Partnership Act of 1932: Fundamentals

Partnership Fundamentals

• Partnership involves individuals running a business together and sharing profits.
• Partners are the individuals, and the firm is their collective entity.
• The minimum number of partners needed is two.
• The Partnership Act of 1932 provides the regulations for partnerships.
• The maximum number of partners is 50, according to the Companies Act 2013, Rule No. 10, 2014.
• The Companies Act could potentially raise the maximum to 100, but it is currently 50.

Essential Conditions for Partnership

• Partners bear unlimited liability, potentially involving personal assets to cover business debts.
• The formation of a partnership requires at least two individuals.
• A partnership requires an agreement, whether written or verbal.
• A written agreement, known as a partnership deed, provides stronger legal standing.
• There is no compulsion to create a deed or register under the 1932 Act.
• The business must be lawful to form a partnership.
• Sharing profits is a key condition of a partnership.
• Mutual agency exists among partners, where each partner acts as a principal and agent.

Partnership Deed vs. Partnership Act 1932

• A Partnership deed is a formal written agreement specifying the terms and conditions of the partnership, defining partner roles, salaries, interest, and commissions.
• The Partnership Act 1932 is used when the partnership deed lacks specific details.
• Partners cannot claim interest on capital, salary, or commissions if the deed is silent.
• According to the Partnership Act 1932, partners providing loans to the business are entitled to 6% annual interest, regardless of the firm's profitability.
• In the absence of a partnership deed, profit-sharing ratios are assumed to be equal.
• If specifically stated, interest on capital or salary must be sourced from profits.

Profit and Loss Appropriation Account

• This account distributes net profit to partners, factoring in aspects like interest on capital, salaries, commissions, and transfers to reserves.
• The credit side records net profit and interest on drawings.
• The debit side records expenses such as interest on capital, partner salaries, and commissions. The remaining profit (divisible profit) goes to partners' capital accounts based on their profit-sharing ratio.
• The account can also show a divisible loss if expenses exceed income.

Charges Against Profit

• These are expenses deducted before calculating net profit.
• These items are listed in the Profit and Loss Account; including items like:
• Interest on Loans from partners.
• Rent paid to a Partner
• Managers Commission
• These expenses must be paid regardless of the business's financial health, even during losses.
• These are subtracted from the net profit in the Profit and Loss Account to find an amount available for distribution to the partners.

Calculation of Interest on Capital

• Interest on capital is typically calculated on the initial capital balance.
• Opening Capital = Closing Capital - Profit + Drawings - Additional Capital.
• Interest is also calculated for any additional capital introduced during the year, based on the amount of time it was invested. Withdrawals reduce how much you receive in interest.

Interest on Drawings

• Partners who withdraw funds during the year must have interest on drawings calculated and paid back
• If the withdrawal date is known, use the exact period for calculating interest.
• If unknown, using a standard period of 6 months.
• Withdrawing equal amounts each month:
  • Beginning: 6.5/12
  • Middle: 6/12
  • End: 5.5/12
• Withdrawing money every quarter:
  • Beginning: 7.5/12
  • Middle: 6/12
  • End: 4.5/12
• Withdrawing money every half-year:
  • Beginning: 9/12
  • Middle: 6/12
  • End: 3/12
• If the money is withdrawn for six months:
  • Beginning: 3.5/12
  • Middle: 3/12
  • End: 2.5/12
• Formula: time left after first drawing + time left after last drawing / 2.
• Product method (unequal withdrawals): Total product * rate / 100 * 1/12

Salary and Commission to Partners

• Multiply a monthly salary by 12 to get the annual salary.
• Use the annual salary if provided.
• Commission calculations:
  • Before: rate / 100
  • After: rate / 100 + rate

Partner's Capital Account

• This account tracks each partner's contributions, withdrawals, share of profits, and losses.
• Opening balance, interest on capital, salary, commission, and share of divisible profit are credited.
• Drawing, interest on drawing, and share of divisible loss balances are debited, and its balance could be either debit (losses) or credit (profits).

Fixed vs. Fluctuating Capital Accounts

• Two capital accounting methods exist:
  • Fixed: Capital and Current Accounts
  • Fluctuating: One Capital Account
• Fixed capital method involves two accounts:
  • Capital account (fixed balance unless capital is introduced or withdrawn).
  • Current account (records salaries, interest, and drawings).
• Fluctuating capital method does not always have a credit balance, and only has one account that changes regularly.

Insufficient Profits

• If the firm's profit is not enough to cover all appropriations (interest on capital and salaries), profit must be divided by an agreed-upon process.
• Firms usually divide expenses using an expense ratio based on capital, commission, or other factors.

Past Adjustments

• There may have been a bookkeeping error in the past requiring adjustment such as mistakes and omissions.
• To do that, create a statement of adjustments with the following columns: "Particulars," partners' names (with debit and credit columns), and a column for the firm.

Guarantee of Profit to a Partner

• If a Partner will be guaranteed a specific amount of profit by the other partners.
• Partners will cover the deficiency with this entry:
  • Partner's Capital A/c Dr (who is covering any shortfalls)
  • To Partner's Capital A/c (the partner being protected)
• Any deficiency will be spread pro rata between all guarantor partners.

Goodwill Valuation: Introduction

• Goodwill is an intangible asset that boosts profits.
• It can be useful, but is not always shown.

Types of Goodwill

• Purchased Goodwill:
  • Goodwill = Purchase Price - Fair Value of Net Identifiable Assets
• Self-Generated Goodwill
  • Goodwill that is generated over time through the hard work and dedication of a company's employees.
  • No Journal entry

Need for Valuation of Goodwill

• Admission of a New Partner: The new partner needs to compensate the existing partners for the goodwill they have created.
• Retirement or Death of a Partner: The retiring or deceased partner is entitled to a share of the goodwill.
• Change in Profit Sharing Ratio: Adjustments are needed to reflect the revised profit-sharing arrangement. The remaining partner(s) would need to compensate the retiring / deceased partner.
• Sale of Business: Goodwill is a valuable asset when selling a business.
• Conversion of Partnership into a Company: Goodwill needs to be valued for accounting purposes.
• Amalgamation of Firms: Combining firms requires valuing goodwill for consolidated financial reporting.

Factors Affecting Goodwill

• Factors contributing to the value of goodwill include things like:
  • Efficient management
  • Favourable location
  • Longer establishment of the business
  • Good quality of product
  • Good industrial relations
  • Favourable contracts
  • Customer relations

Methods of Goodwill Valuation

• Average Profit Method
  • Simple Average Profit Method
  • Weighted Average Profit Method
• Super Profit Method
• Capitalisation method

Simple Average Profit Method

• Use the formula: Average Profit * Number of Year purchased
• Average Profit is simply the addition of a few years' profit / n
• Remember that the amount that partners agree to be paid can have an affect on the result, and hence the profit number. So always deduct partner remunerations from the calculation.

Normal vs. Abormal

• Normal Expenses & Profits should not be included in a business when it is being valued; include abnormal amounts.
• Normal, recurring expenses should be included vs recurring income amounts.
• When you have the total amount, you will have to either add or subtract to the "before profit" to get the real profit number
• With that, consider the depreciation: It will have to either be the loss/reduction of profit to get the normalized result.

Weighted Average Profit Method

• Total Products / TW x Number of Years
• This involves the following columns to perform: Years, Profit, Weight Total
• Partner remunerations must also be accounted for by deducting a total remuneration amount per partner needs to be removed from that result. Apply that using the same formula from above.

Super Profit Formula

• Super Profit = Average Profit - Normal Profit.
• Then, use Number of Years purchased.
• Normal profit can be found via: Capital Employed * Rate / 100. Remember, Capital Employed = Asset - Liabilities

Capitalization Method

• The capitalization can be applied through Average and Super methods.
• Super Profit: SP * 100 / Rate or Return
• Average Profit: Capitalized Profit - Net Assets. Capitalized Profit = Average Profit * 100 / Rate or Return

Change in Profit Sharing Ratio: Key Aspects

• Existing partners adjust agreements as to what to do with payments.
• Gaining partner compensates sacrificing partner to maintain balance (Gaining to Sacrifice Journal Entry)
• Sacrificing Ratio determines profit distribution.
• Sacrificing Ratio = Old - New

Treatment of Goodwill

• This will be found in the balance sheet, and will dictate the company balance due to how useful it can be.
• To remove goodwill:
  • Old Partner's A - Old Ratio: for when in the balance sheet.
  • Gaining to Sacrificing - After adjustments: for additions, or any other adjustments. This follows all journal entries
• Re-evaluation either adds to or subtracts from profit.
• Surplus funds can be retained or gained, along with any changes to current prices.

When Would I Use a Memorandium Account

• Memorandium revaluation account is useful if the change is not meant to stay, or will revert.
• To retain in balance sheet would be an attempt:
  • Pass Necessary entry
  • Without Affecting

Admissions: Ratio

• What happens if you were to provide some things you would not have provided to begin with: Most would be expect close to zero.

Admissions: Goodwill

• How would I properly find the current value if the incoming party for example, doesn't match up. To properly calculate the new amount.

Valuation: Important items

• WCM: Begin with the same amount, and use the correct side
• Investments: Use the correct side, account for it appropriately. Use to correct standard

Guarantee

• Always follow the same procedures in accounting for the sake of standard, instead of providing an opinion.
• It will then be found that "the old value will continue in books"

Retirement: Basic Entry

• Very similar to the re evaluation, and the treatment listed above. Use working notes for potential gains or losses from adjustments.

Death of a Partner: Key Actions

• Capital amounts should match an investment model using the right numbers, while accounting for things like goodwill.
• Take into account the loan balance the partner had.
• Death of a partner can be calculated from 3 months from the point, months or even from that day

Dissolution: Steps

• There are 3 steps to be completed:
• Make it match
• Add credit side (LIABILITIES) to what is sold and everything.
• A simple accounting method should be used to find what is long/short or what is missing.

Practical Entries

• Practical elements include relating to cash with "Liability with the bank", or figuring out the given asset.
• Following different rules will be specific to each situation

Explore the core principles of partnership firms, including partner responsibilities and the Partnership Act of 1932. Learn about liability, the necessity of agreements, and the conditions for establishing a partnership. Discover how profits are shared among partners.