Capital Account: What It Is and How It Works
Every proprietor knows the complexity of running a business. If you are a sole proprietor, a partner in a firm or a shareholder of the business, what is your contribution to the company? And how will you figure out the revenue each of these people will make? This is where the capital account comes into the picture. In this blog, let us learn more about the capital account definition and its benefits in detail.
What is a Capital Account?
Capital Account is an important part of the accounting process. Capital Accounts are applied in the business to document individual ownership rights of the owners in the company. It means that the transactions pertaining to the owner’s funds such as their contributions and revenue are earned by the company after decreasing distributions like dividends. These transactions are recorded under the equity side as ‘shareholder’s equity’ if it’s a company.
In addition, the recorded transactions are represented as owner’s equity for a sole proprietorship or the company’s net worth on a specific day. Hence, capital is the assets and cash of the company. Suppose, it is a public limited company, it means the funds are contributed by investors. And if it is a private limited company, it represents the fund contributed by each member.
To further explain capital accounts, if you are a sole proprietor, the balance in this account comprises the owner’s initial contributions minus any withdrawals (also known as drawings) and the total accumulated profits up to the present time. Likewise, a capital account in a partnership account will comprise outstanding balances of capital contributors of the partners. And taking into consideration, the withdrawals they have made and the profits they have received based on the profit-sharing ratio.
Capital Account is decreased by drawings. So, the profit appropriation to partners maximises their capital account components. A company includes shared capital(equity and preferred capital), additional paid-in capital, retained earnings and any equity reserve.
Capital Account Example
Let us learn about capital account with an example. Assume that two people are setting up a business and they make a decision to split their assets centrally. Each of these owners receives 50% of the profit or loss. Suppose, if these owners invest $25,000 each, the capital account begins at $50,000. If the business performs excellently in the first year with a revenue of $100,000, each owner’s equity will increase by $ 50,000 for a $ 25,000 balance per owner.
Capital account also reveals the exact amount the owners are contributing to the company. During the entire lifespan of your business, capital accounts symbolize the financial stakes of every partner involved in the enterprise. Moreover, it is essential to monitor capital accounts from both a bookkeeping and accounting standpoint, rather than solely focusing on capital accounts for taxation purposes.
Some examples of the capital account are listed below —
Companies also have other types of capital accounts which are mentioned below —
What kind of businesses have capital accounts?
A proprietor’s capital account is structured based on the following types of business which are listed below —
1. Sole proprietor – Here, 100% of the business is owned by the proprietor. The owner’s capital account is documented in the financial statements as ” [Owner’s Name], Capital Account”
2. Partnership/LLC – These account holders comprise partners and members of limited liability companies (LLCs). At the time of joining, the person makes an initial capital investment in the company. The allocation of a partner’s share of profit or loss is established by the fundamental articles of incorporation or the operating agreement of the LLC, taking into account the partner’s equity stake.
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3. Shareholders – In every company, the shareholders have ownership by purchasing shares. So, based on the shares they own in a particular company, they receive dividends. In addition, they have voting rights depending on the shares they own.
4. S-corporations – The S-corporation owner is also a shareholder. Only the accounting function is different when compared to the C-Corporation. And the S-corporation owner works as a partner.
5. If a company owns another – For instance, a corporation might hold shares in an LLC, demonstrating that the capital account isn’t limited to an individual’s sole ownership.
Capital Accounting Formula
This accounting equation can obtain the formula to check the capital account balance :
Assets = Liabilities + Capital
In the above formula, the number of assets acquired at any point in time is the total sum of its liabilities and capital. Hence if we have to compute the capital account on the balance sheet, the formula to use is mentioned below.
Capital = Assets – Liabilities
The amount of capital can be obtained by reducing the number of liabilities from the number of assets reflected in the business’s balance sheet.
Current vs Capital Account
Current and Capital accounts are crucial for a nation’s balance of payments. A country’s net income over a period of time is referred to as a current account. A particular year’s net change of assets and liabilities is recorded in a capital account.
In economic terminology, the current account pertains to the inflow and outflow of funds involving both monetary and non-capital goods, whereas the capital account encompasses the origins and allocation of capital resources. Plus, the total sum of current and capital accounts recorded in the balance sheet will be zero always. Later any discrepancies in the current account are matched and canceled out by an equal surplus or deficit in the capital account.
A country’s current account manages short-term transactions or the distinction between investments and savings. The current account is also known as actual transactions as it impacts income, output, and employment levels through the movements of goods and services in the economy. It also comprises visible trade which involves the export and import of goods, invisible trade which includes the export and import of services, unilateral transfers, and investment income( income received from land or foreign shares).
Foreign exchange inflows and outflows resulting from these transactions are likewise documented in the current account balance. The sum of the total balance of trade is the resulting balance of the current account.
Conclusion
In conclusion, companies can utilise capital account records to make insightful decisions when it comes to investments. It is vital to keep track of the investments, so it will be simpler to track the capital, make wise financial decisions and avoid errors that cause higher risks. Investing in an ERP system is also beneficial to keep track of the capital in the accounting books.