## **Learning Outcomes**

After reading this article, you will be able to explain what capital maintenance means in financial reporting, describe the two main capital maintenance concepts, apply the rules set by the regulatory and conceptual frameworks, and identify how these rules limit distributions to shareholders. You will also understand how profit measurement and constraints protect capital, ensuring compliance for the ACCA FR exam.

## **ACCA Financial Reporting (FR) Syllabus**

For ACCA Financial Reporting (FR), you are required to understand how regulatory and conceptual frameworks ensure the protection of capital and regulate distributions. Revision for this topic should focus on:

- Identifying why capital maintenance is a fundamental concept in financial reporting frameworks
- Distinguishing between financial capital maintenance and physical capital maintenance
- Explaining how capital maintenance constrains profit distribution
- Recognising capital maintenance requirements under IFRS Accounting Standards and their role during asset revaluations or impairments
- Understanding the practical limits placed on dividends or other owner distributions

## **Test Your Knowledge**

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision._

1. What are the two main concepts of capital maintenance recognised by regulatory frameworks?
2. Under what circumstances can a company lawfully declare and pay dividends to its shareholders?
3. Why is capital maintenance important for creditors as well as shareholders?
4. Explain, briefly, what is meant by a 'constraint on distributions' in financial reporting.

## **Introduction**

The concept of capital maintenance underpins the preparation and presentation of financial statements. Capital is not only the basis for owner investment and creditor security, but rules about its preservation serve as a barrier to the excessive distribution of profits. International financial reporting frameworks and company law establish clear principles that restrict distributions to ensure the business remains solvent and its reported profits are genuinely available.

For ACCA exam purposes, you must be able to explain these capital maintenance principles, how they affect entity reporting, and recognise how they constrain divisions of profit.

> **Key Term: capital maintenance**
> The requirement that the capital originally contributed or invested in the business should not be reduced by distributions, ensuring that profit is only recognised if capital is maintained.
>
> **Key Term: financial capital maintenance**
> The concept that profit is only earned if the financial amount of net assets at the end of the period exceeds the amount at the start, after excluding contributions from and distributions to owners.
>
> **Key Term: physical capital maintenance**
> The concept that profit is earned only if the operating capability (often measured by productive capacity or physical assets) is maintained or increased over the period.

## **Capital Maintenance in the Conceptual Framework**

### The Purpose of Capital Maintenance

One of the main purposes of financial reporting is to provide users with a clear picture of an entity's performance—measured as profit—without eroding the amount of capital needed for the business to operate. Capital maintenance ensures reported 'profits' reflect only the surplus after the original capital has been protected.

This principle is important in protecting creditors (by preventing companies from distributing excessive dividends that may threaten solvency) and maintaining fairness among shareholders.

### Types of Capital Maintenance

Two main capital maintenance concepts are recognised in the International Accounting Standards Board's Conceptual Framework:

- **Financial capital maintenance**: Profit is measured by reference to changes in the monetary value of net assets. As long as the net assets (equity) at the end of the period are more than at the start—excluding contributions from or distributions to owners—a profit is recognised.
- **Physical capital maintenance**: Profit is measured only if the company's physical operating capability (such as machine capacity or number of sales outlets) is maintained. This approach is more relevant during periods of high inflation.

Both approaches restrict profit to that which is surplus to maintaining capital, though in practice, IFRS Accounting Standards mainly use the financial capital maintenance model.

### Constraints on Distributions

Company law and accounting standards draw on capital maintenance by restricting the distribution of profits to owners (usually as dividends) unless:

- Profits have been earned in excess of any amount needed to maintain capital
- Unrealised gains (such as certain asset revaluations) are not treated as distributable profits
- Legal capital (such as share capital, and in some cases, capital reserves) is preserved

Entities must therefore ensure that distributions do not reduce capital below statutory, contractual, or prudential minimums.

> **Exam Warning**
> In the FR exam, you may be asked to distinguish between distributable and non-distributable profits, or to identify the impact of revaluations or losses on capital maintenance. Always check whether a profit is realised and that capital is not reduced by a proposed distribution.

## **Capital Maintenance and the Statement of Profit**

The rules of capital maintenance affect the measurement of profit. Only profits made after capital has been maintained are available for distribution. Impairment losses, revaluation deficits, or prior period errors that reduce equity may mean no or reduced profit is available for dividends.

### Non-Distributable Reserves

Certain reserves—such as revaluation surplus or share premium—may not be distributed to owners. These represent unrealised gains, or are legally required to be preserved.

### **Worked Example 1.1**

**Solidus Ltd** has the following equity at the start of the year:

- Share capital: \$500,000
- Retained earnings: \$120,000

At year end, after making a revaluation gain of \$50,000 on property and recording a profit for the year of \$40,000, directors wish to pay a \$100,000 dividend.

Is this dividend permitted under capital maintenance and distribution constraints?

> **Answer:**
> The revaluation surplus of \$50,000 is not a realised profit and cannot be distributed. Only retained earnings can be distributed.
>
> The opening distributable profit is \$120,000. Add the current year's profit of \$40,000 (assuming all realised and after tax): \$160,000. The revaluation surplus is excluded.
>
> The proposed dividend of \$100,000 can be paid only if this does not reduce capital below legal or regulatory minimums and sufficient distributable profits remain after payment. In this example, sufficient retained earnings are available, so the dividend is permitted.

### **Worked Example 1.2**

An entity revalues its investment property upwards by \$100,000 and records a profit for the year of \$20,000. Can the \$100,000 gain be distributed as a dividend?

> **Answer:**
> No. The \$100,000 revaluation gain is unrealised and sits in a non-distributable reserve (e.g., revaluation surplus). Only the \$20,000 realised profit, subject to meeting other legal requirements, can be considered for distribution.

## **Capital Maintenance Constraints in Practice**

### Legal and Accounting Requirements

- Companies can only distribute profits out of realised earnings, not capital or unrealised gains.
- Losses or impairments that lead to losses of capital may restrict or prohibit distributions until the capital is restored.
- Capital maintenance rules may require restatement or restriction of profit in the event of asset write-downs or prior period errors.

### Impact During Asset Revaluations and Impairments

Capital maintenance concepts safeguard that unrealised increases do not give rise to distributable profits, while unrealised losses may immediately restrict distributions.

### **Worked Example 1.3**

**Crest Co** discovers a prior period overstatement of inventory, resulting in an \$80,000 reduction in opening retained earnings. Current year profit is \$60,000. Can any dividend be lawfully paid?

> **Answer:**
> The corrected opening retained earnings now stand at \$0 (if previous retained earnings were only \$80,000).
>
> Only the current year’s profit of \$60,000, which is realised, is available. Assuming all other constraints (e.g., no capital deficit), a dividend up to \$60,000 could be permitted, with prudence applied.

## **Summary**

Capital maintenance protects the original contributed capital and prevents distributions that might endanger the business or creditors. Only profits earned after maintaining capital are available for distribution, and unrealised gains—such as revaluation surpluses—are locked in reserves. Dividends and other distributions are strictly limited to realised profits, and special care is needed when losses, impairments, or prior period corrections affect equity.

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- Capital maintenance ensures capital is preserved before profits are distributed
- There are two main concepts: financial and physical capital maintenance
- Only profits earned after maintaining capital may be distributed—unrealised gains are not distributable
- Capital maintenance is enforced through company law, accounting standards, and internal controls
- Distributions must never reduce equity below minimum required levels or draw on non-distributable reserves

## **Key Terms and Concepts**

- capital maintenance
- financial capital maintenance
- physical capital maintenance

Regulatory and conceptual framework - Capital maintenance and constraints