Introduction
This chapter dives into the fundamentals of accounting for businesses run as partnerships. By the end of the chapter, you'll be able to:
- Grasp the concept of a partnership and its key characteristics.
- Understand the relevant accounting provisions from the Indian Partnership Act 1932.
- Maintain partners' capital accounts using both fixed and fluctuating capital methods.
- Distribute profits or losses among partners and prepare the Profit and Loss Appropriation Account.
- Calculate interest on capital contributions and partner withdrawals in various scenarios.
- Explain how guaranteed profits for a partner impact profit distribution.
- Make corrections to rectify past errors in partners' capital accounts.
- Prepare the final accounts of a partnership firm.
In essence, this chapter equips you with the accounting tools needed to manage and understand the financial health of a partnership.
Accounting for Partnership: Basic Concepts - Class Notes
What is a Partnership?
Sometimes, one person running a business (sole proprietorship) has problems like not enough money or not enough management skills. To solve this, two or more people can join together to run a business. This is called a Partnership. They agree to share the money, management, risks, and profits of the business.
Definition of Partnership:
The Indian Partnership Act 1932 says that Partnership is "the relation between persons who have agreed to share the profits of a business carried on by all or any of them acting for all".
Nature or Features of Partnership:
Two or More Persons: A partnership needs at least 2 people. The maximum number of partners can be 50 (as per Government of India rules), 100 members based on the Companies Act 2013.
Agreement: Partners must have an agreement, either written or spoken, about things like how they will share profits and how much money each will invest.
Business: The agreement must be for carrying on a business. Just owning some property together does not make it a partnership.
Sharing of Profits (and Losses): Partners must agree to share profits. If there's a loss, it's also shared in the same way.
Business Carried on by All or Any of Them Acting for All: The business can be run by all partners, or some partners can act on behalf of all the others. This means each partner is both an owner (principal) and someone who acts for others (agent).
Unlimited Liability: Each partner is personally responsible for all the firm's debts, even using their personal belongings if the business cannot pay.
No Separate Legal Existence: The partnership business does not have a separate legal identity from its partners. It cannot own property or make contracts in its own name. If a partner leaves or a new one joins, the partnership's structure changes.
Utmost Good Faith: All partners must be honest with each other, share all important information, and keep true accounts. No partner should secretly make a profit from the business.
Restriction on Transfer of Interest: A partner cannot sell their share in the partnership to an outsider without getting permission from the other partners.
Partnership Deed / Articles of Partnership
This is a document that contains all the agreed terms of the partnership. It can be spoken or written, but it's much better to have it in writing to avoid future misunderstandings.
Contents of the Partnership Deed:
The partnership deed usually includes:
Name of the firm
Names and addresses of all partners
Type and location of the business
Date when the partnership started
How long the partnership will last, if decided
How much money (capital) each partner puts into the business
How much money each partner can take out (drawings)
Rules for bank accounts
How profits or losses will be shared
If there's interest on capital or drawings
Interest on any loan a partner gives to the firm
If any partner gets a salary or commission
How work is divided among partners
How goodwill (the firm's reputation value) is calculated when a partner joins, leaves, or dies
How accounts are settled if a partner leaves or dies
How accounts are settled if the firm closes down
Rules for keeping and checking accounts (audit)
Rules for solving disagreements (arbitration)
Rules for the firm borrowing money
Rights, duties, and responsibilities of partners
Rules if there is No Partnership Deed or it's Silent:
If there is no partnership deed, or if the deed doesn't mention certain things, the Indian Partnership Act 1932 applies the following rules:
Profit Sharing: Profits and losses must be shared equally among partners, no matter how much capital they contributed.
Interest on Capital: No interest is paid to partners on their capital. If the deed does say to pay interest on capital, it should only be paid if there's a profit; no interest if there's a loss.
Interest on Loan to the Firm: If a partner gives a loan to the firm, they are entitled to get 6% interest per year on that loan. This interest must be paid even if the firm makes a loss.
Interest on Drawings: No interest will be charged on money or goods taken out by partners for personal use (drawings).
Remuneration to Partners: No partner is allowed to receive a salary or commission.
Partners' Capital Accounts
All transactions related to partners are recorded in their capital accounts.
Items that increase a partner's capital (like interest on capital, salary, share of profit) are recorded on the credit side.
Items that decrease a partner's capital (like drawings, interest on drawings, share of loss) are recorded on the debit side.
There are two ways to maintain partners' capital accounts:
Fluctuating Capital Method:
Only one account is kept for each partner: the Capital Account.
All items affecting a partner's capital (like interest on capital, drawings, salary, share of profit/loss) are recorded in this single account.
Because of this, the balance in the capital account keeps changing (fluctuating) every year.
Fixed Capital Method:
Two accounts are kept for each partner:
Capital Account: The balance in this account usually stays the same, unless a partner brings in more capital or permanently withdraws some capital with agreement.
Current Account: All other items like interest on capital, drawings, interest on drawings, salary, commission, and share of profit/loss are recorded here. So, the balance of the current account keeps changing.
Differences between Fixed Capital and Fluctuating Capital Methods:
Fixed Capital Method | Fluctuating Capital Method |
1. Two accounts are maintained (Capital A/c and Current A/c). | 1. Only one account (Capital A/c) is prepared. |
2. Capital amount usually stays the same. | 2. Capital amount keeps fluctuating. |
3. Adjustments (like interest on capital, drawings) are made in the Current A/c. | 3. Adjustments are made in the Capital A/c itself. |
4. Both Current A/c and Capital A/c appear in the Balance Sheet. | 4. Only the Capital A/c appears in the Balance Sheet. |
5. Must be specifically mentioned in the partnership deed. | 6. Not necessary to mention in the deed. |
Drawings Account
Drawings are when a partner takes money or goods from the business for their personal use. The Drawings Account is a personal account.
When a partner takes cash or goods, the Drawings Account is debited, and the Cash or Purchase Account is credited.
At the end of the period, the Drawings Account is closed by moving its balance to the partner's Capital Account or Current Account.
If a partner takes money specifically out of their capital, it's recorded directly in the Capital Account, not the Drawings Account.
Distribution of Profit / Loss among Partners
Profit and Loss Appropriation Account:
This account is an extension of the Profit and Loss Account. It is prepared to show how the net profit (or net loss) of the partnership firm is distributed among the partners.
It starts with the net profit (on the credit side) or net loss (on the debit side) brought from the Profit and Loss Account.
Items like interest on capital, partner's salary, and commission (which are expenses for the firm but income for the partners) are debited to this account.
Items like interest on drawings (which is income for the firm but an expense for the partners) are credited to this account.
The final profit or loss after these adjustments is divided among the partners based on their agreed profit-sharing ratio and transferred to their Capital or Current Accounts.
Important Note: Interest payable on a partner's loan is debited to the Profit and Loss Account, not the Profit and Loss Appropriation Account.
Interest on Capital:
If the partnership deed allows it, interest on capital is calculated on the opening balance of the capital account.
If a partner brings in additional capital during the year, interest is also calculated on this additional amount for the period it remained in the business.
No interest is calculated on Current Account balances.
If the opening capital balance isn't known, you can find it by:
Starting with the Capital at the end of the year.
Adding Drawings, Interest on Drawings, and Share of Loss (if any).
Subtracting Partner's Salary, Partner's Commission, Share of Profit (if any), and Additional Capital (if any).
Interest on Drawings:
Interest on drawings is charged from partners if the partnership deed states so. The calculation depends on when the drawings were made.
If date of withdrawal is not given: Assume drawings were made evenly throughout the year, and charge interest for 6 months on the total amount.
Different amounts withdrawn at different intervals (Product Method):
Calculate the time from the date of withdrawal to the closing date of accounts.
Multiply each drawing amount by its respective time period (this is called the "Product").
Add up all the "Products".
Calculate interest for one month on the sum of products at the given interest rate.
Fixed amount withdrawn every month (Average Period Method):
First day of every month: Average Period = (Total period in months + 1) / 2 = (12 + 1) / 2 = 6.5 months.
Last day of every month: Average Period = (Total period in months - 1) / 2 = (12 - 1) / 2 = 5.5 months.
Middle of every month: Average Period = Total period in months / 2 = 12 / 2 = 6 months.
Guarantee of Profit to a Partner:
Sometimes, a partner is promised a minimum amount of profit as their share, even if their actual share based on the ratio is less.
If a partner's share of profit is less than the guaranteed amount, the difference (deficiency) is usually covered by the other partners in their profit-sharing ratio.
Sometimes, only one of the old partners might give the guarantee, in which case they cover the entire deficiency.
Past Adjustments:
Sometimes, after accounts are closed, it's found that some items were missed or recorded incorrectly. In such cases, necessary corrections are made either in the partners' capital accounts or through a "Profit and Loss Adjustments Account".
Final Accounts:
The Trading and Profit and Loss Accounts and Balance Sheet are prepared in the same way as for a sole proprietorship. The main difference is how the profit is divided among partners. The net profit/loss is transferred to the Profit and Loss Appropriation Account, where all adjustments related to partners (like interest on capital/drawings, salary, etc.) are made before distributing the final profit/loss.
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