ACCOUNTING FOR PARTNERSHIP FIRMS - FUNDAMENTALS (ACCOUNTANCY , CLASS : XII)

 

ACCOUNTING FOR PARTNERSHIP FIRMS - FUNDAMENTALS

 

Definition of Partnership: According to Section 4 of Partnership Act 1932, “Partnership is 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”.

 

Features of Partnership

 

1.     No. of partners: There must be at least 2 persons to form a partnership and as per Rule 10 of the Companies (Miscellaneous) Rules, 2014, a partnership firm cannot have more than 50 members. All such persons must be competent to contract. According to Indian Contract Act, 1872, every person except the following is competent to contract:

(a)  Minor, (b) Persons of unsound mind and (c) Persons disqualified by any law.

 

2.     Agreement: Partnership comes into existence by an agreement, either written or oral. The agreement forms the basis of mutual rights and duties of partners.

 

3.     Sharing of profits: The agreement between/among the partners must be to share profits or losses of the business. There may be a provision in the Partnership Deed that a particular partner or partners shall not bear the losses.

 

4.     Lawful business: A partnership is formed to do a lawful business with the purpose of earning profit. A joint ownership or charitable activity is not business as it does not function with the objective of earning profit.

 

5.     Business can be carried by all or any of the partners acting for all: Business of the partnership can be carried on by all the partners or by any of them acting for all the partners. Each partner is an agent as well as a principal of the firm.

 

6.     Unlimited liability: The partners of a firm have unlimited liability. Personal assets may be used for repaying debts in case the business assets are insufficient.

Partnership Deed: The document containing the partnership agreement among partners is called Partnership Deed.

 

 

Rules Applicable in the Absence of Partnership Deed: In the absence of a Partnership Deed or verbal agreement, the following provisions of Partnership Act, 1932 will be applicable:

1. Profits and Losses are to be shared equally irrespective of their capital contribution; 2. No interest on capitals shall be allowed to the partners; 3. No interest is to be charged on drawings; 4. No partner is entitled to any salary or commission for taking part in running the firm’s business; 5. Interest at the rate of 6% per annum is to be allowed on a partner’s loan to the firm. Such interest shall be paid even if there are losses to the firm; 6. Each partner can participate in the conduct of business.

 

Recording of Partnership Transactions: The profits of the partnership firm are divided among the partners. For this purpose, a Profit and Loss Appropriation Account is prepared and entries for interest on capital, interest on drawing, salary to partners and division of profits among the partners will be passed in this account.

 A specimen of Profit and Loss Appropriation Account is given below:

     Dr.                 Profit and Loss Appropriation Account for the year ended...........     Cr.

Particulars	Amount (`)	Particulars	Amount (`)
To Interest on Capital A/c To Partner’s Salary A/c To Partner’s Commission A/c To General Reserve A/c To Capital / Current A/cs:*      (Share of profit to be distributed       among the partners)	xxx xxx xxx xxx xxx   xxx	By Profit & Loss A/c      (Net profit transferred from        Profit and Loss A/c) By Interest on Drawings A/c	xxx     xxx       xxx

 

Note: (1) * Under fluctuating capital method, we use Capital A/cs and under fixed capital method, we use Current A/cs. (2) Interest, Salary, Commission, Share of profit etc. are to be expressed individually for each partner and then they are to be added in the inner column.

Charge against Profit: It indicates expenses to be deducted from profits while calculating net profit or loss. It is debited to Profit and Loss Account. Examples: Interest on partner’s loan and Rent paid to a partner.

Appropriation out of Profit: It means distribution of net profit among partners under different heads as per the Partnership Deed. Examples: Interest on capital, Salary to partners etc.

Treatment of Interest on Capital:

 

Case I: When the partnership agreement is silent about the interest on capital: In this case, no interest will be allowed on capital.

Case II: When the partnership agreement provides for interest on capital but is silent in treating interest as a charge or appropriation: In this situation, interest on capital will be allowed only when there is a profit.

(i)       In case of Loss: No interest will be allowed on capital.

 

(ii)      When the profit before interest is equal to or more than the amount of interest: Full interest on capital will be allowed.

 

(iii)    When the profit before interest is less than the interest itself: In this case, interest will be restricted to the amount of profit. So, profit will be distributed in the ratio of interest on capital of each partner.

 

Case III: When the partnership agreement provides for treating interest as a charge: Full interest will be allowed whether there is profit or loss.

Interest on Drawings: Interest on drawings is to be charged from the partners, if it is specifically provided in the Partnership Deed. Drawings by a partner may be broadly divided into heads – (1.) Regular Drawings and (2.) Irregular Drawings.

Interest on Regular Drawings: When the amount of drawings is uniform and the time interval between the two drawings is also uniform, then interest on drawings is calculated using Average Period Method.

The formula for calculating interest on drawings under this method is:

 

For example, if a partner withdraws `1,000 per month in the beginning of each month and the rate of interest is 15% p.a. then interest on drawings = (`1,000 ×12) ×15/100 ×6.5/12 = `975

 

Interest on Irregular Drawings: When unequal amount is withdrawn at different dates: In this case interest on drawings is calculated with the help of Simple Method or Product Method.

Note: When the rate of interest is given without the word ‘per annum’: In this case, interest on drawings will be charged without considering time or date of drawing. In other words, interest on drawings will be charged for 12 months. When the date of withdrawal is not given then, interest on total drawings for the year is calculated for six months on the average basis.

Partners’ Capital Accounts: The Partners’ Capital Accounts may be maintained by following any of the two methods: 1. Fixed Capital Accounts Method and 2. Fluctuating Capital Accounts Method.

 

 

 

1.     Fixed Capital Accounts Method: In this case, capital invested by each partner in the firm remains fixed unless a partner introduces additional capital or withdraws out of his or her capital. Here, we maintain Current A/c to record transactions other than transactions relating to capital such as interest allowed on capital, interest charged on drawings, salary payable to a partner, share of profits/losses. Therefore, under this method, two accounts, i.e., Capital A/c and Current A/c for each partner are maintained.

 

2.     Fluctuating Capital Accounts Method: Under this method, only one account namely ‘Capital A/c’ is maintained for each partner. All transactions such as capital introduced or withdrawn, interest allowed on capital, interest charged on drawings, share of profits/losses etc., are recorded in Capital A/c.

Note: In absence of any information, fluctuation capital accounts method should be followed for maintaining the Partners’ Capital Accounts.

 

Past Adjustments or Adjustments in the Closed Accounts: Sometimes, after closing the accounts of a partnership firm, some errors or omissions in the accounts of the earlier years are found. In such cases, instead altering the old accounts, these errors and omissions are rectified by adjusting the Capital Accounts of the affected partners by passing adjustment entry.

For example, A and B were partners in a firm sharing profits in the ratio of 7:5. Their respective fixed capitals were A `1,00,000 and B `70,000. The partnership deed provided that: (a) Interest on capital @ 12% p.a. and (b) A’s salary `600 p.m. and B’s salary `6,000 p.a. The profit for the year ended 31^st March, 2017 was `50,400 which were distributed equally, without providing for the above. Now we have to pass adjustment entry to rectify the above items.

                                      

 

*Remaining profit will have to be calculated when profit has already been distributed in wrong profit sharing ratio.

                                                           Journal

Date	Particulars	L.F.	Dr. (`)	Dr. (`)
2017 March 31	B’s Current A/c                                             Dr.         To A’s Current A/c (Being Adjustment for interest on capital, salary and wrong distribution of profit)		3,800	3,800

 

 

Guarantee of Profit to a Partner: Sometimes, a partner is guaranteed that he/she will get a certain minimum amount of profits of the firm. The profit may be guaranteed to an existing or new partner by (1) any one or more of the partners or (2) by all other partners in a particular ratio. Here we have to calculate: (a) share of profit as per profit-sharing ratio and (b) guaranteed profit. When the profits of the firm are not adequate then the deficit amount of guaranteed partner is borne by other partner(s).

In the absence of information regarding bearing of deficiency, it will be borne by partners in their profit sharing ratio.

 

Illustration: Anwar, Biswas and Divya are partners in a firm. Their Capital Accounts stood at `8,00,000; `6,00,000 and 4,00,000 respectively on 1^st April, 2013. They shared profits and losses in the ratio of 3:2:1 respectively. Partners are entitled to interest on capital @ 6% per annum and salary to Biswas and Divya @ `4,000 per month and `6,000 per quarter respectively as per the provisions of Partnership Deed.

Biswas’s share of profit including interest on capital but excluding salary is guaranteed at a minimum of `82,000 p.a. Any deficiency arising on that account shall be met by Divya. Profit for the year ended 31<sup>st</sup> March, 2014 amounted to `3,12,000. Prepare Profit and Loss Appropriation Account for the year ended 31^st March, 2014.                     [CBSE Delhi, 2013]

 

Solution:

  

 

Note: Biswas’s share of Profit        = `44,000

          Add: Interest on Capital      = `36,000

                                                      `80,000

          Guaranteed Profit = `82,000

          Therefore, deficiency to be borne by Divya = `82,000 – `80,000 = `2,000.

 

 

 

Goodwill: It is the value of the reputation of a firm which enables it to earn more profits in comparison to the normal profits earned by other firms in the similar trade.

 

Features of Goodwill

1.     Intangible asset: Goodwill is an intangible asset which cannot be seen and touched.

 

2.     Not depreciated: It does not suffer wear and tear and as such the question of depreciation does not arise on it like tangible assets but is amortised over its useful life.

 

3.     Types: It can be classified into two categories – purchased and self-generated. Purchased goodwill is that goodwill which is acquired by a firm by making a payment on the purchase of a business. On the other hand, self-generated goodwill is that goodwill which is generated by a number of factors that a running business concern possesses and owing to which it becomes able to earn higher profits. According to AS 26, only purchased goodwill can be recorded in the books.

 

4.     Enhances profits: Since goodwill attracts new customers and helps in retaining old ones, the profits of the firm are higher than usually expected. In this way, the firm starts to enjoy extra profits.

 

5.     Sale with business: Goodwill cannot be sold in part. It can be sold with the entire business only.

 

Factors affecting value of goodwill

 

1.     Advantageous location: If the business is located at a favourable place, it will attract more customers and therefore will have more goodwill.

 

2.     Efficient management: If the business is run by experienced and competent management, its profits will go on increasing, which results in increase in the value of goodwill.

 

3.     Trend of profit: If the profits of a business are increasing continuously, the value of its goodwill will be more. If the profits are declining or if the profits are uncertain, the value of its goodwill will be less.

 

4.     Longer establishment of business: Business established for long is likely to have extensive customer base resulting in higher sale and profit. As a result, it will have higher value of goodwill.

 

5.     Possession of license: if a firm holds an important license, the goodwill of the firm will be more as it will be very difficult for other firms to enter this business in the absence of this license.

6.     Risk associated with business: If the risks faced by the business are higher than normal, the business will have less value of goodwill. On the contrary if the business faces lower risks, it will have higher value of goodwill.

Methods of Valuation of Goodwill: There are three methods of valuing goodwill – 1. Average Profit Method, 2. Super Profit Method and 3. Capitalisation Method.

  

 

 

Illustration: A business has earned average profits of `2,00,000 during the last few years and the normal rate of return in similar business is 10%. Find out the value of goodwill by:

 

      (i)  Capitalisation of Super Profit Method and

 

(ii) Super Profit Method if the goodwill is valued at three years’ purchase of Super Profit.

  The assets of the business were `20,00,000 and its external liabilities `3,60,000.