Capital Comparison Method Step By Step
Peter Marshall Bsc (Econ) BA MBIM is a Fellow of the Society of Business Teachers, and an experienced educator in business subjects. He is also a prolific author and his books have been translated and sold worldwide. He lives in London, UK.
What you need
- Records of assets and liabilities at the start of the accounting period.
- Records of assets and liabilities at the end of the period.
- As many other records as possible for the period in question.
Step by step
To draw up the statement of affairs at the start of the accounting period:
- 1.List the fixed assets in order of permanence, and total.
- 2.List and total up the current assets (in order of permanence).
- 3.List and total up the current liabilities.
- 4.Deduct from last total.
- 5.Add to the total fixed assets.
- 6.List any long-term liabilities (other than proprietor’s capital) e.g. bank loans, mortgages and leases of more than a year.
- 7.Enter as capital whatever figure you need to make this column exactly equal the total net assets figure.
Construct, in exactly the same way, a statement of affairs as at the end of the accounting period. Deduct the opening capital from the closing capital. Add any drawings, and deduct any capital injections by the proprietor throughout the year to arrive at the net profit for the year.
The last two steps are usually built into the format of the closing statement of affairs. In the capital section you deduct the opening capital from the closing capital, and record drawings and capital injections when arriving at and displaying the net profit. You construct the statement as far as possible in standard balance sheet format, and then fill in the missing figures by simple arithmetic.
Suppose Armstrong has failed to keep proper accounts during the last year. Faced with a tax demand, he asks us to calculate his profit for the year to 30 June 200X but he can only provide us with the following information: his leasehold premises were worth £40,000 at the start of the year, but have gone down in value by £2,000 since then. He had plant and machinery worth £5,000 which he has not added to; depreciation of £250 is assumed since then. A motor vehicle valued at £3,000 at the start of the year is now worth only £2,000. The stock level has risen from £2,500 to a present level of £3,600, the debtors figure has gone from
£1,900 to £2,900. The bank overdraft has gone down from £1,200 to £100 and creditors have gone down from £2,200 to £1,800. Furthermore, we know he has taken drawings of £8,200 to live on during the year. Page 162 shows how we would calculate his profit using the capital comparison method.
Additional proof for the taxman
While the calculation of profit based on this method alone may satisfy the proprietor of a small business, the staff at HM Inspector of Taxes are, understandably, likely to require additional proof that the profit figure claimed is accurate. After all, it is asking them to rely 100% on the honesty of the proprietor, not to mention the quality of his memory, in respect of the drawings he has taken.
If we have details of cash and banking transactions, plus accrued debtors and creditors for trading transactions and expenses, we can put together a trading, profit and loss account for the period, and we can use it to prove the figures in the closing statement of affairs. In fact, we could even compile the closing statement of affairs directly from those same sources, with the addition of information from the opening statement of affairs and details of any capital changes and changes in longterm liabilities.
This is how to compile final accounts where many—but not all—the records are available. It involves drawing up:
- opening and closing statements of affairs
- cash and bank account analyses, which itself requires opening and closing bank reconciliations
- total debtors account
- total creditors account
- trial balance
- revenue accounts.