Understanding the capital account
“Capital account” is a phenomenon which for many a business owner is shrouded in mystery. What exactly is a business’ capital account and how is it related to the profit?
Type of business
Sole traderships, general partnerships, limited partnerships and professional partnerships are business formats involving the owners, or “partners”, raising capital in order to enable the launch of operations of an economic nature with the ultimate aim of generating a profit. The business’ equity is made up of the sum total of the capital accounts maintained for the various owners, each of whom as a partner has a capital account of his or her own representing his or her share of the business’ equity.
The initial capital contribution made by a business owner is augmented by the payments he or she makes into the business’ bank account and by his or her share of the profit. Any withdrawals the business owner makes from the business’ bank account – e.g. as advance payments towards his or her profit share – are charged to his or her capital account, as are withdrawals from the business’ equity for things such as the private use of the company car, the use of a business-owned home and the utility bills for such a home or for the privately used portion of the business premises.
The business owner at the launch of the business transfers 100 to the business’ bank account, resulting in the business’ opening balance sheet looking as follows:
Bank 100 Capital 100
We have assumed for the sake of simplicity that no investments will be made in operating assets. The business returns a profit of 50 for its inaugural year, resulting in its year-end balance sheet looking as follows (in theory):
Bank 150 Capital 150
As it happens, the business owner in the course of the year has withdrawn cash from the business bank account in connection with expenses incurred by him or her in a private capacity. This has caused the actual bank balance to turn out at 120 rather than 150 and has resulted in the year-end balance sheet looking as follows:
Bank 120 Capital 120
The business owner’s withdrawals for private purposes, to an annual total of 30, have caused the capital account to go down and have thus affected the business’ equity without impinging on the profit, which despite the private withdrawals remains unchanged, at 50.
The profit appropriation in the context of a general or professional partnership is provided for in a partnership agreement. It is customary to divide the profit into an interest payment on the capital contribution and a fee for work performed. The interest payment lowers the distributable profit (or pushes up the loss). The residual profit is divided in accordance with the arrangements between the partners, i.e. in proportionality to the partners’ respective professional efforts or on a flat-rate basis.
A sole tradership format entails the entire profit accruing to the sole owner, which conveniently does away with the need for a split to be made between interest payment and professional fee.