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Accounting concept that a profit can be realized only after capital of the
firm has either been restored to its original level (called 'capital recovery') or is
maintained at a predetermined level. It is necessary, therefore, to determine the
value of capital before the amount of profit can be computed. Capital
maintenance (paid from the capital funds budget) is the work performed using a
systematic management process to plan and budget for known cyclical repair
and replacement requirements that extend the life and retain the usable
condition of facilities and systems. This includes what is commonly known as
“deferred maintenance”: work that has been deferred on a planned or unplanned
basis to a future budget cycle or postponed until funds are available; when the
work is performed the deferred maintenance backlog is reduced. The concepts
of capital give rise to the following concepts of capital maintenance:
Accounting has not yet advanced to a state of being able to value a business
(or a business's assets). As such, many transactions and events are reported
based upon the historical cost principle (in contrast to fair value). This
principle holds that it is better to maintain accountability over certain financial
statement elements at amounts that are objective and verifiable, rather than
opening the door to random adjustments for value changes that may not be
supportable. For example, land is initially recorded in the accounting records at
its purchase price. That historical cost will not be adjusted even if the fair value
is perceived as increasing. While this enhances the "reliability" of reported
data, it can also pose a limitation on its "relevance."
The FASB defines “fair value” as “the price at which an asset or liability could
be exchanged in a current transaction between knowledgeable, unrelated willing
parties” (FASB, 2004a).4 As the FASB notes, “the objective of a fair value
measurement is to estimate an exchange price for the asset or liability being
measured in the absence of an actual transaction for that asset or liability.”
Implicit in this objective is the notion that fair value is well defined so that an
asset or liability’s exchange price fully captures its value. That is, the price at
which an asset can be exchanged between two entities does not depend on the
entities engaged in the exchange and this price also equals the value-in-use to
any entity. For example, the value of a swap derivative to a bank equals the
price at which it can purchase or sell that derivative, and the swap's value does
not depend on the existing assets and liabilities on the bank’s balance sheet. For
such a bank, Barth and Landsman (1995) notes that this is a strong assumption
to make particularly if many of its assets and liabilities cannot readily be traded.
I will return to the implications of this problem when discussing implementation
of marking-to-market issues below. Fair value is an exit value (the price
received to sell an asset) and transaction costs are not included (hence the
substitution of ‘price’ for ‘amount’). Moreover, the reference to a market rather
than a transaction between parties emphasizes the requirement that the measure
be non entity specific, i.e. it should be based on a hypothetical best market price
rather than the price actually paid or that would be actually obtained by the
reporting entity. More recently, standard setters have preferred to use the term
fair value, meaning a current market value.