It’s all about inflation adjustment
Capital maintenance, just like the name suggests, is the concept of maintaining the capital or preventing the capital deterioration from the excess dividend distributions. In order to allow the business to continue in the same capacity, a necessary amount of capital has to be maintained. This concept allows only the profits to be distributed as earnings to the equity participants.
Basically, there are two methods of the capital maintenance: Financial Capital Maintenance and Physical Capital Maintenance. Entities generally do account for the financial records based on the nominal money terms of the financial capital maintenance. Under nominal money terms of the financial capital maintenance concept, no adjustments are made for the inflation reserves. However, under the real money terms of the capital maintenance concept and physical capital maintenance concept, adjustments for the inflation are made. These concepts help the entities to account for the correct profit and prevent distributing excessive dividends and face capital crunch in the future.
The whole issue of capital maintenance comes down to inflation. Inflation maybe both specific to the entity or a general inflation rate. Inflation adjustments allows entities to present financial statement in such a way that the entity will be able to continue to operate the same business with same financing or operating in the future.
Capital Maintenance Concept
Financial Capital Maintenance
Nominal Money Financial Capital Maintenance
With the financial concept of capital maintenance, a profit is not earned during a period unless the financial value of equity at the end of the period exceeds the financial value of equity at the beginning of the period (after adjusting for equity capital raised or distributed). Historical cost accounting is based on the concept of nominal money financial capital maintenance. Under this concept, an entity makes a profit when its closing equity exceeds its opening equity measured as the number of units of currency at the start of the period.
Real Money Financial Capital Maintenance
An alternative view of financial capital maintenance is used in constant purchasing power accounting. This system is based on the concept of real money financial capital maintenance. Under this concept, an entity makes a profit when its closing equity exceeds opening equity remeasured to maintain its purchasing power.
Constant Purchasing Power Accounting: This requires the opening equity to be uplifted by the general inflation rate. This is achieved by a simple double entry: General Inflation Loss Dr. to General Inflation Reserve Cr. A general inflation rate adjustment in the books indicates that the entity has several business avenues where its capital funds can be utilized in the future. If that is not the case then the specific inflation adjustment should be made, which is also known as physical capital maintenance.
Physical Capital Maintenance
A physical concept of capital is that the capital of an entity is represented by its productive capacity or operating capability. Where a physical concept of capital is used, the main concern of users of the financial statements is with the maintenance of the operating capability of the entity. With a physical concept of capital maintenance, a profit is not earned during a period unless (excluding new equity capital raised during the period and adding back any distribution of dividends to shareholders) the operating capability of the business is greater at the end of the period than at the beginning of the period. This requires the opening equity to be uplifted by the specific rates of inflation that apply to the individual components of the net assets of the company.
Current Cost Accounting: This requires the opening equity to be uplifted by the specific inflation rate. Again, this is achieved by the same simple double entry: Specific Inflation Loss Dr. to Specific Inflation Reserve Cr.
Illustration of Capital Maintenance
X Limited commenced business on 1 January with a single item of inventory which cost Rs.10,000. During the year it sold the item for Rs. 14,000 (cash). During the year general inflation was 5% but the inflation specific to the item was 10%. Profit is calculated under each concept in the following ways.
Statement of Profit or Loss
Financial Capital Maintenance
Physical Capital Maintenance
Financial (Nominal Money Terms)
Financial (Real Money Terms)
Cost of Sales
Statement of Financial Position
Financial (Nominal Money Terms)
Financial (Real Money Terms)
Physical Capital Maintenance
A notable observation is that the amount of the adjustment of distributable profit under the nominal money financial capital maintenance concept is higher as this doesn’t appreciate the inflation adjustment needed in the opening equity.
Why is accounting under physical and real money-based capital maintenance not a compulsory practice?
The concept of accounting under physical and real money-based capital maintenance not a compulsory practice because of the following reasons:
- It leads to the information overload and confusion
- Notional accounting for interest and inflation is not preferred by shareholders seeking maximum return
- Not all investors prioritize reinvestment within the firm but rather are rather focused on the maximization of the returns
- Non comparability of the financial statement across different businesses
- Loss of confidentiality as the disclosure of the specific inflation rate is very key metrics to the sustainability and growth of the entity
- Diminishing power of capital is usually transferred by the business to their customers through the means of increase in the price of the product or the decrease in the quantity of the product
- Not all entities are affected by the inflation rates. Entities with high internal value addition are not susceptible to the adversities caused by the minor inflation rates.
- Capital maintenance is useful for entities intending to run for the long term. Not all entities intend to run for the long term.
- The normal course of increment in the fixed and working capital automatically blocks the drain of the reserves in the normal course of the business as most assets or than cash equivalents are generally illiquid, which helps maintain the operating capacity of the capital by preventing the capital drain.
- The approaches like: fair value accounting, impairment accounting, cost/NRV already requires the entity to record for any material changes in the capacity of the assets. So specific treatment under capital maintenance may not be compulsory.
Financial capital maintenance is likely to be the most relevant to investors as they are interested in maximizing the return on their investment and therefore its purchasing power. Physical capital maintenance is likely to be most relevant to management and employees as they are interested in assessing an entity’s ability to maintain its operating capacity. This is particularly true for manufacturing businesses, where management may need information about the ability of the business to continue to produce the same or a greater volume of goods.
Utilization of Inflation Reserves accounted under Capital Maintenance Concept
As illustrated in the example above, the inflation reserve created out of the inflation reserve are accounted as if they are the component of the equity. This is not utilized by the entity for the distribution of the earnings so they are maintained by the entity as a permanent capital. This can be compared with other form of reserves like asset replacement reserves, capital reserves and similar non-distributable reserves that cannot be utilized by the entity without the specific approval of higher-level authority like BoD or General Meeting of the company. However, since the accounting under real money-based capital maintenance and physical capital maintenance is not a compulsory concept under the Financial Reporting Standards in Nepal and the Companies Law of Nepal, such decision are entirely up to the company’s and its governance team.
Capitalization of Dividend
A major connection of the capital maintenance comes with the dividend decision of the company. We have learnt from the illustration and the discussion above that the accounting under different concepts of capital maintenance leads to the recognition of different accounting profits. Similarly, the dividend distribution decision taken by the company also impacts how the company’s capital is being maintained.
Under the Companies Law of Nepal, the term dividend has been defined to include both cash dividend and stock dividend. Cash dividend decreases the net assets of the company, whereas stock dividend capitalizes the net assets of the company.
Under the Companies Law of Nepal, the general rule to distribute the dividend out of the profit earned during the financial year is:
- BoD recommends a rate of dividend
- The regulatory (e.g. NRB in case of Financial Institutions) has approved the divided distribution
- The dividend distribution rate is presented at the general meeting
- General meeting approves appropriate rate but not exceeding the rate recommended by the BoD
Additionally, when allowed by the AOA, the BoD of a company may also distribute interim dividend out of the profit derived from the previous financial year’s audited financial statement. Directors declare an interim dividend, but it is subject to shareholder approval at the general meeting.
Since, dividends (both cash and stock) are subject to the shareholder approval at the general meeting, the financial reporting standards also states that purposed dividend are only disclosed through notes in the financial statement rather than recognizing them in the books of accounts.
Stock Dividend under Companies Act ≠ Capital Increment under Industrial Enterprises Act
A common confusion regarding the recognition of capital is caused due to the various recognition and approval mechanism under the prevailing laws of Nepal:
- The recognition of the capital under Financial Reporting Standards
- The distribution of stock dividend under Companies Act
- The increment of the capital under Industrial Enterprises Act
The recognition of the long-term capital under each of the above will be different depending on the timing and procedure of the relevant laws.
Under the financial reporting standards, entities record for the equity and long-term capital funds under the principle laid down under the Standards for Financial Instrument. This allows the entities to record equity element with the hybrid financial instrument (like convertible debentures) which in theory will not change the total long-term capital of the fund but the recognition of the equity and debt element will remain different than the conventional long term fund recognition principles. The Companies Act allows the entity to recognize for the stock dividend as an increment in the equity of the company as soon as the stock dividend are approved by the general meeting of the company based on the recommendation of the BoD. Since the Companies Law of Nepal requires entities to substantively follow the applicable Financial Reporting Framework, this should not be an issue for the potential mismatch. Unless, of course, if the entity is not following the applicable financial reporting framework in Nepal.
And there is the approval requirement for the capital increment under the Industrial Enterprise Act, 2076 of Nepal. This provision requires industries to obtain approval for any instance of capital increment and increment in capacity of the industry. The fact that this is not a notice requirement but rather an approval requirement has really seemed to have bought confusion among the investors regarding how to time the approval for the capital increment and actual capitalization of the dividend. A pragmatic solution in such instances is to obtain the approval from Department of Industry or Investment Board and later only then enter into actually capitalizing the dividend of the company.
The timing of the capital increment is thus very crucial. The entity has to manage the time required by the DoI/IBN and management of the internal distributable funds and get the scheme approved by the general meeting and lastly send for recordal in the Company Registrar’s Office or Nepal Rastra Bank, as the case may be.
But why is this timing so important? This is mainly because major tax incentives are based on the industry’s ability to increase the capital and capacity of the company, which holds significant financial priority in any entity.
What does Tax Authority Consider as Capital Increment?
Under Income Tax Act, 2058 of Nepal (Amended by Finance Act, 2078):
दफा ११(३)(ग): एक अर्ब रूपैयाँभन्दा बढीको पुँजी लगानीमा स्थापना हुने र पाँच सयभन्दा बढीलाई वर्षभरि नै प्रत्यक्ष रोजगारी प्रदान गर्ने विशेष उद्योग र पर्यटन उद्योग (क्यासिनो बाहेक) लाई कारोबार सुरु गरेको मितिले पाँच वर्षसम्म पूर्ण रूपमा आयकर छुट दिई त्यसपछिको तीन वर्षसम्म लाग्ने करको पचास प्रतिशत, तर हाल सञ्चालनमा रहेका त्यस्ता उद्योगले कम्तीमा पच्चीस प्रतिशत जडित क्षमता वृद्धि गरी दुई अर्ब रुपैयाँ पुँजी प्याई तीन सयभन्दा बढीलाई वर्षभरि नै प्रत्यक्ष रोजगारी प्रदान गरेमा त्यसरी क्षमता वृद्धिबाट प्राप्त भएको आयमा पाँच वर्षसम्म पूर्ण रूपमा आयकर छुट दिई त्यसपछिको तीन वर्षसम्म लाग्ने करको पचास प्रतिशत ।
दफा ११(३ठ): विशेष उद्योग र पर्यटन क्षेत्रसँग सम्बन्धित उद्योगले आफ्नो सञ्चित मुनाफालाई सोही उद्योगको क्षमता विस्तारको लागि शेयरमा पुँजीकरण गरेको अवस्थामा त्यस्तो पुँजीकरणमा लाभांश वितरण स्वरूप लाग्ने लाभांश करमा शतप्रतिशत छुट हुनेछ ।
Concessions of these nature are provided through the Industrial Enterprises Act or the Income Tax Act. Now the major question is that, what does the tax authority consider as capital increment? Is an issue of stock dividend and enough indication of the capital increment or this needs to have been approved by the Department of Industry as a capital increment?
To dissect this problem, we need to make distinction between the terms “capacity increment” and “capital increment”. A capacity increment may not require a capital increment, it can very well be made out of the reserves available for the distribution. This has been supported by the case of the Yak and Yeti Hotel v/s Tax Office Kathmandu-2. However, recently the DoI and other regulatory authorities have also been concerned about the concept of physical capital maintenance within the industry and whether the current cost of the long-term assets of the company is covered by the long-term funds of the entity or not. This has led to DoI requiring many entities to actually apply for the increment of the capital or the capitalization of the reserves so that the long-term funds nearly represent the long-term asset of the entity.
However, to satisfy the condition of capital increment, the capitalization of dividend is necessary. There has been some adverse assessments in the past where the Income Tax Return of the taxpayer submitted with increased capital without obtaining the capital increment approval from the regulatory, were reassessed to that effect. Reference to the relevant case law: Inland Revenue Office, Biratnagar v/s Pashupati Wire Products.