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Fundamentals of accounting
Fundamentals of accounting

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1.4 Capital in accounting

Every enterprise starts with no money. It needs the owner to put in money to get the business going. Other assets, such as inventory (goods) to be sold to customers, are then bought for future financial benefit.

Businesses need to separate out the money put into the business by the owner from the liabilities it incurs, which need to be repaid. The money ‘owing’ to the owners is known as capital.

Box 3 Accounting records and the business entity concept

Some businesses, such as sole traders, have no separate legal existence from the owner or owners. All the debts of the business are their personal debts and, unlike a limited company, they have unlimited liability for honouring these debts. In spite of this they must always keep the accounting records of the business separate from their own personal affairs. This is known as the business entity concept and is as relevant to a small sole trader as it is to a multinational company.

Activity 3 Understanding the effect of profit or loss on capital in a business

Two years ago Julia started a business at home. She put £500 into the business with her own money to get it going. The income statement at the end of Julia’s first accounting period – a year – showed a loss of £300. Julia’s business performed better in the second year and earned a profit of £700.

  1. What is the capital of Julia’s business at the end of its first accounting period?
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Answer

£200 (Opening capital of £500 for the first accounting period less a loss of £300.)

  1. What is the capital of Julia’s business at the end of its second accounting period?
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Answer

£900 (Opening capital of £200 for the second accounting period plus a profit of £700.)

Later on in this course you will learn about the double-entry accounting system that allows all the information contained about an enterprise’s capital, assets (including cash), liabilities and profit or loss to be traced back, quickly and accurately, to original transactions and financial events.

A principal purpose of double-entry accounting is to prepare reports that contain useful information for a range of decision makers and stakeholders inside and outside the business. In the next section you will learn about the difference between financial accounting, which is for external users of accounting information, and management accounting, which is for internal users of accounting information.