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Category: Category - Capital or Equity

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Discy Latest Questions

  1. This answer was edited.

    Before answering this question you should first have a glance over the concept of interest on capital. Interest on Capital An organisation or an entity is considered as separate from its partners or proprietor or shareholders for that matter. Since the capital brought in by the partners and proprietRead more

    Before answering this question you should first have a glance over the concept of interest on capital.

    Interest on Capital

    An organisation or an entity is considered as separate from its partners or proprietor or shareholders for that matter.

    Since the capital brought in by the partners and proprietor is an obligation for an entity thus the interest payable to the partners or proprietor for that matter is considered as an expense of the firm or an entity. Had not the partners or sole owner brought in the capital the firm or the organisation would have borrowed such amount externally and so, it would have to incur a certain financial charge.

    Adjustment of Interest on Capital in the Financial Statement

    Where the capital is introduced by the sole proprietor the transaction will be journalised as-

    Interest when due –

    Journal Entry

    Interest on capital transferred to profit and loss statement-

    Journal entry at the time of transferring the interest to income statement

    Thus, ultimately the profit of the firm is reduced as such interest is treated as an expense and hence debited in the profit and loss statement and it is shown in the balance sheet by increasing the capital on the liability side of the balance sheet by that amount.

    For Example,

    Mr John is a dealer in the smartphone has introduced capital worth 1,00,000 and the firm shall pay interest @ 6% p.a. at the end of the year.

    It will be displayed in the profit and loss statement as –

    Adjustment in the income statement

     

    It will be displayed in the balance sheet as –

    Adjustment in the financial statement

    Interest on capital is provided out of profits only. Thus in case of loss, no interest is provided.

    In case of a partnership firm – 

    If the firm maintains Fluctuating Capital i.e all entries in respect of salary, interest, profit earned and drawings of partners are transacted through the partner’s capital A/c.

    Thus, where an entity maintains only partners capital account the interest on capital shall be journalised as –

    Interest on capital due –

    Journal Entry for interest on capitalInterest on capital transferred to profit and loss appropriation statement –

    Adjustment in an income statement

    Some entities prefer showing the partner’s capital accounts with the same old figures i.e no entries in respect of salary, interest, profit earned and drawings of partners are transacted through the partner’s capital A/c.

    A separate account is to be opened for the same called “Partner’s Current Account”. The interest on capital here shall be calculated only on fixed capital.

    In this case, such a transaction shall be journalised as –

    Interest due on capital
    Interest on capital when an entity maintains partners current account

    Interest on capital transferred to profit and loss appropriation statement –

    Adjustment in an income statement

    Thus, ultimately the profit of the firm is reduced as such interest is treated as an expense and hence debited in the profit and loss appropriation statement and it is shown in the balance sheet by increasing the partner’s capital/ current a/c on the liability side of the balance sheet by that amount.

    The example given below will be of some help to interpret the above para

    An entity has 2 partners – Alex and Anna at the beginning of the year both have introduced a capital of 100,000  each and it was agreed in the partnership deed that the partners will charge interest @ 12% p.a. every year at the end of the year.

    Hence, the interest of 24,000 (100,000 x 12% p.a x 2 partners) shall be transacted in the balance sheet and Profit and loss statement as –

    If the firm maintains partners capital account only-
    Adjustment in profit and loss appropriation statement

    Extract of Profit and Loss Appropriation Account-

    Adjustment in the statement of accounts

    Adjustment in a balance sheet

    A snippet of the balance sheet is given below

    Interest adjustment in the balance sheet when the entity maintains only capital account

    If the firm maintains partners capital account and partners current account

    Adjustment in profit and loss statement

    Extract of Profit and Loss Appropriation Account-

    Adjustment in Financial Statements

     

    Adjustment in a balance sheet

    A snippet of the balance sheet is given below

    Adjustment in partners current account on liability side of balance sheet

    I have tried simplifying it as much as I could. I hope this helps.


    Aastha Mehta.

     

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  1. This answer was edited.

    The term negative working capital is derived from the concept of working capital. To begin with, I would like to briefly explain the meaning of working capital. In simple terms, Working Capital refers to the total amount of current assets excluding the total amount of current liabilities in a busineRead more

    The term negative working capital is derived from the concept of working capital. To begin with, I would like to briefly explain the meaning of working capital.

    In simple terms, Working Capital refers to the total amount of current assets excluding the total amount of current liabilities in a business. It can have a positive or a negative value, wherein the two are an indicator of the well-being of a business. The formula to calculate working capital is as follows:

    WORKING CAPITAL  = TOTAL CURRENT ASSETS – TOTAL CURRENT LIABILITIES

    Negative Working Capital

    In simple words, Negative working capital refers to the excess of net current liabilities over the net current assets. As the word itself suggests, a ‘negative’ working portrays a downfall in the financial position of a business and its inefficient functioning. A company is said to be facing financial difficulty and is not in a position to pay off its debts when the value of working capital is negative.

    NEGATIVE WORKING CAPITAL  = TOTAL CURRENT LIABILITIES > TOTAL CURRENT ASSETS

    EXAMPLE

    Calculate the working capital of XYZ Ltd.

    (Extract of Balance Sheet)

    PARTICULARS AMOUNT
    CURRENT ASSETS
    Cash and Cash Equivalents 36,000
    Accounts Receivables 20,000
    Stock Inventory 15,000
    Marketable Securities 35,000
    Prepaid Rent 7,000
    TOTAL CURRENT ASSETS 1,13,000
    CURRENT LIABILITIES
    Accounts Payable 15,000
    Accrued Expense 4,000
    Deferred Revenue 40,000
    Taxes Payable 50,000
    Short – Term Debt 10,000
    Interest Payable 7,000
    TOTAL CURRENT LIABILITIES 1,26,000

    Note: As we can see the total current liabilities of XYZ Ltd. are exceeding the total current assets therefore, the working capital is negative.

    Working capital = Total current assets – Total current liabilities

    = 1,13,000 – 1,26,000

    = (13,000)

    Hope this helps.

     

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  1. This answer was edited.

    Equity in accounting refers to the sum of money that is returned or paid to the owners/shareholders at the time of winding up of the company once all of the assets are liquidated and the liabilities are paid off. It is generally referred to as Shareholder's equity or Owner's equity. It can also be cRead more

    Equity in accounting refers to the sum of money that is returned or paid to the owners/shareholders at the time of winding up of the company once all of the assets are liquidated and the liabilities are paid off. It is generally referred to as Shareholder’s equity or Owner’s equity. It can also be calculated with the help of a formula derived from the accounting equation which is as follows:

    EQUITY = TOTAL ASSETS – TOTAL LIABILITIES 

    Treatment of equity in accounting

    Equity is shown in the balance sheet under shareholder’s equity, which is a result of the difference between the total assets and total liabilities of the company. I would like to explain this concept further with the help of an example which is as follows:

    Example

    The following is the balance sheet of XYZ Ltd. which shows their Equity, Liability, and Assets during the current financial year.

    Balance sheet as at 31st March, yyyy

    PARTICULARS NOTE NO. AMOUNT
    EQUITY AND LIABILITIES
    Shareholder’s Fund
    Share capital 1,00,000
    Reserves & Surplus 40,000
    Non-Current Liabilities
    Long- Term Borrowings 14,000
    Current Liabilities
    Short term borrowings 3,000
    Trade Payables 6,000
    Short Term provision 3,000
    Total 1,66,000
    ASSETS
    Non-Current Assets
    Fixed assets 1,10,000
    Current assets
    Inventories 20,000
    Trade Receivables 30,000
    Cash and bank balance 6,000
    Total 1,66,000

    NOTE: As mentioned earlier, equity represents the difference between the total assets and total liabilities which can be easily recognized in the balance sheet given above.

    Total Assets = 1,66,000

    Total Liabilities = 26,000

    Equity = Total assets – Total liabilities

    = 1,66,000 – 26,000

    = 1,40,000 

    Hope this helps.

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  1. This answer was edited.

    Capital is credited in the books of accounts as it is a liability for the business. To make the concept simpler, I would like to familiarize you with the Golden and Modern rules of accounting, which are designed to explain the debit and credit relationship. Rules of Accounting For the application ofRead more

    Capital is credited in the books of accounts as it is a liability for the business.

    To make the concept simpler, I would like to familiarize you with the Golden and Modern rules of accounting, which are designed to explain the debit and credit relationship.

    Rules of Accounting

    For the application of rules, we first need to determine the type of account in question. An account is said to be personal when it is related to firms, companies, individuals, etc. As I mentioned earlier, capital is a liability for the firm/company/business because it is obliged to repay its owner, hence, it is a personal account.

    Golden Rules or The Traditional Rules

    Firstly, we shall consider the golden rules of accounting for personal accounts to determine why capital a/c has a credit balance. The rule is as follows:

    “Debit the receiver,

    Credit the giver”

    Example

    Mr. A is a sole proprietor. The capital invested by him accounts for 1,00,000. The journal entries in his books of accounts are as follows:

    Cash a/c Debit 1,00,000 Debit what comes into the business
    To Capital a/c Credit 1,00,000 Credit the giver

    (being cash invested into the business in the form of capital)

    Here we have credited the capital a/c as the business is liable to repay the invested amount to the proprietor in the form of profits.

    Modern Rules

    The modern rule is as follows:

    Type of account Debit Credit
    Capital Decrease Increase

    Example

    Mr. A commenced business with a capital of 5,00,00. The journal entry is as follows

    Cash a/c Debit 5,00,000 Debit the increase in asset
    To Capital a/c Credit 5,00,000 Credit the increase in capital/liability

    (being cash invested in the form of capital)

    Hope this helps.

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  1. This answer was edited.

    We will first quickly run through the concept of equity - Equity is the capital raised by a company for the purpose of purchase of assets or for making an investment in a specific project or for the smooth functioning of operations. It's important as it represents the value of an investor's stake inRead more

    We will first quickly run through the concept of equity –

    Equity is the capital raised by a company for the purpose of purchase of assets or for making an investment in a specific project or for the smooth functioning of operations. It’s important as it represents the value of an investor’s stake in a company.

    It can also be aid that its the sum of money that the company is required to pay at the time of its liquidation to its shareholders after realising all of its assets and paying off all of its debts. Equity is presented in the financial statement as a component of a Balance Sheet.

    The formula for calculating the company’s equity –

    Shareholder’s Equity = Total Assets – Total Liabilities

    Inclusive list of items under the head” Equity”

    Particulars
    Equity Share Capital
    Reserves and surplus 
    1. Securities Premium Reserve
    2. General Reserves
    3. Capital Redemption Reserve
    4. Revaluation Reserve
    5. Debenture Redemption Reserve
    6. Share Option Outstanding Account
    7. Others- (Specify the Nature and Purpose of such reserve)
    8. Retained Earnings
    Other Comprehensive Income
    1.  Foreign Currency Translation Reserve
    2.  Cash Flow Hedge Reserve
    Vesting and Exercise of Warrants
    Issuance of Non-Controlling Interest
    Repurchase of Stock option
    Issuance of Common Stock
    Stock-Based Compensation
    Exercise of Stock Options
    Additional Paid-in Capital
    The Cumulative Effect of Changes in Accounting Principles related to Revenue Recognition, Income Taxes and Financial Instruments

    It is generally presented under two subheads – Equity and Other Equity.

    The extract shown below indicates the position of Equity in a Balance Sheet –

    Equity in Balance Sheet

     

     

     

     

     

     

     

     

     

    I hope this answers your question.

     


    Aastha

     

     

     

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  1. This answer was edited.

    The simple meaning of capital, as known by many, is the sum of money invested in the business by the owner/shareholder/partners. It can be in the form of cash or assets. From the accounting perspective, capital is generally of three types, equity capital, debt capital, and working capital. Capital aRead more

    The simple meaning of capital, as known by many, is the sum of money invested in the business by the owner/shareholder/partners. It can be in the form of cash or assets. From the accounting perspective, capital is generally of three types, equity capital, debt capital, and working capital.

    Capital as a Liability

    A very common question that strikes us is that even though capital is invested by the owner in the form of cash or assets, why is it recorded on the liabilities side of the balance sheet? From the accounting perspective, Capital is a liability because the business is obliged to repay its owner.

    To make the point clear, I would like to introduce you to the two different accounting perspectives of the same.

    Internal Liability

    Firstly, in the case of equity capital, it refers to ownership and represents the owner’s fund. The company is obliged to repay the owners as it is an internal liability and interest on capital is also paid during the operations of a company. A company is considered as a separate legal entity from its owner. The proprietor/shareholder/partners have invested the amount with an aim and expectation of profits in return.

    However, the owners are repaid only if any amount is left after paying off all the obligations during the winding up of the company. It is not a mandatory liability like in the case of debt capital. It can also be represented as follows:

    Assets = Liabilities + Capital

    I have used the accounting equation to show the shareholder’s equity/capital as a difference and balancing figure between the company’s liabilities and assets. Since the capital invested is used to pay off all the debts, it has a credit balance and is recorded on the liabilities side of the balance sheet.

    External Liability

    Secondly, let us assume that company A has borrowed a certain sum of money from the company B, and holds onto the amount invested for realizing feasible profits in the future. The company is obliged to repay, irrespective of profits or loss.

    In simple words, I can conclude that capital is a liability.

    Capital as shown in the balance sheet

    Balance Sheet as at 31st March,yyyy

    Liabilities Amount  Assets Amount
    Capital 2,40,000 Cash in hand 70,000
    (+) Net Profit 70,000 Accounts receivables 50,000
    (-) Drawings (30,000) Patents 10,000
    (-)Interest on capital (20,000) Equipment 45,000
    Retained Earnings 10,000 Building 90,000
    Sundry Creditors 40,000 Prepaid Expense 35,000
    Outstanding Rent/Salary 5,000 Goodwill 20,000
    General Reserve 10,000 Investments 60,000
    Loan taken from Bank 55,000 Accrued Income 10,000
    3,80,000 3,80,000

    Hope this helps.

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  1. This answer was edited.

    Zero Working Capital Before diving into the concept of Zero Working Capital, let me help you understand the meaning of Working Capital. Working Capital is the term used to demonstrate whether the company possesses adequate current assets to discharge off its current liabilities. It is calculated asRead more

    Zero Working Capital

    Before diving into the concept of Zero Working Capital, let me help you understand the meaning of Working Capital.

    Working Capital is the term used to demonstrate whether the company possesses adequate current assets to discharge off its current liabilities. It is calculated as follows:

    Working Capital = Total Current Assets – Total Current Liabilities

    Now, taking this forward let us interpret the theory of Zero Working Capital.

    The Working Capital of a company can be positive or negative, ie. the total current assets may exceed the total current liabilities or vice-versa. However, there can be a situation when the total current assets are equivalent to the total current liabilities of the company. Such a situation is referred to as Zero Working Capital. Zero Working Capital is when,

    Total Current Assets = Total Current Liabilities, or

    Total Current Assets – Total Current Liabilities = Zero

    Example

    Zero Working Capital

    Using the data given in the balance sheet above, let us calculate the zero working capital.

    1. Total Current Assets = Cash in hand/bank + Sundry Debtors + Bills Receivable + Inventory
    = 15,000 + 1,80,000 + 1,00,000 + 55,000
    = 3,50,000

    2. Total Current Liabilities = Sundry Creditors + Bills Payable + Outstanding Expenses
    = 1,95,000 + 85,000 + 70,000
    = 3,50,000

    As there is no excess of Total Current Assets over the Total Current Liabilities, this situation is referred to as Zero Working Capital.

    Benefits and Approach of Zero Working Capital

    Zero Working Capital is one of the latest techniques in working capital management. Let us now understand the benefits and approach of zero working capital in real-life scenario.

    1. Reduction in the level of investments in working capital

    Zero Working Capital is a strategy to reduce the level of investment in the working capital and thereby increase the investments in the long term assets. Following this strategy, companies avoid excess investments in current assets and prefer paying off their current liabilities using the existing current assets only.

    2. Savings in Opportunity Cost of Funds

    Working Capital earns a very low rate of return as compared to long term investments. Also, maintaining zero working capital will help save the opportunity cost of funds as the company can now use the excess funds to exploit various other opportunities.  So, owing to its benefits, the management would certainly prefer zero working capital.

    3. Just-in-Time Methodology

    Zero Working Capital approach will be possible only if the Just-in-Time methodology is adopted by the company. Following the demand-based production and distribution system is advised. Very low or zero inventory is emphasized. Everything should be produced and supplied as and when the demand for the same arises.

    To keep in pace with the Just-in-Time practice, the receivable and payable terms should also be modified. Payable time granted by the supplier should be extended and the credit terms granted to the debtors should be cutback. This will ensure that you have the cash required to fund the supplier’s payment.

    Conclusion

    Zero Working Capital eventually helps in better management of the current assets and current liabilities but still considered to be a difficult scenario to be implemented in practical business life.

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  1. This answer was edited.

    Working capital = Current Assets - Current Liabilities I believe if you want to understand how the above formula works you will need to understand each part of this formula i.e you will first need to have a clear understanding about the concept of current assets and current liabilities. Current asseRead more

    Working capital = Current Assets – Current Liabilities

    I believe if you want to understand how the above formula works you will need to understand each part of this formula i.e you will first need to have a clear understanding about the concept of current assets and current liabilities.

    Current assets

    It refers to all the assets including cash and cash equivalents which are expected to be converted within a year or within the operating cycle of an entity if such entity has an operating cycle longer than a year.

    Current liabilities

    It refers to all the payables or debts which an entity expects to discharge within a year or the operating cycle of such entity provided such an entity has an operating cycle longer than a year.

    I understand that even though you got a rough idea of this concept you may not be confident while applying this concept hence, to relate to this concept a numerical example would be of great help.

    So, I believe once you have a look at the below-mentioned example you will be in a better position to comfortably apply this formula:

    Working Capital Position in Balance sheet

    Here, Working Capital = Current Assets – Current Liabilities

    = Cash in Hand + Cash at Bank + Trade Receivables + Prepaid Rent –Trade Payables  –                  Outstanding Salaries

    = 5,000 + 56,000 + 64,000 + 3,000 – 20,000 – 20,000

    = 128,000 – 40,000

    = 88,000.

    It will add more value to your understanding if you also interpret the concept of Gross Working Capital and Net Working Capital.

    Gross Working Capital

    Gross working capital is a sum total of current assets of an entity. It includes

    • Cash and Cash Equivalents
    • Trade Receivables
    • Inventory
    • Short term Investments
    • Other Marketable Securities.

     

    Net Working Capital

    Now, the net working capital of an entity is nothing but the working capital of an entity. In simple terms, it is a difference between current assets and current liabilities of an entity.


    Aastha Mehta

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