Preparation of Financial Statements – Partnerships
Welcome to one of the most interesting topics in A Level Financial Accounting: Partnerships! You’ve already mastered the Sole Trader, and now we’re just adding a few extra owners into the mix.
Don't worry if this chapter seems intimidating. The Statement of Profit or Loss (SOPL) and Statement of Financial Position (SOFP) are almost identical to what you already know. The key difference is how the profit is divided amongst the partners. This division process is handled by a special account called the Appropriation Account, which is the heart of this chapter.
Let's dive in and understand how multiple owners change the accounting game!
1. Understanding the Partnership Structure (AS Level Review)
A Partnership is simply a business structure where two or more people (known as partners) agree to share risks and rewards by running a business together. Unlike a limited company, partners have unlimited liability.
The Partnership Agreement vs. The Partnership Act 1890
The rules of the partnership are ideally set out in a legal document called the Partnership Agreement (sometimes called the Partnership Deed). This document specifies things like:
- The Profit Sharing Ratio (PSR).
- Whether partners receive a salary.
- Interest allowed on Capital (IoC) and Interest charged on Drawings (IoD).
- Rules for dissolution or partner retirement.
Quick Review: The Partnership Act 1890
If the partners are sensible, they write an agreement. If they are *not* sensible (and have no written agreement), the law steps in and uses the rules set out in the Partnership Act 1890. This is a crucial concept to remember!
Under the Partnership Act 1890, the default rules are very strict:
- Salaries: No partner receives a salary.
- Interest on Capital (IoC): No interest is allowed on capital contributed.
- Interest on Drawings (IoD): No interest is charged on drawings taken.
- Profit/Loss Sharing: Profits and losses must be shared equally, regardless of how much capital each partner invested.
- Interest on Loans: A partner who provides a loan (separate from capital) is entitled to 6% interest per annum (this is treated as an expense in the SOPL, not the Appropriation Account).
Memory Trick (The Act's Rules): Remember PILA D – Profit is equal, Interest on Loans is 6%, all other items (Salaries, IoC, IoD) are Denied!
2. The Financial Statements for a Partnership
The financial statements are prepared in three main stages:
a) Statement of Profit or Loss (SOPL)
The SOPL calculates the Net Profit or Profit for the Year. It is prepared exactly the same way as a sole trader’s SOPL. The only partnership-specific item you might find here is Interest on Partner’s Loans (if applicable), which is treated as a business expense.
Key Takeaway: The SOPL calculates the profit the partnership made before it’s divided among the owners.
b) The Appropriation Account
This is the unique document for partnerships. Its sole purpose is to show how the Net Profit (or Loss) calculated in the SOPL is distributed among the partners according to their agreement.
Step-by-Step Guide to the Appropriation Account
- Start with the Net Profit for the Year (Credit side).
- Add: Interest on Drawings (IoD). (This is income for the business, charged to the partners.)
- Deduct (Appropriations):
- Partner Salaries.
- Interest on Capital (IoC).
- The resulting balance is the Residual Profit (or Loss).
- This Residual Profit is then divided among the partners using the Profit Sharing Ratio (PSR) and transferred to their Current Accounts.
The Appropriation Account format is usually vertical, starting with Net Profit and showing all additions and deductions to arrive at the final share of profit.
c) Statement of Financial Position (SOFP)
The SOFP is similar to a sole trader's, but the Capital and Reserves section is slightly different. Instead of one Capital figure, you show the balances for each partner's:
- Individual Capital Account.
- Individual Current Account.
Formula Reminder:
Capital Employed = Capital Accounts Total + Current Accounts Total + Non-current Liabilities (Loans)
3. Partner Accounts: Capital vs. Current Accounts
Partnerships often use two separate accounts for each partner to maintain clarity:
i) The Capital Account
The Capital Account records the partners’ long-term investment in the business. These accounts are usually maintained as fixed capital accounts, meaning the balance rarely changes, except for:
- Permanent introduction of new capital.
- Permanent withdrawal of capital (rare).
If capital accounts are fixed, all day-to-day transactions flow through the current accounts.
ii) The Current Account
The Current Account records the day-to-day interactions between the partner and the business. The balance fluctuates yearly based on profit shares and drawings.
Quick Look: Partner Current Account T-Format
Debit (Deductions/Decrease):
- Opening Debit Balance (if any)
- Drawings (cash or goods taken by partner)
- Interest on Drawings (IoD)
- Share of Loss (if the Appropriation Account resulted in a loss)
- Closing Credit Balance (Balance c/d)
Credit (Additions/Increase):
- Opening Credit Balance (Balance b/d)
- Partner Salary
- Interest on Capital (IoC)
- Share of Profit (from Appropriation Account)
- Closing Debit Balance (Balance c/d)
Did you know? A partner’s Current Account can have a debit balance (a negative balance). This means the partner has withdrawn more funds than they have earned in profit/salary/interest that year, effectively owing money to the partnership.
Key Takeaway: Capital accounts show the permanent investment; Current accounts show the revolving balance of profit shares, salaries, and drawings.
4. Advanced Partnership Accounting: Changes in Partnership (A Level Focus)
When a partnership changes its composition (e.g., admitting a new partner, retirement, or changing the Profit Sharing Ratio), certain assets and liabilities must be revalued, and goodwill must be accounted for. This ensures fairness to all partners.
a) Goodwill and Revaluation of Assets (Syllabus 3.1.2)
Goodwill represents the non-physical value of a business—its reputation, customer loyalty, and good location. This extra value isn't usually recorded unless the business is purchased (Purchased Goodwill).
- Inherent Goodwill: This is internally generated goodwill (the value built up over time). It is only accounted for in the partners' Capital Accounts when there is a change in the partnership structure (e.g., retirement or change in PSR). It is usually calculated, adjusted between the old partners, and then immediately written off.
Revaluation of Assets
When partners agree to a change, they must calculate the true value of their existing assets and liabilities. Any increases or decreases in value are calculated and transferred to a Revaluation Account.
The Revaluation Account Process:
- Increase in Asset Value / Decrease in Liability Value → Credit Revaluation Account (gain).
- Decrease in Asset Value / Increase in Liability Value → Debit Revaluation Account (loss).
- The balance (gain or loss on revaluation) is transferred to the Capital Accounts of the OLD PARTNERS in their OLD PROFIT SHARING RATIO.
Common Mistake to Avoid: Revaluation gains/losses must *only* be shared among the partners who were around when that gain/loss was generated (i.e., the old partners). A new partner does not share in past gains.
b) Dissolution of a Partnership
Dissolution means the partnership is closing down and ceasing operations. The goal is to sell all assets, pay all liabilities, and distribute the remaining cash among the partners.
To manage this process, two special ledger accounts are required:
1. The Realisation Account
2. The Bank/Cash Account (used to settle final payments)
Analogy: The Realisation Account is the "Closing Down Sale" Account
This account is used to record the profit or loss made on selling all the assets and paying the liabilities.
Step-by-Step: Preparing the Realisation Account
Phase 1: Transfer Assets and Liabilities
- Transfer all non-cash assets (except non-current asset provision accounts) to the Debit side of the Realisation Account (at their book value).
- Transfer all third-party liabilities (e.g., trade payables, external loans) to the Credit side of the Realisation Account (at their book value).
- Transfer any Provisions for non-current assets (e.g., Accumulated Depreciation) to the Credit side of the Realisation Account.
Phase 2: Record Cash Transactions
- Record the cash received from selling the assets → Credit Realisation Account (Debit Bank/Cash).
- Record the cash used to pay off liabilities → Debit Realisation Account (Credit Bank/Cash).
- Record any dissolution expenses (e.g., legal fees) → Debit Realisation Account (Credit Bank/Cash).
Phase 3: Balance and Final Settlement
- Balance the Realisation Account. If the Credit side > Debit side, there is a Profit on Realisation. If the Debit side > Credit side, there is a Loss on Realisation.
- Transfer the profit/loss on realisation to the Partners' Capital Accounts using the final Profit Sharing Ratio (PSR).
- The remaining balances in the Capital Accounts are then settled using the final Bank/Cash account balance.
Key Takeaway (A Level): Changes in partnerships require specific accounts (Revaluation and Realisation) to fairly distribute gains/losses to the appropriate partners based on their *old* or *new* responsibilities.
Quick Review Box
Appropriation Account: Divides Net Profit (IoD added; Salaries, IoC deducted; Residual Profit split by PSR).
Capital Accounts: Permanent investment; usually fixed.
Current Accounts: Day-to-day transactions; fluctuating balance.
Partnership Act 1890: Only applies if no agreement (Equal profits, 6% IoL, no IoC/IoD/Salary).
Revaluation Account: Used when partners change; profit/loss shared by old partners.
Realisation Account: Used for dissolution (closing down); calculates total profit/loss on asset sales and liability settlements.