Physical capital maintenance is very different from financial capital maintenance

Physical capital maintenance is very different from financial capital maintenance

Updated on 16-05-2016

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 is authorised at all levels of inflation (including hyperinflation) and deflation in IFRS in the Conceptual Framework (2010), 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 during hyperinflation in IAS 29 Financial Reporting in Hyperinflationary Economies. It has been implemented under IAS 29 in terms of the monthly published CPI which, unfortunately, does not result in any capital maintenance at all. 

In fact, IAS 29 in terms of the IASB promoted monthly published CPI was implemented for the final 8 years in Zimbabwe´s hyperinflationary economy (hyperinflation in Zimbabwe ended on 20 November 2008) with no positive effect at all, an irrefutable fact the IASB stubbornly refuses to admit. The IASB refuses point blank to research the very successful implementation of financial capital maintenance in units of constant purchasing power in terms of a Daily Index as it was very successfully done in Latin America from 1960 to 1994. The IASB very irresponsibly ignores the fact that daily indexing of all item in terms of all (at least daily) changes in the general price level eliminates the effect of inflation during inflation, the effect of hyperinflation during hyperinflation and the effect of deflation during deflation. 

The IASB also very 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 in various comment letters published on their website that the effect of hyperinflation in the entire economy during hyperinflation in the monetary unit is only eliminated (as it was very successfully done in Brazil in the 1990's) when a DAILY CPI is used and that the use of the monthly published CPI is a waste of time as was very clear with the ineffective use of IAS 29 during hyperinflation in Zimbabwe. 

Capital maintenance in units of constant purchasing power (not IAS 29) 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) above 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 is REQUIRED during hyperinflation in terms of IAS 29. Unfortunately IAS 29 has been implemented since 1989 in terms of the monthly published CPI which makes it useless during hyperinflation. 

IAS 29 does not actually REQUIRE the use of the monthly published CPI. Companies simply used the monthly published CPI because the Daily CPI has never been used for accounting purposes on a national scale outside of Latin America. In Latin America the use of daily indexing also was not seen as being the implementation of an accounting model in terms of the Daily CPI. It was always seen as monetary correction, something required by the central bank, not an accounting requirement. 

IAS 29, Par. 8 requires the following: "The financial statements of an entity whose functional currency is the currency of a hyperinflationary economy, whether they are based on a historical cost approach or a current cost approach, shall be stated in terms of the measuring unit current at the end of the reporting period."

The Daily CPI is also a "measuring unit current at the end of the reporting period." The use of the Daily CPI when IAS 29 is implemented during hyperinflation is thus authorised in IFRS. Unfortunately no-one has implemented IAS 29 in terms of the Daily CPI yet because the IASB very irresponsibly refuses to point out to countries in hyperinflation that Daily indexing of all items would remove the effect of hyperinflation during hyperinflation and that it is authorised in IAS 29. Brazil used a type of Daily CPI during a number of years leading up to June 1994. They used their Unidade Real de Valor daily index which was based on the daily US Dollar exchange rate during hyperinflation. During those years they eliminated a great deal of the effect of hyperinflation during hyperinflation in their monetary unit by indexing most of the economy in terms of their daily index, namely the Unidade Real de Valor. 


Thus financial capital maintenance in units of constant purchasing is widely used in hyperinflationary economies. It (not IAS 29) 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.

Update (16-05-2016)

Some respondents in their comment letters regarding the IASB´s Exposure Draft Conceptual Framework for Financial Reporting feel that a new Conceptual Framework should state that a physical capital maintenance concept will never be used. 

"Specific suggestions included that the Conceptual Framework should state that a financial concept of capital maintenance should be adopted, or that a physical capital maintenance concept will never be used."

Project Conceptual Framework 

Paper topic Feedback summary—Measurement and Capital Maintenance 

Par 65 (a), P 15

Nicolaas Smith

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