Final accounts preparation series
In a previous article I wrote about those who aspire to be self-employed and why it’s important for sole traders, and the accounting technicians who compile their accounts, to understand the concept of capital.
In that article, we discussed the fundamental accounting concepts that underpin our understanding of what capital is, in other words, the money a business owes its owner, or owners, at any given time. We also focussed on sole traders as opposed to partnerships, even though the definition and concepts apply to both. Therefore, we’re now going to consider what happens at year-end, once a profit or loss has been calculated and the owner(s) capital account(s) need updating as a result.
Updating the capital account at year-end
Let’s start with a sole trader and assume they’ve made a profit in the year. As the business only has one owner, all the profit is added to their opening capital, and their drawings deducted, to calculate their closing capital. This takes place in the capital account, which is credited to increase it for the profit and debited to decrease it for the drawings. In the process, the drawings and profit accounts are in effect cleared, ready to start the new financial year with nil balances.
However, if there’s more than one owner, then there’s more than one person who wants a share of any profits, and this is where things get a little more complicated.
Dealing with two capital accounts
Firstly, whereas a sole trader has a single capital account, in a partnership this account is split into two capital accounts. One is still known as the capital account, and is used to record a partner’s long term investment in the partnership. The other is called the current account and it records a partner’s short-term capital. In other words, the amount that the business owes the partner, but that fluctuates over financial years.
To make matters even more complex, each partner will have both of these types of capital accounts. So, three people in partnership would mean three capital accounts and three current accounts, a pair for each partner!
So what’s the role of the capital account?
Let’s try and simplify things by clarifying the role of the capital account. This is where each partners’ initial investment is recorded.
It’s only increased if they add a significant capital injection or decreased if they permanently withdraw some or all of their investment from the business. The capital account is used when there are significant changes in the ownership of a partnership, such as partners leaving or joining.
It’s because the capital account is only used when there are significant changes, that there is a need for the current account. It’s role, therefore, is to record the routine changes that come about in the normal course of business.
Imagine you and I are in partnership. When we started our business, you invested £30,000 and I invested £20,000. We also sensibly drew up an agreement, although it is useful to note that a partnership agreement is not a legal requirement and that not all partnerships have one. Our agreement sets out how we’ll share the profits and losses of the business at the end of each year.
In effect, it states the items that impact our short-term capital:
- I receive a £6,000 annual salary
- 5% commission is paid on sales
- No interest is paid on capital balances
- 2% interest is charged on drawings
- Profit ratio, you:me is 2:1
Let’s say we’re now at the end of our third year of trading and the partnership had been operating nicely, with me working full time and you part time. However, this year business was slow. There have been no significant changes since the business’s conception and this year’s net profit was £30,000.
We both want a share of the profit and our agreement gives us the rules to divide it between us. We know that as we’re in a partnership, the value of our short term capital is the balance on our current accounts but are unsure how the figures get there. The answer is that an appropriation account is used.
Introducing the appropriation account
When the profit is appropriated, it is shared. The process is similar to allocating and apportioning overheads in management accounting.
Firstly, we allocate the items in the agreement that have ring fenced some of the profit. In our agreement, that’s the salary and sales commission*. It would have also included interest on capital balances, if we’d included a provision for that.
As these items allocate some of the profit to us, they are deducted from it:
The interest on drawings* is also an allocated item but is, in effect, added back to the profit figure as it is interest paid not received. It therefore decreases the amount of profit allocated to us both:
Now that we’ve allocated all the items in the agreement, we can see what’s left over to appropriate, share or apportion:
Unfortunately, this year the net profit is insufficient to cover all the allocated items and has turned into a small loss.
Be careful not to confuse this with the business making a loss because it didn’t! The £30,000 net profit still remains, it’s simply that our agreement has allocated all of it between us and there is none left over at the end of that stage to share any further.
Completing the appropriation process
That said, we still need to complete the appropriation process, it’s just that we now have a loss to share. That’s done by using the profit sharing ratio:
Once the appropriation account is complete, the figures can be posted to the current accounts and we’ll discuss how to do that in part 2 of this series: current accounts.
* Note: these figures have been made up for illustrative purposes.
Gill Myers is a self-employed accounts consultant. She has taught AAT qualifications since 2005 and written numerous articles and e-learning resources.