Partnership Fundamentals

• Bookkeeping is the process of recording financial transactions.
• Accountancy involves summarizing, analyzing, and reporting these transactions.

Partnership Fundamentals

• A partnership is an association of two or more persons who agree to share the profits of a business carried on by all or any of them acting for all.
• The Indian Partnership Act, 1932 governs partnerships in India.
• Key features of a partnership include:
  • Agreement: It must be based on an agreement (written or oral) between partners.
  • Association of two or more persons: Minimum two partners are required, there is also a limit to the number of partners.
  • Sharing of profits and losses: Partners must agree to share profits and losses in a specific ratio.
  • Mutual agency: Each partner can act on behalf of the firm and bind all other partners by their actions.
  • Business: The partnership must be formed to carry on a lawful business.
• A partnership deed is a written agreement that outlines the terms and conditions of the partnership.
• Typical clauses in a partnership deed include:
  • Name of the firm
  • Names and addresses of the partners
  • Nature of the business
  • Date of commencement of partnership
  • Capital contribution of each partner
  • Profit/loss sharing ratio
  • Interest on capital and drawings
  • Salaries or commissions to partners
  • Rights and duties of partners
  • Procedure for admission, retirement, or expulsion of a partner
  • Method for resolving disputes.
• In the absence of a partnership deed, the following provisions apply according to the Indian Partnership Act, 1932:
  • Profits and losses are shared equally.
  • No interest is allowed on capital.
  • No salary or commission is payable to partners.
  • Interest on loans advanced by a partner to the firm is allowed at 6% per annum.

Profit and Loss Appropriation Account

• This account shows how the net profit of the firm is distributed among the partners.
• Items typically recorded in the Profit and Loss Appropriation Account include:
  • Interest on capital
  • Partner's salaries or commissions
  • Transfer to reserves
  • Interest on drawings
  • Share of profit/loss for each partner
• The balance of this account is added to or subtracted from the partners' capital accounts.

Partners' Capital Accounts

• Two methods for maintaining partners' capital accounts: fixed capital method and fluctuating capital method.
• Under the Fixed Capital Method:
  • Capital accounts remain fixed unless additional capital is introduced or capital is withdrawn.
  • All adjustments like share of profit or loss, interest on capital, drawings, and salaries are recorded in a separate Current Account for each partner.
• Under the Fluctuating Capital Method:
  • Only one account is maintained for each partner, combining both capital and all adjustments.
  • The balance of the capital account fluctuates over time.

Change in Profit-Sharing Ratio

• A change in the profit-sharing ratio among existing partners is a reconstruction of the partnership.
• This requires adjustments to ensure fairness.
• Adjustments required when the profit-sharing ratio changes:
  • Determination of sacrificing and gaining ratios
  • Accounting for goodwill
  • Revaluation of assets and liabilities
  • Adjustment for reserves and accumulated profits/losses.

Sacrificing and Gaining Ratios

• Sacrificing Ratio: The ratio in which partners have surrendered their share of profit in favour of another partner.
• Calculated as: Old Ratio - New Ratio.
• Gaining Ratio: The ratio in which a partner has gained a share of profit.
• Calculated as: New Ratio - Old Ratio
• The sacrificing partner is compensated by the gaining partner for the loss of profit share.

Accounting for Goodwill

• Goodwill is the value of the reputation of a firm in respect of profits expected in future over and above the normal profits.
• When the profit-sharing ratio changes, the gaining partner compensates the sacrificing partner for goodwill.
• The common methods of goodwill valuation are:
  • Average Profit Method: Goodwill is calculated as the average of past years' profits multiplied by a certain number of years' purchase.
  • Super Profit Method: Goodwill is calculated based on the excess of actual profits over normal profits.
  • Capitalization Method: Goodwill is determined by capitalizing the super profits or the average profits.
• Accounting Treatment:
  • Gaining partner's capital account is debited.
  • Sacrificing partner's capital account is credited.

Revaluation of Assets and Liabilities

• Assets and liabilities are revalued to reflect their current market values.
• Any increase or decrease in the value of assets and liabilities is recorded in a Revaluation Account (Profit and Loss Adjustment Account).
• The profit or loss on revaluation is distributed among the old partners in their old profit-sharing ratio.
• Accounting entries:
  • For increase in the value of assets: Asset A/c Dr. to Revaluation A/c
  • For decrease in the value of assets: Revaluation A/c Dr. to Asset A/c
  • For increase in the value of liabilities: Revaluation A/c Dr. to Liability A/c
  • For decrease in the value of liabilities: Liability A/c Dr. to Revaluation A/c
  • For undistributed profit on Revaluation: Revaluation A/c Dr. to Partners' Capital/Current Accounts
  • For loss on Revaluation: Partners' Capital/Current Accounts Dr. to Revaluation A/c

Adjustment for Reserves and Accumulated Profits/Losses

• Reserves and accumulated profits/losses existing on the date of change in profit-sharing ratio belong to the old partners.
• They are transferred to the old partners' capital/current accounts in their old profit-sharing ratio.
• Accounting entries:
  • For accumulated profits (e.g., General Reserve, Profit and Loss Account credit balance): Reserves/Accumulated Profits A/c Dr. to Partners' Capital/Current Accounts
  • For accumulated losses (e.g., Profit and Loss Account debit balance): Partners' Capital/Current Accounts Dr. to Accumulated Losses A/c
• Alternatively, reserves and accumulated profits/losses can be retained in the books, and an adjustment entry is passed.
  • Gaining Partner’s Capital/Current Account Dr. to Sacrificing Partner’s Capital/Current Account (with the proportionate share of net effect of reserves and accumulated items).