Accountancy Chapter 1 – Accounting for Partnership: Basic Concepts

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Chapter 1 – Accounting for Partnership: Basic Concepts

Accountancy Chapter 1 – Accounting for Partnership: Basic Concepts

1. Nature of Partnership

A partnership is a business structure formed by two or more persons who agree to operate a business together and share its profits and losses. The Indian Partnership Act, 1932, defines it 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 Features of Partnership:

  1. Two or More Persons:
    • For a partnership to be formed, there must be at least two people. The maximum number of partners is capped at 50 as per the Companies Act, 2013.
  2. Agreement:
    • Partnership arises from a mutual agreement between the partners. This agreement may be oral or written, but it’s recommended to have a written document to avoid disputes.
  3. Business:
    • The partnership must be formed for carrying on a business. Simply owning property together does not make the co-owners partners unless they engage in business activities with a profit motive.
  4. Mutual Agency:
    • Each partner acts as both a principal and an agent for the other partners. This means that the actions of one partner in the course of the business bind the others.
  5. Profit Sharing:
    • Partners must agree to share the profits (and losses). Without this agreement, no partnership exists. Even if only profits are mentioned, the sharing of losses is implied by law.
  6. Liability:
    • The liability of partners is joint and several, meaning each partner is individually and collectively responsible for the firm’s liabilities. Partners’ personal assets can be used to settle firm debts.

2. Partnership Deed

A partnership deed is a written agreement between the partners, outlining the terms of their business relationship. While not compulsory, it is advisable for clarity in business operations.

Contents of the Partnership Deed:

  1. Names and Addresses:
    • This includes the names of the firm and the partners.
  2. Capital Contributions:
    • The amount of capital each partner contributes to the firm is specified.
  3. Profit and Loss Sharing Ratio:
    • Specifies how profits and losses will be shared among partners. If not specified, profits and losses are shared equally.
  4. Interest on Capital and Drawings:
    • States the interest to be paid on partners’ capital and drawings, if any. If no rate is agreed upon, interest on capital is not allowed, and no interest is charged on drawings.
  5. Salaries and Commissions:
    • Specifies if any partner is entitled to receive a salary or commission. If the deed is silent, partners do not get a salary or commission.
  6. Settlement of Accounts on Dissolution:
    • Outlines the procedure to follow if the partnership is dissolved. This includes settling the liabilities and distributing the remaining assets.
  7. Admission, Retirement, or Death of a Partner:
    • Explains how to handle the admission of new partners, retirement, or the death of an existing partner, including changes to profit-sharing ratios.

3. Provisions of the Indian Partnership Act, 1932 (Relevant for Accounting)

If the partnership deed is silent on certain matters, the following provisions of the Indian Partnership Act, 1932, apply:

  1. Profit Sharing:
    • In the absence of an agreement, profits and losses are shared equally by all partners, irrespective of capital contributions.
  2. Interest on Capital:
    • Partners are not entitled to interest on their capital unless specifically agreed upon. If the deed is silent, no interest is paid on capital.
  3. Interest on Drawings:
    • No interest is charged on partners’ drawings unless the deed specifies otherwise.
  4. Interest on Loans:
    • If a partner advances a loan to the firm, they are entitled to interest at 6% per annum unless otherwise agreed.
  5. Remuneration:
    • Partners are not entitled to a salary or remuneration for participating in the business unless it is expressly agreed in the deed.

4. Maintenance of Partners’ Capital Accounts

There are two primary methods for maintaining the capital accounts of partners:

a) Fixed Capital Method

  • Capital accounts remain fixed unless there is an introduction or withdrawal of capital.
  • Any adjustments for share of profit, interest on capital, drawings, and remuneration are recorded in separate Current Accounts.
  • Capital accounts will show a constant balance (unless additional capital is introduced or withdrawn), while current accounts fluctuate based on transactions.

Example:

  • A partner contributes Rs.1,00,000 as capital. At year-end, their capital account will still show Rs.1,00,000 unless additional capital is introduced or withdrawn. Profit shares, salaries, and drawings will be shown in a current account.

b) Fluctuating Capital Method

  • Under this method, all transactions (such as drawings, profit shares, interest on capital, etc.) are directly recorded in the capital account, causing it to fluctuate.
  • No separate current account is maintained.

Example:

  • If the same partner (with Rs.1,00,000 capital) receives Rs.10,000 as profit and withdraws Rs.5,000, their capital account will show Rs.1,05,000 at year-end.

5. Distribution of Profits

The Profit and Loss Appropriation Account is prepared to show how profits or losses are distributed among the partners.

Steps to Prepare the Profit and Loss Appropriation Account:

  1. Start with the Net Profit as determined from the Profit and Loss Account.
  2. Adjustments:
    • Interest on Capital: Credited to partners’ accounts.
    • Interest on Drawings: Charged to the partners’ accounts.
    • Salaries or Commissions: Credited to respective partners if the deed specifies.
  3. Balance Distribution:
    • The remaining profit is shared among the partners according to the agreed profit-sharing ratio.

6. Interest on Capital

Interest on capital is allowed when agreed upon in the partnership deed, usually to ensure that partners who contribute larger capital receive a fair return.

Calculation of Interest on Capital:

  • Scenario 1: If capital is contributed equally and the profit-sharing ratio is unequal, the partners may agree to pay interest on capital to balance the inequality.
  • Scenario 2: If capital is contributed unequally but profits are shared equally, the partners may still agree to pay interest on capital.

Example: If Partner A contributes Rs.2,00,000, and Partner B contributes Rs.1,00,000, with an interest rate of 10% per annum, Partner A will receive Rs.20,000 and Partner B Rs.10,000 as interest on capital.

In cases where capital is added or withdrawn during the year, interest is calculated on the average capital for the relevant time period.

7. Interest on Drawings

Interest on drawings discourages partners from withdrawing excessive amounts. The deed must specify the rate and terms for charging interest on drawings.

Methods of Calculation:

  1. Fixed Withdrawals at Regular Intervals:
    • If the same amount is withdrawn every month, interest is calculated based on the time of withdrawal (e.g., at the start, middle, or end of the month).
  2. Varying Withdrawals:
    • The Product Method is used. Each withdrawal is multiplied by the number of months it remained in the business, and the interest is calculated on the total product.

Example: If a partner withdraws Rs.10,000 at the beginning of each month and the interest rate is 8%, the interest would be calculated for 6.5 months on the total withdrawal amount.

8. Guarantee of Profit to a Partner

Sometimes a new partner is admitted with a guaranteed minimum profit. If the partner’s profit share falls below the guaranteed amount, the deficiency is borne by the remaining partners, either jointly or in a specified ratio.

Example:

Partner A and Partner B admit Partner C with a guarantee of Rs.25,000 as their share of profit. If the firm’s total profit is Rs.1,20,000 and C’s share (based on the profit-sharing ratio) is only Rs.20,000, then A and B must contribute Rs.5,000 to ensure that C receives Rs.25,000.

9. Reconstitution of Partnership Firms

A reconstitution of a partnership firm occurs due to:

  1. Admission of a new partner.
  2. Retirement or death of an existing partner.
  3. Changes in the profit-sharing ratio.

Each of these scenarios requires revaluation of the firm’s assets and liabilities, adjustment of goodwill, and redistribution of profits and losses.Example: On the admission of a new partner, the profit-sharing ratio is recalculated, and existing partners may have to share the goodwill of the firm with the incoming partner.

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