Do you fancy working for yourself? Understanding capital will be essential.
Lots of us who study accountancy intend to become our own boss someday, or simply do our own bookkeeping. Understanding the concept of capital and what it means for a sole trader is vital for both the would-be self-employed and aspiring accounting professionals who compile their accounts.
Before we start I’m going to refer you back to some previous study tips on balancing a trial balance, as they cover fundamental points on the relationships between account categories and how they relate to financial statements. We need to understand these basics as they are building blocks of accounting theory and systems.
Let’s start with a definition of capital. What we’re talking about is the amount that a business, at any time, owes its owner(s).*
To fully understand this definition though, we also need to know about underpinning accounting concepts:
- Dual effect – every business transaction will have two effects which are both equal and opposite, and therefore balancing.
- Separate entity – the owner of a business, and their personal affairs, are regarded as separate and different to the business.
- Accounting Equation – assets less liabilities equal capital
When we combine all these concepts, they explain why, when an owner puts their personal money into a business bank account, it has the effect of both increasing the business bank account balance and increasing the capital account balance.
It’s also why the balance on the capital account is owed to the business’s owner, who in effect is treated as a payable by the business. Finally, the accounting equation shows the relationship between the assets, liabilities and capital of the business. The amount of capital in the business is not fixed but changes as the business buys assets, borrows funds and makes a profit or loss.
The accounting equation is also the basis for the Statement of Financial Position (SFP), which shows current and non-current assets less current and long-term liabilities to leave total net assets, namely capital. There is then a ‘financed by’ section which explains that closing capital figure, which is opening capital (closing capital from the previous year) plus this year’s profit or loss, less drawings.
Capital therefore is a constant and irremovable feature of a sole trader’s accounts but with a constantly changing balance. It’s increased by any profit the sole trader’s business makes and deceased by any drawing they take out of it through the course of the year or if the business makes a loss.
So that’s the theory but what does it mean in practice?
Firstly we need to be aware that capital, drawing and profit are all accounted for separately throughout the year and only come together on the SFP at year-end.
Capital account – records the permanent investment the owner has in the business. Can be both increased and decreased by cash injections or withdrawals and by investments or withdrawals in kind. For example, personal assets introduced or business assets withdrawn from the business to become the owner’s personal property.
Drawing account – records the day-to-day money taken out of the business by its owner, usually for living expenses. Can be increased by drawing in kind, for example, goods or services withdrawn from the business for the owner’s personal use.
Profit or Loss – income and expenses are recorded throughout the year and then profit or loss is calculated on the Statement of Profit or Loss (SPL) at year end, and transferred to the SFP.
Let’s suppose that the aspiration to work for yourself has come true and you are about to become a sole trader. Imagine you have £10,000 to put into a business bank account.
From the accounts above we can see that the concepts of dual effect and separate entity have been applied.
We can also see that the balance on the capital account is £11,000 which means that this is how much the business owes you at this point in time. However, when we calculate your assets and liabilities they are worth £11,550 and £700 respectively, so the accounting equation shows: **
This conflicts with the balance on the capital account but we can be confident that the accounts are correct because we know that once we get to year-end and compile the SFP there will be a sub-calculation which will then reconcile:
* As this article relates to sole traders we will just refer to one owner from now on but the basic definition of capital would apply to partnerships as well as other forms of business ownership.
** Please note that assets have been calculated as Bank £9,750 + Office Equipment £1,100 + Purchases £700. However, purchases and inventory are not the same but have been valued as such at this stage because it is the first purchase that the business has made and there have been no sales. The fact that there have been no sales yet also means there is no profit to affect the capital figure.
Read more study tips for AAT level 3:
- FAPR accounting adjustments when partnerships dissolve
- Common mistakes students make at AAT Advanced level
- Margins and mark-ups
Gill Myers is a self-employed accounts consultant. She has taught AAT qualifications since 2005 and written numerous articles and e-learning resources.