Accounting for Partnership: Basic Concepts

Accounting for Partnership: Basic Concepts

• As a business expands, more capital and people are needed to manage and share risks, leading to the adoption of a partnership.
• Partnership firm accounting has its own peculiarities.
• The chapter discusses basic aspects of partnership, including profit distribution, and capital account maintenance.
• Situations like partner admission, retirement, death, and dissolution are addressed in subsequent chapters.

Nature of Partnership

• Partnership happens when two or more individuals collaborate to establish a business and share its profits and losses.
• Section 4 of the Indian Partnership Act 1932 defines partnership as the relationship between individuals agreeing to share a business's profits, carried on by all or any of them acting for all.
• Partners are individually called 'partners' and collectively, 'firm,' with the business name referred to as the 'firm's name.'
• A partnership firm lacks a separate legal identity from its partners.

Essential Features of Partnership

• Requires at least two individuals (partners) with a possible maximum of 50.
• Formed through an agreement for business and profit/loss sharing, which can be oral or written, though written is preferred to avoid disputes.
• The agreement is to carry out some form of business activity.
• Mutual agency means the business may be carried on by all or any of the partners acting for all, implying every partner can participate in business affairs and there is a mutual agency relationship.
• Vital element is the sharing of profits and implied sharing of losses.
• Each partner bears joint liability with all others, and several liability to third parties for firm actions while a partner has unlimited liability.

Partnership Deed

• It comes into existence through an agreement that can be oral or written.
• Contained within the document, and includes the business objective, each partner's capital contributions, profit/loss sharing ratio, and partners' interest entitlements.
• Clauses can be altered with all partners agreeing, and the deed preferably registered with the Registrar of Firms, and properly drafted per the 'Stamp Act.'

Contents of the Partnership Deed

• Details include firm name, business address, partners' names/addresses, capital contributions, partnership start date, bank account rules, profit/loss sharing, and interest rates (capital, loan, drawings).
• Also covers auditor appointment, partner salaries/commissions, individual partner rights/duties, loss treatment from partner insolvency, firm dissolution account settlement, dispute resolution, and rules for partner changes.
• Normally covers all relationship matters; if it's absent, the Indian Partnership Act of 1932 governs.

Provisions of Partnership Act Relevant for Accounting

• Profit Sharing Ratio: If the deed is silent, profits/losses are shared equally.
• Interest on Capital: No partner can claim interest on capital as a right unless expressly agreed upon in the deed.
• Interest on Drawings: No interest is charged on drawings unless it is mentioned in the deed.
• Interest on Loan: A partner gets 6% p.a. interest on a business loan.
• Remuneration for Firm’s Work: Partners are not entitled to a salary or other remuneration for firm work without the provision in the deed.
• Indian Partnership Act specifies that a partner deriving profit from any transaction, property usage, firm connections, or firm name must account for it and pay it to the firm.
• A partner running a similar and competing business must account for and pay the firm all profits made.

Special Aspects of Partnership Accounts

• Differs from sole proprietorship regarding capital account maintenance, profit/loss distribution, past profit appropriation adjustments, reconstitution, and dissolution.
• The first three aspects mentioned above are taken up in the following sections of the chapter
• The remaining aspects have been covered in the subsequent chapters.

Maintenance of Capital Accounts of Partners

• All transactions relating to partners are recorded in the books of the firm through their capital accounts.
• Two available methods: fixed capital and fluctuating capital, differing on whether non-capital transactions are recorded in the capital accounts or not.
• In Fixed Capital Method, capital remains fixed unless more capital is introduced or withdrawn.
• Profit/loss shares, capital interest, drawings, and drawings interest are recorded separately in a Partner's Current Account.
• Partners' capital accounts always show a credit balance that remains (fixed) year-after-year unless capital is added or withdrawn.
• Current accounts may show a debit or credit balance; two accounts are kept for each partner, viz. capital and current accounts.
• The partners' capital accounts always appear on the liabilities side in the balance sheet.
• While the partners' current account’s balance is shown on the liabilities side if a credit balance exists or on the side of assets in the case of a debit balance.
• In the Fluctuating Capital Method one account is maintained for each partner, i.e., the capital account.
• All adjustments, like profit/loss shares, capital interest, drawings, or salary/commission, are recorded directly in the capital accounts.
• Fluctuating Capital Method makes the balance in the account fluctuate over time, which is why it is named as such.
• If there are no specific instructions the capital account should be prepared using Fluctuating Capital Method.

Distinction between Fixed and Fluctuating Capital Accounts

• Fixed Capital uses a 'capital account' and 'current account,' while Fluctuating Capital uses only a capital account.
• Fixed Capital posts drawings, salary, interest on capital, etc., to current accounts; Fluctuating Capital posts all adjustments to capital accounts.
• Fixed Capital balances remain unchanged unless capital is added to/withdrawn, while Fluctuating Capital balances vary yearly.
• Fixed Capital accounts always show a credit balance where sometimes Fluctuating Capital may show a debit balance.

Distribution of Profit among Partners

• Profits/losses are shared among partners in an agreed-upon ratio; otherwise, they do so equally.
• Adjustments like interest on drawings, interest on capital, salary, and commissions are necessary; a Profit and Loss Appropriation Account is prepared to ascertain the final distributable profit/loss.

Profit and Loss Appropriation Account

• It's an extension of the firm's Profit and Loss Account that shows how profits are allocated among partners.
• It starts with the net profit/net loss and makes adjustments related to partner's salary, partner's commission, interest on capital, interest on drawings, etc.
• The balance of the Profit and Loss Account is transferred into the Profit and Loss Appropriation Account.

Journal Entries

• If Profit and Loss Account shows a credit balance for the interest of capital; Interest on Capital A/c Dr. and To Partner's Capital/Current A/cs (individually).
• For transferring interest on capital to Profit and Loss Appropriation Account: Profit and Loss Appropriation A/c Dr. and To Interest on Capital A/c.
• Partners Capital/Current A/c's (individually) Dr. to Interest on Drawings A/c, for charging interest on drawings to partners' capital accounts.
• Interest on Drawings A/c Dr. to Profit and Loss Appropriation Account for transferring interest on drawings to Profit and Loss Appropriation Account.

Partner's Salary:

• Salary to Partner A/c Dr. to Partner's Capital/Current A/c's individually.
• Profit and Loss Appropriation A/c Dr. to Salary to Partner's A/c, for transferring partner’s salary.

Partner's Commission

For crediting commission allowed to a partner; Commission to Partner A/c Dr. to Partner's Capital/Current A/c's (individually). For partners' capital accounts: Profit and Loss Appropriation A/c Dr. to Commission to Partners Capital/Current A/c.

Share of Profit or Loss after appropriations

If there is Profit, Profit and Loss Appropriation A/c Dr. to Partner's Capital/Current A/c's individually.

• If there is Loss, Partners Capital/Current A/c individually Dr. to Profit and Loss Appropriation A/c.

Interest on Capital

• Interest is credited at an agreed rate to a partner proportional to the period the capital was in the business during a given year, usually when the partnership deed allows it.
• Generally provided when: capitals are unequal but profits are shared equally, or capital contribution is the same profits and loss is unequal.
• The calculation must take any capital additions or withdrawals made during the accounting period into consideration.

Interest on Drawings

• Allows charging interest on money withdrawn from a company by partners for personal use.
• Such an interest discourages the partners from withdrawing an excessive amount of money.

When Fixed Amounts was Withdrawn Every Month

• If a fixed amount of money is withdrawn by the partners, at equal time interval, say each month or each quarter, attention must be paid to whether the fixed amount was withdrawn at the beginning (first day) of the month, middle of the month or at the end (last day) of the month.
• Calculation of average period: is withdrawn at the beginning of each month:
• Average Period = No. of months of 1 drawings + No. of month of last drawings/ 2
• On the other hand you can take a period of seven and a half months ie to the end of each quarter.

When Varying Amounts are Withdrawn at Different Intervals

• The interest is calculated using each product individually, by the product method.
• For each withdrawal, money is multiplied by the period in months that it has been withdrawn.

Guarantee of Profit to a Partner

• Sometimes a partner is admitted into a firm with a guarantee of certain minimum amount by way of his share of profits of the firm.
• The minimum guaranteed amount shall be paid to such new partner when his share of profit as per the profit sharing ratio is less than the guaranteed amount.

Past Adjustments

• Omissions or errors in recording may occur with transactions resulting in the need for adjustments for correction impact, done either through a "Profit and Loss Adjustment Account" or directly.
• When these arise they require correction by ‘Profit and Loss Adjustment Account’, or directly in the capital accounts