Accounting for Partnership: Basic Concepts

Nature Of Partnership

When two or more persons decide to carry on a business jointly and share its profits and losses, they form a partnership. A partnership is a popular form of business organisation, especially for small and medium-sized enterprises, as it allows individuals to pool their financial resources, skills, and expertise.

In India, partnership is governed by the Indian Partnership Act, 1932. Section 4 of this Act defines partnership as "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."

Key Characteristics of a Partnership:

1. Association of Two or More Persons:

There must be at least two persons to form a partnership. The maximum number of partners is generally limited by the Companies Act, 2013 (currently 50 for non-banking businesses and 100 for banking businesses, unless specified differently by the government). These persons must be competent to contract.

2. Agreement:

Partnership arises from an agreement between the persons. This agreement can be oral or written. A written agreement (Partnership Deed) is highly recommended to avoid future disputes.

3. Existence of Business:

There must be a business that the partners agree to carry on. The term 'business' includes every trade, occupation, and profession. The intention must be to carry on some form of economic activity.

4. Profit Sharing:

The agreement must be to share the profits of the business. While sharing of profits is essential, sharing of losses is implied. Profit sharing is the primary evidence of partnership, although it is not conclusive proof on its own.

5. Business Carried on by All or Any of them Acting for All (Mutual Agency):

This is a crucial characteristic. Each partner is both an agent and a principal. They are an agent because they can bind the firm by their actions taken within the scope of the business. They are a principal because they are bound by the actions of other partners. Any partner can carry on the business, and their actions will be binding on all other partners.

6. Unlimited Liability:

Except for Limited Liability Partnerships (LLPs), partners in a general partnership have unlimited liability. This means that if the assets of the firm are insufficient to pay off the firm's debts, the personal assets of the partners can be used to satisfy the claims of creditors.

Accounting for partnerships involves unique aspects due to the presence of multiple owners (partners) and the distribution of profits among them, which differs from a sole proprietorship.

Partnership Deed

A Partnership Deed is a written agreement between the partners that clearly defines the terms and conditions governing the partnership. It is a crucial document as it regulates the mutual rights, duties, and liabilities of the partners and the firm. While a written deed is not legally mandatory, it is highly desirable to prevent misunderstandings and disputes among partners.

Contents Of The Partnership Deed

A well-drafted Partnership Deed typically includes the following key clauses:

1. Name and Nature of the Firm and Business:

The official name of the partnership firm and the type of business it will conduct.

2. Names and Addresses of the Partners:

Full details of all individuals entering into the partnership.

3. Commencement of Business:

Date from which the partnership business will start operating.

4. Duration of Partnership:

Whether the partnership is for a fixed period, for a particular venture, or at will.

5. Capital Contribution:

Amount of capital to be contributed by each partner. Whether the capital will be fixed or fluctuating.

6. Profit Sharing Ratio:

The ratio in which partners will share the profits and losses of the firm.

7. Interest on Capital:

Whether interest will be allowed on partners' capital and at what rate.

8. Interest on Drawings:

Whether interest will be charged on partners' drawings and at what rate.

9. Salary or Commission to Partners:

Whether any partner will be entitled to a salary, commission, or other remuneration for their services.

10. Interest on Loans by Partners:

Rate of interest payable on any loan provided by a partner to the firm.

11. Drawings:

Rules regarding the amount and timing of drawings by partners.

12. Goodwill:

Method of valuation of goodwill on admission, retirement, or death of a partner.

13. Accounts and Audit:

Maintenance of accounts, accounting period, and arrangements for audit.

14. Admission, Retirement, Death, and Dissolution:

Terms and conditions for the admission of a new partner, retirement of an existing partner, settlement of accounts on the death of a partner, and dissolution of the firm.

The Partnership Deed provides a clear framework for the accounting treatment of various items related to partners.

Provisions Of Indian Partnership Act, 1932 Relevant For Accounting

In the absence of a Partnership Deed, or if the Deed is silent on a particular matter, the provisions of the Indian Partnership Act, 1932, will apply. These provisions are crucial from an accounting perspective:

1. Sharing of Profits and Losses:

Profits and losses are to be shared equally among the partners, irrespective of their capital contribution.

2. Interest on Capital:

No interest on capital is allowed to partners.

3. Interest on Drawings:

No interest on drawings is charged from partners.

4. Salary or Remuneration to Partners:

No salary, commission, or any other remuneration is allowed to any partner for taking part in the business.

5. Interest on Loan by Partners:

If a partner has given a loan to the firm, they are entitled to interest on such loan at the rate of 6% per annum. This interest is a charge against profit (i.e., it is payable whether there is profit or loss).

6. Admission of a Partner:

A new partner can be admitted only with the consent of all existing partners.

These provisions of the Act override any conflicting clause in the Partnership Deed or apply where the Deed is silent. Therefore, it is vital for accountants to refer to the Partnership Deed first, and if it's silent, then apply the relevant provisions of the Act.

Special Aspects Of Partnership Accounts

Accounting for a partnership firm has several special aspects compared to accounting for a sole proprietorship, primarily due to the involvement of multiple owners (partners) and the specific terms of their agreement.

Key Special Aspects:

1. Maintenance of Partners' Capital Accounts:

Detailed accounts are maintained for each partner to record their capital contributions, share of profit/loss, drawings, interest on capital, interest on drawings, salary, commission, etc. (Discussed in Section I4).

2. Distribution of Profits and Losses:

Profit or loss for the period is distributed among partners according to the profit sharing ratio specified in the Partnership Deed (or equally as per the Act). This distribution is often shown in a separate Profit and Loss Appropriation Account. (Discussed in Section I5).

3. Adjustments for Items related to Partners:

Items like interest on capital, interest on drawings, partner's salary/commission are recorded and adjusted, usually through the Profit and Loss Appropriation Account, as per the Partnership Deed.

4. Reconstitution of the Firm:

Accounting becomes particularly complex when there is a change in the relationship among partners, leading to the reconstitution of the firm. This includes:

• Admission of a New Partner: Accounting for capital contribution, goodwill, revaluation of assets and liabilities, and adjustment of reserves and accumulated profits/losses.
• Retirement or Death of a Partner: Accounting for the retiring/deceased partner's share of goodwill, revaluation, reserves, accumulated profits/losses, and settlement of their account.
• Change in Profit Sharing Ratio: Adjustment for goodwill and reserves/accumulated profits/losses.

5. Dissolution of the Firm:

Accounting at the time the firm is closed down, involving the realisation of assets, payment of liabilities, and final settlement of partners' accounts.

These special aspects require specific accounting procedures and presentation in the financial statements of a partnership firm.

Maintenance Of Capital Accounts Of Partners

Each partner in a firm has a Capital Account to record their stake in the business. Apart from the initial capital introduced, various transactions related to partners are also recorded in their Capital Accounts. There are two main methods for maintaining partners' capital accounts: Fixed Capital Method and Fluctuating Capital Method.

Fixed Capital Method

Under this method, the partners' original capital contributions remain fixed or unaltered unless additional capital is introduced or capital is permanently withdrawn. Transactions related to drawings, interest on capital, interest on drawings, partner's salary/commission, and share of profit/loss are recorded in separate accounts called Partners' Current Accounts.

Accounts Maintained:

• Partners' Capital Accounts: Records only initial capital, fresh capital introduced, and permanent withdrawal of capital. Generally show a Credit balance.
• Partners' Current Accounts: Records all other transactions related to partners (drawings, interest on capital, salary, commission, share of profit/loss). Can show either a Debit or Credit balance.

Journal Entries (Examples):

Interest on Capital:

Drawings:

Share of Profit:

Fluctuating Capital Method

Under this method, only one account, the Partners' Capital Account, is maintained for each partner. All transactions related to partners (initial capital, fresh capital, permanent withdrawal, drawings, interest on capital, interest on drawings, salary, commission, share of profit/loss) are recorded directly in the Partners' Capital Accounts.

Accounts Maintained:

• Partners' Capital Accounts: Records all transactions related to partners. The balance of this account fluctuates from period to period. It generally shows a Credit balance, but can sometimes show a Debit balance if drawings and losses exceed capital.

Journal Entries (Examples):

Interest on Capital:

Drawings:

Share of Profit:

Distinction Between Fixed And Fluctuating Capital Accounts

The method to be followed for maintaining partners' capital accounts should be specified in the Partnership Deed. If the Deed is silent, the Capital Accounts are treated as fluctuating.

Distribution Of Profit Among Partners

The profit earned by a partnership firm is distributed among the partners according to their Partnership Deed. This distribution happens after the Net Profit for the year has been ascertained by preparing the Profit and Loss Account. The distribution is shown in a separate account called the Profit and Loss Appropriation Account.

Profit And Loss Appropriation Account

This account is an extension of the Profit and Loss Account. It is a Nominal Account prepared to show how the net profit (or loss) of the firm is distributed or appropriated among the partners. It deals only with items related to partners based on the Partnership Deed.

Items debited to P&L Appropriation Account:

• Interest on Capital
• Partner's Salary
• Partner's Commission
• Transfer to Reserves (like General Reserve - if created out of profit)
• Share of Profit transferred to Partners' Capital/Current Accounts

Items credited to P&L Appropriation Account:

• Net Profit (transferred from P&L Account)
• Interest on Drawings

Profit and Loss Appropriation Account for the year ended [Date]

Items like Interest on Loan to a partner are a charge against profit, not an appropriation. They are debited to the Profit and Loss Account before calculating Net Profit, not shown in the P&L Appropriation Account. Partner's salaries/commissions and Interest on Capital are generally appropriations of profit, meaning they are allowed only if there is sufficient profit, and are debited to the P&L Appropriation Account.

Interest On Capital (IOC)

Interest on Capital is allowed to partners based on the Partnership Deed. It is calculated on the opening balance of each partner's capital. If fresh capital is introduced or capital is permanently withdrawn during the year, interest is calculated pro-rata for the period the capital was used.

Calculation of IOC:

$IOC = Opening\ Capital \times Rate$

If capital changes during the year, interest is calculated on the capital balance for the specific periods it remained unchanged.

Answer:

Journal Entry:

This Interest on Capital A/c will be closed by transferring it to the debit side of P&L Appropriation A/c.

Note:

If Capital is maintained under the Fixed Method, IOC is credited to Partners' Current Accounts. If under Fluctuating Method, it is credited to Partners' Capital Accounts.

IOC is generally allowed only on the opening capital balance. If the capital figure given in the Trial Balance is the closing capital, adjustments might be needed to find the opening capital before calculating IOC.

Interest On Drawings (IOD)

Interest on Drawings is charged from partners on the amounts or goods they withdraw from the business for personal use. It is based on the Partnership Deed. It is an income for the firm and is credited to the Profit and Loss Appropriation Account.

Calculation of IOD:

The method of calculation depends on the pattern of drawings.

$IOD = Total\ Drawings \times Rate \times \frac{Period}{12}$ (if rate is p.a. and period in months)

$IOD = Total\ Drawings \times Rate \times \frac{Period}{365}$ (if rate is p.a. and period in days)

The 'Period' depends on when the drawings were made.

When Fixed Amounts Was Withdrawn Every Month:

If a fixed amount is withdrawn at regular intervals each month, an average period can be used. Assume financial year ends 31st March.

• Beginning of every month: Average period = (12 months + 1 month) / 2 = 6.5 months.

  $IOD = Total\ Monthly\ Drawings \times 12 \times Rate \times \frac{6.5}{12}$

• Middle of every month (around 15th): Average period = 12 months / 2 = 6 months.

  $IOD = Total\ Monthly\ Drawings \times 12 \times Rate \times \frac{6}{12}$

• End of every month: Average period = (12 months - 1 month) / 2 = 5.5 months.

  $IOD = Total\ Monthly\ Drawings \times 12 \times Rate \times \frac{5.5}{12}$

Answer:

When Fixed Amount Is Withdrawn Quarterly:

If a fixed amount is withdrawn at regular intervals each quarter (3 months). Assume financial year ends 31st March.

• Beginning of every quarter: Average period = (12 months + 3 months) / 2 = 7.5 months.

  $IOD = Total\ Quarterly\ Drawings \times 4 \times Rate \times \frac{7.5}{12}$

• Middle of every quarter (e.g., mid-May, mid-Aug): Average period = 12 months / 2 = 6 months.

  $IOD = Total\ Quarterly\ Drawings \times 4 \times Rate \times \frac{6}{12}$

• End of every quarter: Average period = (12 months - 3 months) / 2 = 4.5 months.

  $IOD = Total\ Quarterly\ Drawings \times 4 \times Rate \times \frac{4.5}{12}$

Answer:

When Varying Amounts Are Withdrawn At Different Intervals (Product Method):

If amounts withdrawn are not uniform or intervals are irregular, the product method is used.

Steps:

1. For each withdrawal, calculate the 'Product' by multiplying the Amount Withdrawn by the number of months (or days) from the date of withdrawal to the end of the accounting period.
2. Sum up all the products.
3. Calculate IOD on the Total Product for one month (or one day) at the given rate.

$IOD = Sum\ of\ Products \times Rate \times \frac{1}{12}$ (if period is in months)

$IOD = Sum\ of\ Products \times Rate \times \frac{1}{365}$ (if period is in days)

Answer:

When Dates Of Withdrawal Are Not Specified:

If the total amount of drawings for the year is given, but the dates of withdrawal are not specified, it is assumed that the drawings were made evenly throughout the year. In such a case, interest on total drawings is calculated for an average period of six months.

$IOD = Total\ Drawings\ for\ the\ year \times Rate \times \frac{6}{12}$

Answer:

Journal Entry for Charging Interest on Drawings:

Interest on Drawings A/c will be closed by transferring it to the credit side of P&L Appropriation A/c.

Partner's Salary / Commission:

If allowed by the Deed, partner's salary or commission is a distribution of profit and is debited to P&L Appropriation A/c and credited to Partner's Capital/Current A/c.

Journal Entry:

Partner's Salary/Commission A/c is closed by transferring it to the debit side of P&L Appropriation A/c.

Guarantee Of Profit To A Partner

Sometimes, in a partnership firm, a partner is guaranteed a minimum amount of profit in a given year. This means that if the firm's actual distributable profit (after all appropriations) is less than the guaranteed amount for that partner, the deficiency will be borne by the other partner(s) or the firm itself, as specified in the guarantee agreement.

The guarantee can be given by:

• The firm to one partner.
• One partner to another partner.
• Some partners to one partner.

Accounting Treatment:

The Profit and Loss Appropriation Account is prepared as usual, determining the total distributable profit or loss. The profit (before guarantee adjustment) is then distributed among partners according to the profit sharing ratio.

If the guaranteed partner's share of profit (calculated normally) is less than the guaranteed minimum amount, the difference (deficiency) is calculated. This deficiency is then debited to the Capital/Current Account(s) of the partner(s) who guaranteed the minimum profit (in their profit sharing ratio, unless otherwise agreed) and credited to the Capital/Current Account of the guaranteed partner.

Answer:

If the firm incurred a loss, or if the profit before appropriation was insufficient to cover all appropriations (like IOC, Salary) and the guarantee, the treatment becomes slightly more complex, involving distinguishing between charge and appropriation. However, if guarantee is the only 'appropriation' item, the deficiency calculation follows the same principle.

Journal Entry for Guarantee Adjustment (if deficiency arises):

This adjustment entry is passed after the profit has been appropriated in the P&L Appropriation Account (showing the final shares directly).

Past Adjustments

Sometimes, after the accounts have been closed and profits distributed among partners, certain errors or omissions are discovered. These could be:

• Interest on Capital or Interest on Drawings was not allowed or charged.
• Partner's Salary or Commission was not provided.
• Profits and losses were shared in the wrong ratio.

Rectifying these errors in the next accounting period requires adjusting the partners' Capital Accounts (if fluctuating) or Current Accounts (if fixed) directly. Instead of altering the past year's accounts, a single adjustment journal entry is passed in the current year to correct the net effect of the error(s) on the partners' accounts.

Accounting Treatment:

A Statement of Adjustment is usually prepared first to ascertain the net amount to be debited or credited to each partner's account. This statement shows what should have been done and what was actually done, calculating the difference for each partner.

Steps:

1. Prepare a Statement of Adjustment (Memorandum Account or Table).
2. Credit the partners with items that should have been credited to their Capital/Current Accounts (e.g., Interest on Capital, Salary, Commission).
3. Debit the partners with items that should have been debited to their Capital/Current Accounts (e.g., Interest on Drawings).
4. Calculate the total credit and total debit for each partner based on these items.
5. The net amount of profit that should have been available for distribution is calculated (Net Profit as per P&L Account + Total IOD - Total IOC - Total Salary - Total Commission - Transfer to Reserves). This remaining profit/loss should be distributed in the correct profit sharing ratio. Debit partners' accounts with their share of this final distributable profit/loss.
6. Alternatively, and more commonly, after steps 2 and 3, calculate the difference between the total credits and total debits for each partner (this is the adjustment required for individual items). Sum the total of all net credits and net debits across partners (these should be equal). This total represents the adjustment needed to the profit figure. Distribute this amount in the correct profit sharing ratio. This is the amount of profit/loss that was wrongly distributed.
7. Find the final net effect (Debit or Credit) for each partner by netting off all the adjustments (credit for IOC, Salary, Share of Corrected Profit; debit for IOD, Drawings, Share of Wrongly Distributed Profit/Loss).
8. Pass a single adjustment journal entry in the Journal Proper, debiting the partner(s) with a net debit effect and crediting the partner(s) with a net credit effect.

Answer:

This single entry corrects the cumulative impact of the past error(s) on the partners' accounts in the current year. This method avoids reopening past year's accounts.