What is a Capital Account – Its Working, Importance and How to Report it on Tax Forms
A capital account is a part of an entity’s balance of payments. It is a general ledger account that records the contributed capital of the shareholders plus the retained earnings.
Companies usually post details about their capital account at the bottom of their balance sheet. In the case of a sole proprietorship, a capital account might be referred to as owner’s equity. On the other hand, in the case of a company owned by shareholders, this account becomes shareholder’s equity.
Read on to know the types of capital accounts and their importance.
What Is a Capital Account?
A capital account keeps record of the outflows and inflows of capital that might affect the assets and liabilities of a business organisation. In simpler words, a capital account tracks the assets and invested cash in a business.
The capital account of a business tracks the surplus cash, machinery, receivable accounts, property, or houses of the owners. It reflects all financial resources a business has or uses to operate.
Why Are Capital Accounts Important?
A capital account is one of the most integral parts of a business organisation because of the following reasons:
- It showcases the amount that stays invested in the company by its owners at the end of a financial year.
- Accountants can utilise this account to determine the number of assets that are capital-financed or how much amount is debt-financed.
- A capital account also helps calculate various financial ratios, including the debt-to-income ratio.
- It helps financial institutions to decide whether the business is eligible to receive a loan or not.
How Does a Capital Account Work?
You can create a capital account through either of the following methods:
- Spreadsheet
- Accounting software
You need to keep a clear record of all income and expenditures of your company to assess the overall funds in your account. Ensure to update this account at regular intervals with relevant financial information, such as:
- Loss
- Profits
- Additional owner investments
- Purchase of assets
While sole proprietorships can have one capital account, partnership firms can have one or more capital accounts for each owner. For instance, if one partner owns one-third of a firm, the particular company might allocate one-third of the retained earnings to him/her.
Additionally, if the company has multiple shareholders, it can pay dividends to them through a single capital account.
Example:
Here is an example of how capital accounts can be utilised across different firms:
1. Sole Proprietorship
A sole proprietorship means the business has a single owner. For instance, if Mr Sharma opens a business venture with his own capital, he is the sole proprietor of the business. Thus, in this case, Mr Sharma’s capital account will be presented in his name.
2. Partnerships and LLC
In businesses that have multiple partners, there are typically different capital accounts for each partner. All partners split the retained earnings as per the business agreement.
For example, if Mr Sharma and Mr Verma open a business together in a space that Mr Verma owns, both of them might agree that Mr Verma owns two-thirds of the business. Therefore, both of them will have separate capital accounts.
Shareholders typically buy ownership of a particular company and receive dividends depending on the number of shares they own. For example, Company X is an organisation with 100 shares. It records retained earnings in a dedicated capital account. The company also pays regular dividends to its shareholders. Now, Ms Dubey, who owns 30 shares of company X, will receive 30% of the dividend from the company’s capital account.
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What are the Types of Capital Accounts?
Upon knowing the capital account definition, it is crucial that you are well-versed with the types of capital accounts.
Typically, there are two methods by which you can maintain a capital account in a partnership firm. Find details about them below:
1. Fixed Capital Account
This is the type of capital account where a business organisation maintains two different accounts. Both these accounts feature different types of transactions undertaken by the partners’ capital. The two accounts created under this are current account and capital account.
If you plan to display a fixed capital account, note that this type of account remains constant, and you need to mention it clearly in the partnership deed.
2. Fluctuating Capital Account
In this type of capital account, all partners’ capital keeps on fluctuating. Unlike fixed capital accounts, it displays simply one account. There is no need for individuals to showcase this detail in the partnership deed.
What Are the Rules Regarding Capital Accounts?
Here are some of the important rules that accountants must keep in mind while creating capital accounts:
- All financial and operational information of a business should be documented properly. Based on how a firm was set up, these documents can include partnership documents, LLC operating agreements, profit and loss statements and more.
- The amount in the capital accounts should be equal to the difference in value between the assets accounts and the liability accounts.
- A partner’s opening capital account balance should be equal to the value of his/her contribution to the partnership.
- The capital account must also mention the amount of money the owner can withdraw. However, sole proprietors and single-member LLCs do not generally mention these details, as they can create or borrow capital as they wish.
How to Report Capital Accounts on Tax Forms?
Individuals or business entities can file any of the tax returns discussed below to report their capital accounts:
- ITR – 3: For taxpayers who make an income from a profession or from owning a business.
- ITR – 4: For individuals or partnership firms who generate income from a business.
- ITR – 5: For Limited Liability Partnerships and companies
To report capital accounts on the tax forms mentioned above, one has to enter the different values related to a capital account on the balance sheet of the I-T return forms.
Difference between Current Account and Capital Account
The current and capital accounts of an entity are two of the most important aspects of a balance sheet. The current account tracks transactions to record the net income of a company over a period of time. On the other hand, capital accounts record the flow of assets and liabilities during a particular financial year.
A Few Helpful Tips to Maintain Capital Accounts
Although the aspects of a capital account are easily understandable, you might face certain difficulties while managing it. Thus, mentioned below are a few quick tips that will help you maintain your capital account:
1. Keep Correct Records
The most efficient way to manage your capital account is by keeping correct records of all profits and losses. These details are important to ensure that you get an accurate report regarding your company’s expenses, earnings, dividends and more.
2. Pay On Time
It is also important for a business to make timely payments to the supplier so that the amount gets reflected in the retained earnings on time. This will also reduce the probability of late payments and interest rate hikes. Following this will also ensure that you maintain a disciplined payment method and avoid fraudulent activities.
3. Monitor Your Account
Accounts receivable is the account that receives the money that a customer or company pays you. You should closely monitor such accounts to make way for more profit. To streamline this, consider contacting your customers as soon as possible. By receiving the profits you deserve on time, you will be able to balance your accounts easily.
4. Use Accounting Software
Utilising accounting software is one of the fastest, most convenient and safest ways to ensure the correct maintenance of your capital account. Additionally, this will also save you the time and effort you would have spent through the manual process. You can use this software for other financial activities, such as sending invoices and more.
Final Word
Evidently, business organisations can use a capital account to make wise financial decisions. However, for this, your accounting records must be accurate and clear. Try to keep track of your investments and expenditures and follow the tips mentioned above to effectively manage your capital account.
FAQs
Ans. Cost accounting is a type of accounting which aims to cover the total production cost of a company. It measures the variable cost of every other production phase along with fixed costs, including lease expenses.
Ans. LLC, or a limited liability company, is somewhat similar to a partnership. However, a key difference between these companies is that an LLC can be created with a single member, while a partnership requires two or more people. Moreover, LLCs are also required to complete certain state requirements, which are not needed in the case of partnerships.
Ans. Accounts receivable refers to the amount that your company will receive from customers in return for goods and services. Simply put, it is the sum that a customer owes you due to contractual obligations. On the other hand, accounts payable is the sum you owe to your supplier. It comes under liabilities in your company’s balance sheet.
Ans. Capital is the overall financial resources in the form of money that a businessperson contributes to establish a business and generate profits. Capital can include cash, equipment, land, buildings and more. Further, companies can also have different types of capital, such as working capital, commercial capital, net worth and borrowed capital.
Ans. A capital account needs to track owners’ cash or asset contribution during a particular year. It should also assess the amount a business distributes for personal use. Additionally, a capital account must also track the profit and loss of partners in an organisation.
Disclaimer
This article is solely for educational purposes. Navi doesn't take any responsibility for the information or claims made in the blog.
