship responsibilities are best served by reporting physical capital maintenance e.g. is the capacity of the waterworks, waste water system, etc. in the local town the same as, or better, than it was last year?

Some Key Performance Indicators (KPIs) will be chosen to report this.

The Framework states: ― ‘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.”


So: physical capital maintenance is not generally about ‘measurements currently reported in balance sheets’. Physical capital maintenance is not often used.

Financial capital maintenance in nominal monetary units (HCA) is the generally accepted accounting model worldwide. It is an option in IFRS: see the Conceptual Framework, Par. 4.59(a).

Financial capital maintenance in units of constant purchasing in terms of the monthly CPI is REQUIRED during hyperinflation in terms of IAS 29. Thus it is widely used in hyperinflationary economies. It was very widely used  - very successfully - from 1964 to 1994 in Latin America during high inflation as well as hyperinflation, but always in terms of a DAILY INDEX. That is why it was so successful in South America while IAS 29 in terms of the monthly published CPI had no positive effect at all during the 8 years it was implemented in Zimbabwe´s hyperinflationary economy. IAS 29 was a total disaster in Zimbabwe.

Physical capital maintenance is rarely used.

Nicolaas Smith

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