Accounting for partnership part 1

CH : 1ACCOUNTING FOR

PARTNERSHIP FIRM – FUNDAMENTALS

Meaning of Partnership

• A partnership firm is an association of two or more persons to carry on a legal business and share its profits or losses. The persons who join hands together to do a business are individually known as partners and collectively a firm.

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• According to Sec 4 of the Indian Partnership Act, 1932, "the term partnership is the relation between two or more persons who have agreed to share the profit of the business carried on by all or any of them acting for all

Essential elements of Partnership

•1. At least two persons: There must be at least two persons to form a partnership and all such persons must be competent to contract.

•2. Agreement: There must be an agreement to form a partnership. This agreement can be oral or written.

•3. Legal Business: An agreement should be for the purpose of carrying on the business or profession. The business to be carried on by the partners should be legal.

.• •4. Profit Sharing: The agreement between the

partners must be to share the profits or losses of the business in the particular ratio.

• •5 Mutual agency: There should be a mutual agency relationship among the partners. 'Mutual Agency' relationship means that each partner is both an agent and the principal. Each partner is an in the sense that he can bind the other partners by his acts done.

6. Number of partners: The minimum limit of the partners in a firm is two and maximum number of partners in a banking firm should be 10 and in the other firm should be 20.

Meaning of Partnership Deed

• As stated above a partnership is formed by an agreement. This agreement can be oral or written. Though the law does not expressly require that there should be an agreement in writing but the absence of written agreement may be the source of problem in managing the affairs of the partnership firm.

Contents of Partnership deed

• 1. Name of the firm.• 2. Name and addresses of all the partners.• 3. Nature and place of the business.• 4. Duration of partnership.• 5. Date of commencement of partnership.• 6. Amount of capital contributed by each

partners.• 7. Ratio in which profits and losses are to be

shared.

• 8. Interest on partner's capital and drawings.• 9. Interest on loan by the partner to the firm.• 10. Salary, Commission, etc. if any payable to

a partner.• 11. Method of computation and treatment of

Goodwill on the reconstitution of the firm.• 12. Mode of settlement of accounts in case of

retirement/death of a partner.• 13. Mode of settlement of accounts in case of

dissolution of the firm.

Rules in the absence of the Partnership Deed

• (i) The partners will share the profits and losses in the equal ratio.• (ii) Interest on loan will be given @ 6% p.a. to the partners.• (iii) No interest is allowed to partners on the capital invested by them.

.• (iv) No partner .is to get any remuneration such as salary, commission etc for participating in the business.• (v) No interest will be charged on drawings made by the partners.

Meaning of Profit and Loss Appropriation Account:

• Profit and Loss Appropriation Account is an extension of Profit and Loss Account that is prepared to distribute the net profit among the partners. All adjustments relating to partners like interest on capital, interest on drawings, commission to partners etc. are made in this Account.

Purpose of Profit & Loss Appropriation Account:

• The main purpose of preparing Profit & Loss Appropriation Account of a Partnership concern is to calculate and distribute the divisible Profit & Loss. The Income Tax Act and the audit rule does not permit the partnership firm to consider the amount as business expenditure which is payable to the partners

Accounting TreatmentItems Accounting Entries

Capital contributed in cash Dr. Cash Cr. Partners’ Capital Accounts

Share of profits Dr. Profit and Loss Appropriation Cr. Partners’ Current Accounts

Share of losses Dr. Partners’ Current Accounts Cr. Profit and Loss Appropriation

Interest on capital Dr. Profit and Loss Appropriation Cr. Partners’ Current Accounts

Partners’ salaries Dr. Profit and Loss Appropriation Cr. Partners’ Current Account

Items Accounting entries

Interest on partners’ loan

Dr Profit and loss appropriationCr Partners’ current

Partners’ drawings Dr Partners’ current Cr Partners Drawings

Interest on drawings Dr Partners’ currentCr Profit and loss appropriation

Methods of Maintaining Capital Accounts of the Partners

•The partner's Capital Accounts are maintained according to Fluctuating Capital Method or Fixed Capital Method.

Fluctuating Capital Method

• Under fluctuating capital method, only one account viz. capital account for each partner is maintained and all the transactions relating to a partner are recorded in his capital account. As a result, the balance in the Capital Account keeps on fluctuating.

PARTNER’S CAPITAL A/CParticular Rs. Particular Rs.

To balance b / fTo cash/bank A/c ( withdrawl ]To drawingsTo interest on drawingsTo Profit & Loss A/c (share of loss)To balance c/f

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By balance b/fBy cash/bank (additional capital)By interest on capitalBy salaryBy CommissionBy P&L Appropriation A/c (share of profits)By balance c/f

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Dr.                                          Partner's Capital Account                           Cr.

Fixed Capital Account:

• Under Fixed Capital method, two accounts viz. capital account and current account for each partner are maintained. The transactions relating to introduction or withdrawal of capital are recorded in Capital Account and other transactions like interest on capital, salary, interest on drawings, drawings are recorded in Current Account.

,Particular Rs. Particular Rs.

To cash/bank A/c (withdrawal)To balance c/f

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By balance b / fBy cash/bank (additional capital)By balance c/f

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Dr.                                          Partner's Capital Account                           Cr.

.Particular Rs. Particular Rs.

To balance b/fTo drawingsTo interest on drawingsTo Profit & Loss A/c (share of loss)To balance c/f

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By balance b/fBy interest on capitalBy salaryBy CommissionBy P&L Appropriation A/c (share of profits)By balance c/f

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Dr.                                          Partner's Current Account                          Cr. 

,Basis Fixed Capital Method Fluctuating Capital Method

Change in Capital The capital remains unchanged except in some special circumstances

The capital fluctuates quite frequently from period to period

No of accounts Two accounts are maintained viz: capital account and current account

One account is prepared i.e. capital account.

Adjustments of drawings etc.

All adjustments of drawings, salary etc are done in capital account

All adjustments of drawings, salary etc are done in current account

Negative Balance Fixed Capital Account can never show a negative balance.

Fluctuating Capital Account can show a negative balance.

Distinction between Fixed Capital Method and Fluctuating Capital Method

Basis Capital Account Current AccountNeed Capital Account is opened in the case

fluctuating capital method and fixed capital method

Current account is prepared only in case of fixed capital method.

Nature of accountCapital account in fixed capital method remains fixed from year to year.

Current account fluctuates from year to year.

Accounting treatment

Amount invested by the partner is to be recorded.

Transactions such as drawings, salary, and interest on capital are recorded.

Balance of account

Capital account in fixed method show only credit balance.

Current account can show a credit or debit balance

Following are some of the differences between Capital Account and Current Account

DIFF. B/W CAPITAL AND CURRENT A/C

Basis Drawings against capital Drawings against profits

Debited It is debited in capital account It is debited in drawings account

Part It is a part of capital It is a part of expected profits

Interest It is considered in calculation of interest on capital

It is not considered in calculating the interest on capital

Effect It reduces capital It does not reduce capital.

.Basis Capital Account Current Account

Need Capital Account is opened in the case fluctuating capital method and fixed capital method

Current account is prepared only in case of fixed capital method.

Nature of account

Capital account in fixed capital method remains fixed from year to year.

Current account fluctuates from year to year.

Accounting treatment

Amount invested by the partner is to be recorded.

Transactions such as drawings, salary, and interest on capital are recorded.

Balance of account

Capital account in fixed method show only credit balance.

Current account can show a credit or debit balance

Calculation of Interest on drawings:

• The drawings are usually made by the partners at regular intervals. Thus, the interest on drawings is calculated with reference to the time period involved. It can be worked out by any one of the following methods:

1. When dates of drawings are not given

• (i)      Average period method: If the dates of drawings are not given, the interest on drawings is calculated on the average basis on the total amount of drawings made during the accounting period for half of the accounting period. It is based on the assumption that the amounts were drawn evenly through out the accounting year.

  Formula:• Interest on drawings = Total drawings ×

Rate/100 × 6/12

.(ii)     Average rate of interest method or when drawings are made irrespective of the time period: Sometimes the average rate of interest is given in the question, in such a case; it is assumed that the rate of interest is already half on the basis of 6 months. Thus, time will not be considered.

• Formula: Interest on drawings = Total drawings × Average Rate/100

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When dates of drawings are given:

• (i)      Product Method: When different amounts are withdrawn at different intervals, the interest will be calculated with the help of product method. In this each amount of drawings is multiplied with number of days/months (from the date of drawings to the date of final accounts) to find out the product and then products are totaled. Interest is calculated on total product at the rate of interest for one month or one day.

• Formula: Interest on drawings = Total of Product × Rate/100 × 1/365 or 1/12

.• (ii)     Monthly/quarterly drawings method: If uniform amount is withdrawn at each time and the interval between two withdrawals also is uniform. In such a case interest on drawings is calculated with monthly drawings method. Time period in this method is calculated as follows:

In that case there will be following cases:

• When drawings are for 12 months period

At the beginning of each month = Total drawings × Rate/100 × 6.5/12

At the end of every month = Total drawings × Rate/100 × 5.5/12

At the middle of every month = Total drawings × Rate/100 × 6/12

When drawings are for 6 months period

• o At the beginning of each month = Total drawings × Rate/100 × 3.5/12• o At the end of every month = Total

drawings × Rate/100 × 2.5/12• o At the middle of every month =

Total drawings × Rate/100 × 3/12

When drawings are made quarterly during the period

• o At the beginning of each quarter = Total drawings × Rate/100 × 7.5/12• o At the end of every quarter = Total drawings × Rate/100 × 4.5/12

Interest on Partner's Capital:

• Interest on capital is to be allowed to the partners if the same is provided in the partnership deed and is allowed at the given rate with reference to time period for which the capital has been used in the business.

•             Formula: Interest on capital = Amount of Capital × Rate/100 × Time

Case Provision1. If the partnership agreement is silent for interest on capital.

No interest on capital will be allowed.

2. If the partnership agreement provides for interest on capital but is silent as to treatment of interest as a charge or appropriation.

Interest on capital will be allowed only if there are profits(a) In case of loss   -  No interest on capital will                  be allowed(b) Profit > Interest -  Full interest on capital(c) Profit < Interest -Profit will be given capital ratio

3. If the partnership agreement provide for interest on capital as a charge.

Full interest on capital will be provided whether there is profit or loss.

Salary or Commission to a Partner

• Salary or Commission to a partner is to be allowed if the partnership agreement provides for the same. These are allowed only if there are profits.

.• Calculation- Commission may be allowed as a

percentage of Net Profits before charging such commissions or after charging such commissions.

• 1.      Commission as % of Net Profit before charging such Commissions

                      = Net profit before commission x Rate of commission/100 

• 2.      Commission as % of Net Profit after charging such Commissions

                      = Net profit before commission x Rate of commission/100 + Rate of Commission     

Accounting TreatmentSalary or Commission to a partner

being an appropriation out of profits shall be transferred to the debit of P& L Appropriation A/c and credit of the Partner's Capital A/c.

Interest on Partner's Loan to a Firm

• Rate of Interest- In case any partner has given loan to the firm; he is entitled to interest on such loan at an agreed rate of interest. If there is no agreement as to the rate of interest on loan, the partner is entitled to rate of interest on loan @ 6% per annum.

• Interest on loan is debited to P& L A/c and is credited to the Partner's Loan A/c.

Guarantee of minimum profit to a partner

• Sometimes a partner may be guaranteed a minimum amount of his share in Profit. Such a partner to whom such guarantee has been provided is called guaranteed partner and the partner who had given such guarantee is called guaranteeing partner. Such minimum amount is called guaranteed amount.

STEPS:• Step 1: Calculate the Actual share of

Profit/Loss of Guaranteed Partner for the given accounting period.

• Step 2: Calculate the amount of deficiency as follows:

Deficiency = Guaranteed amount - Actual share of profits

• Step 3: Distribute the amount of deficiency among the guaranteeing partners in their guaranteed ratio.

.• Step 4: Distribute the actual profit/loss among all the partners in their profit sharing ratio as if there is no guarantee arrangement.

• Step 5: Recover share of deficiency (as per step 3) from the guaranteeing partners and give credit for the same to the guaranteed partner.

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