01 901 2014

The Tree of Capital

A core concept in financial accounting is the accounting equation which states that

Assets = Capital + Liabilities

What is capital? Diligent students will have learnt that in the financial statements of a sole trader, capital is typically comprised of:

Opening Capital plus Capital Introduced during the Year, plus Net Profit for the Year (or less Net Loss for the Year) less drawings (cash or goods taken for personal use).

To go a step further students of advanced Financial Reporting courses will be aware that in company financial statements, the capital section of the Statement of Financial Position is likely to contain line items such as Share Capital, Share Premium, Revaluation Reserve and Retained Earnings. Non Controlling Interest is an additional line item included in the Capital section of a consolidated Statement of Financial Position.

Returning to basics, capital is something – it could be money, a property, shares or some other investment – that generates an income for whoever owns it.

Are capital and income the same thing? No. A good way to remember the difference is to think of an apple tree. The tree itself is the “capital”. The apples it produces are the “income”. Returning to the accounting equation, by manipulating the equation, we know that Assets less Liabilities (i.e. Net Assets) equals Capital. A sole trader will use the capital (i.e. Net Assets) at their disposal to generate income. The same logic applies to companies.

Let’s take the example of a company which issues additional ordinary shares at a premium. The money received from issuing the additional shares will be accounted for as follows:

Dr Bank X
Cr Ordinary Share Capital X
Cr Share Premium X

The capital base of the company has been expanded, and so the company can now use to cash received from the share issue, to grow the income generated – hence an expansion of the capital base should, if managed properly, will lead to an increase in income and profit and future growth for the business.
The discussion above if of relevance to ATI, CPA and ACCA financial reporting students

Colm Foley
StudyOnline.ie Lecturer in Accounting and Auditing