Capital Account Definition
The capital account in accounting refers to the general ledger that records the transactions related to owners funds i.e. their contributions as well as earnings earned by the business till date after reduction of any distributions such as dividends. It is reported in the balance sheet under the equity side as “shareholders’ equity” in the case of a company. For a sole proprietorship, it is represented as “owner’s equity”.
Explanation
- For a sole proprietorship, the amount in this account would consist of the proprietor’s contributions net of any amounts withdrawn, i.e. drawings and accumulated profits to date.
- Similarly, for a partnership firm, this account would include the outstanding balances of capital contributions of the partners after accounting for drawings made by them and profit distributions done to them in accordance with the profit-sharing ratio. While drawings would reduce the capital balance, the profit appropriation to partners would increase their capital accounts.
- Talking about the company, it includes share capital (both equity and preference capital), additional paid-in capital, retained earnings as well as any equity reserve.
Formula
The formula for a capital account can easily be derived using the accounting equation. Let us first have a look at the accounting equation.
As we can see, the amount of assets in any business at any point in time is the sum of its liabilities and capital. Thus, if we want to calculate the amount in the capital account, we need to use the below formula:
We can derive the amount of capital by reducing the number of liabilities from the number of assets reflecting on the balance sheet of any business.
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Examples of Capital Account
Let us have a look at the extracts of the balance sheet of a company, ABC Ltd. We will try to understand how the capital account of a company looks like:
As seen in the above balance sheet extracts, this account of a company is reflected as “Equity” in the balance sheet. The total equity includes different components of equity, such as share capital, share premium, retained earnings, and so on.
Components of Capital Accounts
- Stock Capital: This includes the amount of equity and preference stock. It represents the amount invested by the stockholders against which they have been issued units of stocks.
- Additional Paid-in Capital: It represents the amount received from the stockholders in excess of face value. It is also known as “stock premium”.
- Other Capital Contributions: For sole proprietors and partnership firms, they would include the owners’ capital account, i.e. the capital balance of the sole proprietor and the partners, respectively.
- Retained Earnings: This represents the accumulated profits of a business on a particular date. Also, any reserves created out of such accumulated profits shall also be taken into account.
Importance
- The capital account becomes an essential part of the financial statements of any business because it represents the amount that remains invested in the business by the owners on a particular day.
- We can use this amount to identify how much of assets have been financed with capital, i.e. owners and how much portion is debt-financed.
- This account can be used to calculate different financial ratios such as debt-equity ratio, and so on.
- It helps the banks and other financial institutions to decide whether to grant further loans to such a business or not.
Limitations
- This account alone is not decisive for reaching any conclusion; if investors want to analyse the financial position of a business, they need to look at the entire balance sheet.
- The calculation can vary slightly from one business form to another.
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