What is capital?
Generally, Capital refers to any financial resources or properties owned by a business that are used in furthering development and generating income.
It can include cash or other assets brought into a business by the owners. However, the term can have a variety of other meanings in different context.
Here are a few:
1. Capital are funds raised to support a particular business or project. This is the total resources in cash used to set up a business.
2. It can also represent the accumulated wealth of a business, represented by its assets less liabilities.
3. Capital, in some cases can also mean stock or ownership in a company.
How it differs from money
While it may seem that capital is almost the same as money, there is an important difference between capital and money.
Money is a medium to buy and sell goods or services within a company or between two companies or people and has a more immediate purpose.
Capital, however, includes assets such as investments, stocks, and other assets that are long-term and could benefit the company in the future. Economists see it as a wealth used to create more wealth. Capital involves the aspects of a company that help build and improve it, that form its base for generating incomes.
When a person starts a business, he brings some money in cash and some in assets (building, furniture and machinery). These are his capital.
For instance, you want to start an accounting tuition center in your town with $2000 in cash. Due to non availability of space, you are using your room for tuition centre. Therefore, your $2000 and room are the capital and it will appear in the liability side of your balance sheet.
Its accounting treatment
When a sole proprietor or partner brings capital, cash comes in the business, the cash is debited and the name of person who brought money is credited in journal entry and capital account mention with his name.
For instance, Michael brought $50000 into his small business as capital.
- Debit Cash account $50000 because the business received cash (See double entry rules
- Credit Michael’s Capital account $50000 (Michael gave money to the business as capital)
In partnership accounting, capital generally means money which is given by each partner to start or keep up a firm. There is always an interest on capital for each partner based on the amount contributed. The percentage the company will share is stated on the partnership deed.
In company accounting, where owner is different from management, the meaning of capital is different from sole proprietorship and partnership.
In company, a business receives capital from shareholders by issuing them shares. Shares are the smallest part of company’s capital. Its face value may be $1 to $1000 depending on the nature of business they engage in. At the end of the year, each shareholder receives dividend from the company. The amount of shares a shareholder own in a company will decide the dividend he/she will receive by the end of the year.
How accounting treats Capital in Balance Sheet
In balance sheet, we treat capital as a liability. It appears on the liability side of the balance sheet. It is part of the equity or net worth of a company. We explained why we treat capital as a liability in one of our articles.
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Simple formula of calculating capital
Capital = Assets – Liabilities
Where assets are what the business own while liabilities are what it owe.
Shareholder's Equity = Total asset – Total liabilities (Debentures + preference share capital + current liabilities)
Some terms that relate to capital include:
1. Capital gains: This means increase in the value of stock and other assets at the time of sales.
2. Capital structure: This is the mix of debt and equity in the balance sheet.
3. Capital improvements: This is the improvements made to capital assets.
4. Working capital: This means the value of the assets minus the current liabilities. It also means the amount for running the daily activities of an organization.
5. Capital employed: This is the excess of total assets over current liabilities. This is represented as Total assets - Current liabilities.
6. Loan capital: This is the total amount a business borrowed from external sources e.g debentures, bonds etc.
Tax on capital
Since the company owns capital, it has to be protected. However, ownership can be transferred or sold from one person to another usually faces tax.
Capital that has appreciated in value over the course of a company’s ownership from time of purchase to time of sale (capital gains), could be liable to tax. The tax goes to the public benefit.