Partnership Accounts II: Partnership Capital Accounts & How to Calculate It – SS2 Financial Accounting Lesson Note (Second Term)

A partnership capital account is an account in which all the transactions between the partners and the firm are recorded. It shows each partner’s contributions, share of profits and losses, and the amounts to be paid to the partner. The closing balance is transferred to the balance sheet as the partner’s capital.

Behavioural objectives

By the end of the lesson, students should be able to:

• state what a partnership capital account is and what it records;
• distinguish between fixed and current capital accounts;
• calculate each partner’s capital contribution from the profit-sharing ratio;
• list the steps for calculating a partnership capital account;
• state the advantages and disadvantages of the partnership capital account.

What does a partnership capital account record?

A partnership capital account maintains records of different types of transactions between the partners and the firm, which include:

1. The contributions by partners to the firm. Every transaction detail is recorded, from the initial contribution to the subsequent ones. Partners can make contributions in cash or in the market value of assets.
2. The profits made and losses incurred by the business. The account allocates them in the proportions set out in the partnership agreement.
3. The distributions to be made to the partners based on their shares.

With the partnership capital account prepared, it is easy to distribute the assets and liabilities to the partners. It is also easy to settle the account when a partner is admitted or retires.

However, in a partnership other than a limited liability partnership, the capital account becomes useless. The partners have to pay from their personal estate if assets are less than liabilities, and the capital account cannot be enforced for limitation of liability.

The basis of the partnership can also be changed by transactions such as salary and interest to partners, which can sometimes create conflicts between the partners.

What is a partnership firm?

A partnership firm is a business entity in which two or more persons doing business together agree to share the profits from the business in a pre-defined profit ratio, as partners.

The partnership agreement can be oral or written. Profit-sharing can be based on capital contribution or mutually decided.

The accounts of a partnership firm differ from those of a proprietorship. They include the partners’ capital accounts, in which the capital contributed by partners and all the transactions between the firm and the partners are recorded.

What are the types of partner’s capital account?

A partner’s capital account can be of two types: fixed capital and current capital. In a fixed capital account, only the capital contribution is credited. All other transactions are recorded in the current account.

What is the format of a partnership capital account?

The standard partnership capital account format below shows how the details of transactions and contributions are recorded.

How do you calculate partnership capital?

Capital contribution from the profit-sharing ratio

The capital contribution usually depends on the share of profits. Suppose the firm needs an investment of $1,000,000 and there are four partners.

• If the profit-sharing ratio is equal, each partner contributes $250,000 ($1,000,000 / 4).
• If the profit-sharing ratio is 2:5:1:2, partner A contributes $200,000 ($1,000,000 × 2/10), partner B $500,000 ($1,000,000 × 5/10), partner C $100,000 ($1,000,000 × 1/10) and partner D $200,000 ($1,000,000 × 2/10).

By mutual decision, partners can contribute more or less than the profit-sharing ratio requires. Sometimes only one partner contributes the capital, while the others invest their time and talent.

Steps for calculating the partnership capital account

1. Credit the capital account with the capital contributed by partners, the share of profit, remuneration of partners, interest on capital, and any receipt or asset directly associated with the partner.
2. Debit the capital account with drawings, any liability directly related to the partner, and similar items.
3. Distribute the share of profit in the profit-sharing ratio before calculating the closing capital.
4. Calculate the closing capital by deducting the debits from the credits. This gives the effective capital contribution.
5. Transfer the closing capital to the balance sheet as the partner’s capital account.

What are the advantages of the partnership capital account?

1. The capital accounts of partners keep the records transparent.
2. If the business closes, the amount to be received or distributed to each partner can be easily determined.
3. The liabilities of each partner can be easily fixed.
4. Transparent records make it easier to take decisions that maximise the benefit to the firm.
5. A partnership capital account can be presented and accepted as a legal document.
6. Clear accounts make it easy to admit a new partner and to settle the account when a partner retires.

What are the disadvantages of the partnership capital account?

1. In a partnership other than a limited liability partnership, the partners are jointly and severally responsible for outside liabilities. If liabilities are more than assets, the risk of one partner is passed to the others in their profit-sharing ratio and paid from personal estate. The partners’ capital account is of no value in this case because it cannot be enforced for limited liability.
2. In most organisations, no separate current account is prepared, so the basis of capital contribution changes with transactions.
3. A change in the basis of the capital can lead to conflict.

Evaluation

1. What is a partnership capital account?
2. State three types of transaction recorded in a partnership capital account.
3. What is the difference between a fixed capital account and a current capital account?
4. A firm needs an investment of $1,000,000 and has four partners with an equal profit-sharing ratio. How much does each partner contribute?
5. Give two disadvantages of the partnership capital account.

Assignment

1. Write out the five steps for calculating a partnership capital account.
2. State four advantages of the partnership capital account.