What is Partnership Capital Account?

Explanation

A business entityBusiness EntityA business entity is one that conducts business in accordance with the laws of the country. It can be a private company, a public company, a limited or unlimited partnership, a statutory corporation, a holding company, a subsidiary company, and so on.read more in which two or more persons doing business together agree to share the profits arising from business in the pre-defined profit ratio as partners is called the partnership firm. The partnership agreement can be oral as well as written. The profit-sharing can also be based on capital contribution or mutually decided.

The accounts of the partnership firm differ from that of the proprietorship. It also contains the partners’ capital account in which the capital contributed by partners and all the transactions between the firm and partners are to be recorded. The partner’s capital account can be of two types, i.e., current and fixed capitalFixed CapitalFixed capital refers to the investment made by the business for acquiring long term assets. These long term assets don’t directly produce anything but help the company with long-term benefits.read more. If the account is a fixed capital account, then the only capital contribution is to be credited, and all other transactions are to be recorded in the current account.

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How to Calculate?

Usually the capital contributionCapital ContributionContributed capital is the amount that shareholders have given to the company for buying their stake and is recorded in the books of accounts as the common stock and additional paid-in capital under the equity section of the company’s balance sheet.read more depends upon the share of profits like if business of partnership firm requires the investment of $ 1,000,000 and there are four partners in the partnership firm and profit sharing ratio is equal then each partner’s contribution will be $ 250,000 ($ 1,000,000 /4) whereas if the profit sharing ratio is 2:5:1:2 then the capital contribution of partner A will be $ 200,000 ($ 1,000,000 * 2/10), partner B will be $ 500,000 ($ 1,000,000 * 5/10), partner C will be $ 100,000 ($ 1,000,000 * 1/10) and partner D will be $ 200,000 ($ 1,000,000 * 2/10).

The steps for calculating the partnership capital account are as under:

  • Step #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.Step #2 – Debit the capital accountCapital AccountThe capital account refers to the general ledger that records the transactions related to owners funds, i.e. their contributions earnings earned by the business till date after reduction of any distributions such as dividends. It is reported in the balance sheet under the equity side as “shareholders’ equity.”read more by drawings, any liability directly related to the partner, etc.Step #3 – Share of profit is distributed in the profit-sharing ratio before calculating closing capital.Step #4 – Closing capital is calculated by reducing the debits from the credits to calculate the effective capital contribution.Step #5 – The closing capital is transferred to the balance sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders’ equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner’s capital equals the total assets of the company.read more as a partner capital account.

Example

ABC and Co are a partnership firm with the three partners, A, B, and C. Profit sharing ratio of each partner is equal, and the capital contribution of each partner is also equal. The total requirement of investment in the business is $ 300,000. The firm does not maintain a separate current account and all the transactions are to be recorded in the capital account itself. Other details are as under:

Draw the Partners Capital account and record the above transactions.

Solution:

  • Capital Contribution = $ 300,000 / 3 = $ 100,000Interest on Capital = $ 100,000 * 12% = $ 12,000 per partner.Profit Share =$75,000/3 =$25,000 per partner

Advantages

  • Transparency in the records is maintained through the capital account of partners.In the event of the closure of a business, the amount to be received or distributed to each partner can be easily determined.The liabilities of each partner can be easily fixed.Decisions can be easily taken to maximize the benefit to the firm because of transparent records.A partnership capital account can be presented and accepted as a legal document.With the transparency and clarity of accounts, it is easy to admit the new partner, or it gets easy to settle the account at the time of retirement of a partner.

Disadvantages

  • In the case of a partnership other than a limited liability partnership, the partners are jointly and severally responsible for the outside liabilities; hence the risk of one partner is transferred to other ones in their profit-sharing ratio and from the personal estate if liabilities are more than assets and the partners capital account becomes of no value in this case as the capital account cannot be enforced for limited liability.As in most organizations, no separate current account is prepared; hence the basis of capital contribution gets changed with transactions.There are chances of conflict in case of a change in the basis of the capital.

Conclusion

A partnership capital account is an account in which all the transactions between the partners and the firm are to be recorded. With the preparation of the partnership capital account, it becomes easy to distribute the assets and liabilities to the partners and becomes easy to settle the account at the time of admission or retirement of partners.

But in the case of a partnership other than a limited liability partnership, the capital account becomes useless as the partners have to pay from the personal estate in case assets are less than liabilities, and the capital account cannot be enforced for limitation of liability. Moreover, the basis of the partnership can be changed with the transactions like salary and interest to partners, which can sometimes create conflicts between the partners.

This has been a guide to What is a Partnership Capital Account & its Definition. Here we discuss the example of a partnership capital account and how to calculate it, and its advantages and disadvantages. You can learn more about it from the following articles –

  • Limited Partnership (LP)Investment PartnershipSole Proprietorship vs PartnershipDifference Between Joint Venture and Partnership