I´m just re-reading through my books for Level 2 AAT as I easily forget all my double entry bookkeeping etc.
It got me thinking about capital when it is explained in books and how it really is in real life.
When a business owner introduces capital at the start of the business, why does this sit in the capital account? Why is this not used for assets etc? Is capital a form of savings to fall back on? Also, when and how would capital be increased?
Would this be through income such as rental etc or would it come from sales? At which point would a business know to put a large chunk of money into the capital account?
Right well look at it. When that example introduced capital, it bought something. There's your credit capital account and debit asset of some kind - be it cash at bank; vehicle or other current or fixed asset.
Not being facetious at all. It's a long time since i studied and it made no sense at all to me at the time.
The "Capital" account is a record of all the money the business owner has put into the business. That money is, probably, put into a bank account, which is an asset. So if someone puts £10000 into their fresh business, they have £10000 assets (cash in the bank) and also are showing £10000 capital (money invested in the business).
The balance sheet shows this, in that the top half, Assets - Liabilities, must balance the bottom half, the Capital section (which includes the "Capital" account but some other stuff too).
So your thinking of the Capital as a kind of bank account is not correct, it is simply a record of what money has been put in. The bank account is in the assets section, and that's where the money actually is in real life. That's then used to buy other stuff, replacing one asset (cash in bank) by another (stock, for example). As long as the total assets (what the business owns) - the total liabilities (what the business owes) = the capital (the total invested in the business), all's well and you've down your double-entry bookkeeping correctly.
Capital would be increased by the business making a profit, or the owner putting more money (or value) into the business.
Sales should ideally generate profit, once the cost of sales and other overheads (i.e. expenses, such as rent) are taken into account, but the business might make a loss, which is just a negative profit, That profit / loss is transferred at regular intervals to the capital section, showing the worth of the business increasing (with profits) or decreasing (with losses) over time.
The owner might need to put a chunk of money into the capital account, i.e. increase the investment in the business, and so increasing capital, by adding cash to an asset, such as a bank account, if the business is making a loss and the owner needs to pay some of its debts. But if the business is doing well, the owner can reduce the capital (probably by reducing the bank account asset by making a withdrawl) and go off to Barbados on a holiday.
