Accounting (9615) | Partnership accounts

Hello Future Accountants! Getting Started with Partnership Accounts

Welcome to the exciting world of Partnership Accounts! You've mastered Sole Traders, but when two or more people join forces, the accounting gets a little more interesting—and a lot more focused on fairness.

This chapter moves beyond simply calculating profit; we focus on how to share that profit fairly among the partners, based on their agreement. Don't worry if this seems tricky at first, we will break down the rules step-by-step. Mastering this section is crucial for A-Level success!

1. Defining a Partnership and Its Rules

A partnership is a business structure where two or more individuals (the partners) agree to share in the profits or losses of a business carried on by them all, or any of them acting for all.

1.1 The Partnership Agreement (Deed)

Ideally, partners draw up a formal, written contract called the Partnership Deed (or Agreement). This is the 'rule book' of the partnership. It dictates how financial matters are handled, including:

• The Profit Sharing Ratio (PSR).
• Whether partners receive a Salary.
• Rates of Interest on Capital (IoC).
• Rates of Interest on Drawings (IoD).
• Interest on Partner's Loans (IoL).

Analogy: Think of the Partnership Deed as a prenup agreement—it sets the terms of how the assets will be handled while the business is running!

1.2 The Partnership Act 1890: The Safety Net

What happens if the partners are casual and start trading without a formal deed? They fall back on the Partnership Act 1890. You must know these rules by heart!

If there is no written agreement, the Act dictates the following:

• Profit Sharing Ratio (PSR): Profits and losses must be shared Equally.
• Interest on Capital (IoC): None is allowed.
• Interest on Drawings (IoD): None is charged.
• Partnership Salaries: None is allowed.
• Interest on a Partner’s Loan (IoL): Allowed at a fixed rate of 5% per annum.

Key Takeaway: Always check if a Deed exists. If yes, use the deed's terms. If no, apply the strict rules of the Partnership Act 1890.

2. Preparing Partnership Financial Statements

The financial statements of a partnership are almost identical to a sole trader's, with one crucial addition: the Appropriation Account.

2.1 The Income Statement (Same as Sole Trader)

The Income Statement (Trading and Profit and Loss Account) is prepared exactly as you learned previously, calculating the Net Profit before any partner specific items (like IoC or salaries) are considered.

Exception: Interest paid on a Partner’s Loan is treated as a standard expense and must be deducted here, before calculating Net Profit. This is because a partner's loan is a debt to the business, not a share of profit.

2.2 The Appropriation Account (The Distribution Stage)

This is the unique statement for partnerships. It takes the Net Profit calculated above and shows how it is distributed among the partners.

Purpose: To calculate the Residual Profit (the final amount left) that is then shared according to the agreed Profit Sharing Ratio (PSR).

Step-by-Step Layout of the Appropriation Account

Start with Net Profit:

• Add: Interest on Drawings (IoD). (This is income for the partnership).
• Less: Interest on Capital (IoC). (This is a charge against the profit).
• Less: Partnership Salaries. (This is a fixed allowance).
• Less: Bonus (if applicable, though less common at this level).

The resulting figure is the Residual Profit (or Loss).

Final Step: Distribute the Residual Profit among partners using the **Profit Sharing Ratio (PSR)**.

Did you know? IoC and Salaries are payments made to partners regardless of whether the business makes a profit (though they cannot create a deficit greater than the Net Profit, forcing partners to pay in cash). They are technically allocations of profit, not expenses of the business.

3. Detailed Partner Adjustments

These calculations involve understanding the dual effect (Double Entry) of each item on both the Appropriation Account and the Partners' personal accounts.

3.1 Interest on Capital (IoC)

This compensates partners for the money they leave invested in the business. It is calculated on the amount of capital they have supplied and is considered a payment TO the partner.

• Impact on Appropriation Account: DEBIT (Reduces the profit available for sharing).
• Impact on Partner's Current/Capital Account: CREDIT (Increases the amount owed to the partner).

Formula Example: IoC = Capital Balance x Rate % x (Months/12, if capital changes mid-year)

3.2 Interest on Drawings (IoD)

This is a charge levied on partners who take money or goods out of the business before the end of the financial year. It is considered income FOR the partnership.

• Impact on Appropriation Account: CREDIT (Increases the profit available for sharing).
• Impact on Partner's Current/Capital Account: DEBIT (Reduces the amount owed to the partner).

Common Mistake to Avoid: IoC reduces profit; IoD increases profit. Keep the directions clear!

3.3 Partnership Salaries and Loan Interest

Partnership Salary:

• Treated exactly like IoC: DEBIT Appropriation Account (cost to the firm), CREDIT Partner's Current/Capital Account (benefit to the partner).

Interest on Partner’s Loan:

• This is NOT an appropriation item. It is a genuine business expense, like interest paid on a bank loan.
• It must be deducted before calculating Net Profit in the Income Statement.
• Double Entry: DEBIT Income Statement (Expense), CREDIT Partner's Loan Account (or sometimes Partner's Current Account).

4. Partners’ Accounts: Capital vs. Current

Partnership accounting requires tracking two main accounts for each partner: the Capital Account and the Current Account. The choice of how to use these depends on whether the partners adopt fixed or fluctuating capital methods.

4.1 Fixed Capital Accounts Method

This is the most common and generally preferred method. The partner’s Capital Account balance remains Fixed and only changes in two scenarios:

1. If a partner introduces new, permanent capital.
2. If a partner makes a permanent withdrawal of capital.

All other regular transactions—salaries, IoC, IoD, and share of profit—go through the Current Account.

The Current Account will show:

• CREDIT side (Increases in balance): IoC, Salary, Share of Profit.
• DEBIT side (Decreases in balance): Drawings, IoD, Share of Loss.

4.2 Fluctuating Capital Accounts Method

Under this method, only one account (the Capital Account) is kept for each partner. All transactions (IoC, salaries, drawings, profits, etc.) flow directly into the Capital Account, causing the balance to fluctuate from year to year.

5. Accounting for Changes in Partnership

Life changes, and so does the partnership. When a new partner is admitted or an existing partner retires, the financial relationships must be recalculated. (Remember: Dissolution—closing the firm down completely—is NOT examined at this level.)

When the partnership changes, two critical concepts must be addressed: Revaluation of Assets and Goodwill.

5.1 Revaluation of Assets

When a partner is admitted or retired, the existing assets (like land or machinery) may be undervalued or overvalued in the Statement of Financial Position (SOFP). The firm must calculate their current market value.

The Revaluation Account:

A temporary account is opened to record the gains or losses from writing up or writing down assets. The crucial rule here is:

The gain or loss on revaluation belongs ONLY to the existing partners and must be shared in their OLD Profit Sharing Ratio (PSR).

• Gains on Revaluation (e.g., land value goes up): DEBIT Asset Account, CREDIT Revaluation Account. The final gain is DEBIT Revaluation Account, CREDIT Old Partners' Capital Accounts (in old PSR).
• Losses on Revaluation (e.g., machinery value goes down): DEBIT Revaluation Account, CREDIT Asset Account. The final loss is DEBIT Old Partners' Capital Accounts (in old PSR), CREDIT Revaluation Account.

5.2 Treatment of Goodwill

Goodwill is the monetary value of a business's non-physical assets, like its strong reputation, customer loyalty, or brand name. It is valuable to existing partners.

When a new partner joins, they benefit from this established goodwill. When a partner leaves, they should be compensated for their share of the goodwill they helped build.

Method 1: Goodwill Account is Opened and Immediately Written Off (Memorandum Method)

1. Establish Goodwill: Calculate the total value of the firm’s goodwill.
2. Credit Old Partners: Debit Goodwill Account (with the total value), Credit Old Partners’ Capital Accounts (in their OLD PSR). This records the goodwill and gives the existing partners their fair share.
3. Write Off Goodwill: Immediately write off the Goodwill. Credit Goodwill Account (with the total value), Debit ALL Partners’ Capital Accounts (in the NEW PSR). This immediately cancels the goodwill and shares the "cost" among everyone in the new ratio.

The net effect: The existing partners receive a net credit, representing the capital injection from the new partner (or the loss absorbed by the remaining partner). The Goodwill account is closed.

6. The Statement of Financial Position (SOFP)

After the Appropriation Account and the Partners' Accounts are finalized, the SOFP is prepared. The only key difference from a sole trader's SOFP is the Equity section (Capital and Current Accounts).

Equity Section in the SOFP:

1. Non-Current Liabilities: This includes any Partners' Loans.
2. Equity:
   • Capital Accounts (Total of all fixed capital balances).
   • Add: Current Accounts (Total of all credit balances).
   • Less: Current Accounts (Total of all debit balances, if any partner is overdrawn).

Note: After admission or retirement, the SOFP must show the new revalued figures for assets, and the Capital Accounts must reflect the final balances calculated in the adjustment process (including goodwill and revaluation amounts).

Final Key Takeaway

Partnership accounting is about profit distribution and managing relationships. Always refer back to the Deed or the Act to determine how profit is shared, and ensure that when a partnership changes, the benefits (like revaluation gains and goodwill) are correctly allocated to the partners who earned them (the old partners).