#4409 - Partnership - Accounting

Partnership: An Introduction

A partnership is an association of 2 or more persons who operate a business for profits. Every partnership should draw up a Partnership Agreement

However, if a partnership is formed without a Partnership Agreement, any dispute arose can be settled by referring to the Partnership Act

Main Differences between Partnership & Sole-Proprietorship

1. Partnerships are relatively easy to establish.

2. The ability to raise funds may be increased.

3. Prospective employees may be attracted to the business if given the incentive to become a partner.

4. There is a wider pool of knowledge, skills and contacts.

1. Partners are jointly and individually liable for the actions of the other partners.

2. Profits must be shared with others and decision also be shared.

3. The partnership may have a limited life; it may end upon the withdrawal or death of a partner.

4. A major disadvantage of a partnership is unlimited liability.

Contents of Partnership agreement

Following are normally included in Partnership (written) agreement:

• Capital invested by each partner

• Profit and loss sharing ratio

• Interest on capital (% per annum)

• Interest on drawings (% per annum)

• Partners’ salaries

• Conditions for admission of a new partner

• Procedures, when a partner dies or retire

If there is no Partnership agreement, Following rules should apply (given by Partnership act 1890)

1. Profit and loss are to be shared equally(50:50)

2. Interest on capital is not allowed

3. Interest on drawing is not allowed

4. Partner’s salaries are not allowed

5. If any partner provides a loan to partnership, he will get 5% per annum interest on loan.

Final Accounts of a Partnership:

1. Profit & Loss Account (including Profit & Loss Appropriation Account)

In Partnership up to Net Profit everything is same as sole trader.

Net Profit obtained from the Profit & Loss Account is then transferred to “Profit & Loss Appropriation Account”. The main purpose of Appropriation Account is to appropriate the net profit among all partners based on the Partnership Agreement.

Partnership (Name)

Profit and Loss Appropriation Account for the year ended ……………………….

$ $

Net profit xxx

Add: Interest on drawings

• Partner A xx

• Partner B xx xxx

xxx

Less: Interest on capital

• Partner A xx

• Partner B xx (xx)

Less: Partner’s salary

Partner A (xx)

Residual Profit xxx

Profit share

• Partner A xx

• Partner B xx xxx

**Residual profit is shared in the ratio stated in the partnership agreement

*Now we will look at the items of appropriation account in detail:

1. Interest on Drawings

Partners are entitled to drawings from time to time. To discourage drawings, an interest on drawings is levied. (Note: Interest on drawings will increase the net profit distributable to the partners)

2. Interest on Capital

Partners may not contribute equal amount of capital. Hence, it is reasonable to grant interest on capital contributed as Partner contributing more capital can place the extra amount in other investments.

3. Partners’ Salaries

In a partnership business, there are some partners who are active and others who are not (or “sleeping”). Hence, it is fair to pay salary to active partners. (Note: No salary should be paid to a Sole-Trader since he is entitled to the entire profits from his business)

(i) When Partner’s salary is paid by cash, the accounting entries are as follows:

(ii) When Partner’s salary has NOT been paid, the accounting entries are as follows:

(Note: When the partner’s salary is not paid, the Current Account of the partner concerned is credited, showing the amount due to him)

4. Distribution of Profits

Before distribution of profits,

• Interest on capital & Partners’ salaries should be deducted from the net trading profit

• Interest on Drawings should be added to the net trading profit

Then the remaining profit is shared according to the profit and loss sharing ratio.

5. Loans from Partners and Interest on loans

Loans from partners are treated in the same manner as loans from external source.

Occasionally, a partner may give a loan to the partnership during times of financial difficulty. This loan cannot be treated as capital contribution. Hence, an interest should be paid on the loans (Note: At year-end, the Interest on Loans Account is closed, and the total is transferred to Profit & Loss Account [TPL])

i) When interest on loan is paid by cash, the accounting entries are as follows:

(ii) When interest on loan has NOT been paid, the accounting entries are as follows:

Partners’ Current Account

Separate Current Accounts are opened for each partner with a view to record the day-to-day transactions affecting the partners.

• Credit entries in the Current Account include interest on capital, accrued partner’s salary & share of profit

• Debit entries in the Current Account include drawings & interest on drawings

2. Balance sheet

The first section of the balance sheet of a partnership is similar to a sole trader (assets and liabilities will be shown exactly same as in a simple balance sheet of sole trader). The second section shows the capital and current account of each partner.

Partnership (Name)

Balance Sheet as at ……………

$ $ $

Owners’ Equity

Capital

Partner A XX

Partner B XX

XXX

Current Account

Partner A:

Balance b/d XX

Interest on capital XXX

Partner’s Salary XX

Share of Profit XXX

XXX

Less: Drawings (XX)

Interest on drawings (XX)

XX

Partner B:

Balance b/d XX

Interest on capital XXX

Partner’s Salary XX

Share of Profit XXX

XXX

Less: Drawings (XX)

Interest on drawings (XX)

XX

XXX

XXX

Note: the figure in the box should be balance with the net assets (Total assets less Total liabilities)

** The above balance sheet will be prepared only if there is capital (fixed) and current accounts (both) are maintained. If partners only maintain a fluctuating capital account then only capital account will be shown in the balance sheet there will be no current account in the books.

Fixed and Fluctuating Capital accounts:

There are 2 choices open to partnership (i) fixed capital accounts + current accounts (ii) Fluctuating capital accounts.

Fixed Capital accounts: these are similar to the sole trader’s capital account, all other things like profit, interest on capital, interest on drawing, salaries etc. goes into current account

Fluctuating capital accounts: all adjustments like profit, interest on capital, salaries goes to the capital account, there is no current account exists.

***Exam focus: Examiner often asks to show capital and current accounts both that’s why fixed capital accounts are preferred.

Test your understanding 1:

Q: Afridi and Dhoni are partners of a firm known as AD Trading. Afridi contributes $300,000 as capital while Dhoni contributes $200,000 as capital. The Partnership Agreement provides that:

1. Profit and loss should be distribute equally

2. Interest on capital @ 4% per annum

3. Interest on Drawings is to be charged at the rate of 10% per annum.

4. Interest on Loan is to be at the rate of 10% per annum.

5. Only Dhoni is entitled for a $1000 salary per month

Additional information:

Net Profit before interest (PBIT) for the year is $ 689000

Afridi and Dhoni both withdraw $5000 on 1 Jan 20XX and $5500 on 1 July 20XX.

Afridi gives a loan of $5,000 to the partnership business on Jan 01. The Partnership Agreement provides that On Dec 31, a partial payment of $200 for interest on loan was paid to Afridi.

Required:

(a) Partner Current Accounts,

(b) The Profit & Loss appropriation account) for the year ended 31 Dec 20XX.

(c) Balance Sheet extract...