Practice Activity 11.3 Fairness of capital contribution versus profit or loss sharing ratio

Ebubechukwu and Febechukwu contribute ₦500,000 and ₦300,000 respectively to commence a partnership business in April 2018. The profit sharing ratio is 5:3. The work done by both partners is of equal nature. Both partners are actively involved in the partnership business.

The profit for the year ended 31 March 2019 is ₦1,500,000.

Required:

Calculate the amount of profit attributable to each partner for the year ended 31 March 2019. How fair is the profit attributable to each partner compared to the capital contributed? Make recommendations on the step that should be taken to ensure that the profit attributable to each partner compared to the capital contributed is fair.

A suggested solution to practice activity 11.3

Since there are two partners in the partnership firm, the profit shall be shared as follows:

The profit for the year ended 31 March 2019 is: ₦1,500,000

The profit or loss sharing ratio is 5:3.

This implies that 5 + 3 = 8

Calculation of profit attributable to each partner

Thus, the profit of ₦1,500,000 for the year ended 31 March 2019 is allocated to each partner as follows:

Ebubechukwu: 5/8 * ₦1,500,000 = ₦937,500

Febechukwu: 3/8 * ₦1,500,000 = ₦562,500

Fairness of the profit attributable to each partner compared to the capital contributed by the partner

Ebubechukwu will receive ₦937,500, that is, ₦375,000 more than the profit allocated to Febechukwu. The difference between the two shares of profit should be adequate to compensate Ebubechukwu for contributing extra capital into the partnership business.

The difference between the two shares of profit should not be excessive.

Ebubechukwu has ₦375,000 more than the profit allocated to Febechukwu.

Ebubechukwu contributed ₦500,000 into the partnership business. This is ₦200,000 more than the capital contributed by Febechukwu.

₦375,000 extra profits is excessive because Ebubechukwu contributed extra ₦200,000 as capital into the partnership business.

The calculation of adequate compensation received by a partner for investment of extra capital in a partnership business is a daunting task.

Recommendation

Thus, it is recommended that the interest on capital is devised as a means to adequately compensate a partner for investing extra capital relative to the amount of capital contributed by other partner(s) in a partnership business. The interest on capital should be paid before the determination of the partnership’s profit for the year and the allocation of profits based on the profit sharing ratio.