Learning Accounting through an example

During Day Three

Oberoi, went to the wholesale market, bought vegetables with Rs. 260 and then set out on his trip around the locality selling vegetables.

End of day Three

Oberoi, counted the cash with him at the end of the day. It was Rs. 300. The extra Rs. 40 (300 − 260) is on account of the profit he made on day three.

He then recollected that he used Rs. 40 from the sale proceeds for buying provisions for his household. Had he not used that Rs. 40 for his own use, he would have had Rs. 340 with him, whereby his profit would have been Rs. 80 (340 − 260).

• Drawings

The amount used by the owners of business for personal purposes is termed drawings.

Influence of drawings on capital

Had Oberoi not used up the Rs. 40 as drawings he would have been left with a capital of Rs. 340 for starting his business affairs on day four. Since he used up Rs. 40 as drawings his capital is now less by Rs. 40 i.e. Rs. 300 on day four.

From this we learn one another fundamental understanding in accounting/business.

• Drawings decrease Capital

As we withdraw amounts from business for personal purposes, the amount of capital available for business would get reduced.

Profit and Loss. Drawings and ?

As profits increase capital and losses decrease capital, what is the term that implies an increase in capital that is opposite in nature to drawings??

Putting in additional funds as capital is the act that is opposite in nature to drawings. There is no specific term that is used to identify this. We just call it capital or to be more specific "Additional Capital".

Recollect

Profits increase capital
Losses decrease capital
Drawings decrease capital
Additional Capital increases capital

During Day Four

Oberoi, had a capital of Rs. 300 with him. He went to the wholesale market, bought vegetables for Rs. 350 taking a credit of Rs. 50 from the wholesale vendor. He then set out on his trip around the locality selling vegetables.

End of day Four

Oberoi, counted the cash with him at the end of the day. It was Rs. 400. What would be his profit now, is it Rs. 100 (400 − 300) since his capital is Rs. 300 only or Rs. 50 (400 − 350) since the cost of the vegetables he sold is Rs. 350.

It would be appropriate to think that the profit is Rs. 50 and not Rs. 100. The capital that Oberoi invested from his own sources is Rs. 300. He also invested Rs. 50 additionally by taking credit from the wholesaler. Both Rs. 300 from his own sources and Rs. 50 from loaned sources are capital for the business.

• Owned Capital

Amounts and other resources invested in the business by the owners of the business as their contribution towards Capital.

• Loaned Capital

Amounts and other resources borrowed by/for the business from outsiders also forms capital for the business which we call loaned capital. The owner/owners of the business are collectively responsible for the loan.

These are also called debts or debts owed by the business.

• Total Capital = Owned Capital + Loaned Capital

The capital employed in the business is a sum total of the capital from own sources and capital from loaned sources. That is the reason the profit should be calculated by comparing the amount Oberoi has with Rs. 350 and not with Rs. 300.

Own Loaned Capital is Owned Capital

The owners of the business may invest in the business by taking loans personally and investing that in their name as capital contribution. The responsibility for this amount lies with the person who is borrowing the amount and not the business. This should not be misunderstood as loaned capital for the business.

• Creditors

The person to whom we (i.e. the business organisation here) owe money are called creditors.

Eg:	In the illustration above, the wholesale vendor who gave vegetables on credit to Mr. Oberoi, is a creditor to Mr. Oberoi.

End of day Four

Oberoi, repaid the amount due (cleared the debt) to the wholesale vendor i.e. Rs. 50 and used Rs. 20 towards drawings. He is left with Rs. 330 (400 − 50 − 20) as capital for the fifth day.

During Day Five

Oberoi, went to the wholesale market, bought vegetables with Rs. 330 and then set out on his trip around the locality selling vegetables.

End of Day Five

Oberoi, counted the cash with him at the end of the day. It was Rs. 330. There is no surplus or shortage, which implies he has made neither profit nor loss.

He then recollected that one of the customers, Mrs. Vimla, did not give him the amount she had to (Rs. 10) since she was not having change. Since she was a regular customer, he offered to take the amount the next day. Had she given that amount also he would have been left with Rs. 340 which would have resulted in a profit of Rs. 10 (340 − 330).

• Debtors

The persons who owe money to us (i.e. the business here) are called debtors.

Eg:	In the illustration above, Mrs. Vimla who owes an amount to Mr. Oberoi is a debtor to Mr. Oberoi or his business.

Do Debtors/Creditors Increase/Decrease Capital ?

By increase or decrease in capital that we have learned earlier, we mean increase or decrease in owned capital. When we just say capital we always mean owned capital. Creditors no doubt would increase loaned capital and that should be seen as a different entity.

Please do not consider the idea of increase/decrease in capital in relation to Debtors/Creditors.

Author Credit : The Edifier

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