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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/cDebit1,00,000Debit what comes into the business
    To Capital a/cCredit1,00,000Credit 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 accountDebitCredit
    CapitalDecreaseIncrease

    Example

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

    Cash a/cDebit5,00,000Debit the increase in asset
    To Capital a/cCredit5,00,000Credit 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.

    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

    LiabilitiesAmount AssetsAmount
    Capital2,40,000Cash in hand70,000
    (+) Net Profit70,000Accounts receivables50,000
    (-) Drawings(30,000)Patents10,000
    (-)Interest on capital(20,000)Equipment45,000
    Retained Earnings10,000Building90,000
    Sundry Creditors40,000Prepaid Expense35,000
    Outstanding Rent/Salary5,000Goodwill20,000
    General Reserve10,000Investments60,000
    Loan taken from Bank55,000Accrued Income10,000
    3,80,0003,80,000

    Hope this helps.

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