Chapter Notes

Nature of Partnership

When two or more people decide to start a business together and share its profits and losses, they have formed a partnership. The Indian Partnership Act of 1932 officially defines a 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."

The individuals in the partnership are called 'partners', and together they are known as the 'firm'. The name they operate under is the 'firm's name'.

For a business to be considered a partnership, it must have the following essential features:

• Two or More Persons: A partnership must have at least two people. The Companies Act 2013 gives the Central Government the power to set the maximum number of partners, which cannot be more than 100. Currently, the maximum number of partners allowed in a firm is 50.
• Agreement: A partnership is born from an agreement between the partners. This agreement, which outlines how they will conduct business and share profits, can be either oral or written. While an oral agreement is valid, a written one is always preferred to prevent future disputes.
• Business: The partners must agree to carry on a specific business. Simply co-owning property does not make people partners. [!example] If Rohit and Sachin buy a piece of land together, they are just joint owners. However, if they are in the business of buying and selling land to make a profit, they are considered partners.
• Mutual Agency: The phrase "carried on by all or any of them acting for all" is the foundation of this feature. It means that a relationship of mutual agency exists between partners. Each partner acts as both a principal (owner) and an agent for all other partners. This means one partner's actions in the course of business can bind all other partners. If this element of mutual agency is missing, a partnership does not exist.
• Sharing of Profit: The main goal of the partnership must be to share profits and losses. The definition in the Act mentions sharing profits, but the sharing of losses is implied. An organization created for charitable purposes is not a partnership.
• Liability of Partners: Each partner has unlimited liability. This means they are jointly and individually responsible for all the firm's debts. If the firm cannot pay its debts, a partner's personal assets can be used to settle them.

Partnership Deed

A partnership is formed through an agreement, which can be oral or written. When this agreement is put in writing, the document is called a Partnership Deed. It serves as the rulebook for the partnership, detailing all the terms and conditions that govern the relationship between the partners.

A Partnership Deed typically includes the following details:

• Names and addresses of the firm and its partners.
• The nature of the firm's main business.
• The amount of capital contributed by each partner.
• The profit and loss sharing ratio.
• The date the partnership started and its accounting period.
• Rules for operating bank accounts.
• The rate of interest on capital, loans, and drawings.
• Details about salaries or commissions payable to any partner.
• The rights, duties, and liabilities of each partner.
• Procedures for settling accounts upon dissolution of the firm or in case of admission, retirement, or death of a partner.
• Methods for resolving disputes among partners.

Provisions of Partnership Act Relevant for Accounting

If a Partnership Deed does not exist, or if it is silent on certain issues, the provisions of the Indian Partnership Act, 1932 automatically apply. For accounting purposes, these rules are:

• Profit Sharing Ratio: Profits and losses are to be shared equally among all partners, regardless of their capital contribution.
• Interest on Capital: No partner is entitled to receive interest on the capital they have contributed.
• Interest on Drawings: No interest is to be charged on any money withdrawn by partners for personal use.
• Interest on Loan: If a partner has given a loan to the firm, they are entitled to receive interest at a rate of 6% per annum.
• Remuneration for Firm's Work: No partner is entitled to a salary or any other form of payment for participating in the business.

Furthermore, the Act states that unless otherwise agreed:

• If a partner earns a profit from any transaction of the firm or by using the firm's property or name, they must pay that profit to the firm.
• If a partner runs a business that competes with the firm's business, they must pay all profits earned from it to the firm.

Special Aspects of Partnership Accounts

Accounting for a partnership firm is very similar to that of a sole proprietorship, but with a few key differences related to the partners themselves:

• Maintenance of Partners' Capital Accounts.
• Distribution of Profit and Loss among the partners.
• Adjustments for past errors in profit appropriation.
• Reconstitution of the firm (e.g., admitting a new partner).
• Dissolution of the firm.

This guide focuses on the first three aspects.

Maintenance of Capital Accounts of Partners

All transactions related to the partners—such as capital contributions, withdrawals, share of profit, salary, and interest—are recorded through their capital accounts. There are two methods for maintaining these accounts: the Fixed Capital Method and the Fluctuating Capital Method.

Fixed Capital Method

Under this method, the initial capital contributed by each partner remains fixed or unchanged, unless a partner introduces additional capital or permanently withdraws capital as per the agreement.

All other adjustments—like share of profit, interest on capital, drawings, and interest on drawings—are recorded in a separate account for each partner, called the Partner's Current Account.

This means two accounts are maintained for each partner:

1. Capital Account: This account only records the initial, additional, or withdrawn capital. It will almost always show a credit balance.
2. Current Account: This account records all other transactions between the partner and the firm. It can have either a debit or a credit balance.

Fluctuating Capital Method

Under this method, only one account—the Capital Account—is maintained for each partner. All transactions, including capital contributions, share of profit, salary, drawings, and interest, are recorded directly in this single account.

As a result, the balance of the capital account fluctuates from year to year. This is the default method used if the partnership agreement or problem instructions do not specify which one to follow.

Distinction between Fixed and Fluctuating Capital Accounts

Distribution of Profit among Partners

Profits and losses are distributed among partners according to their agreed-upon ratio. If the Partnership Deed is silent, profits and losses are shared equally.

In a partnership, certain adjustments related to the partners must be made before the final profit is distributed. To do this, a Profit and Loss Appropriation Account is prepared.

Profit and Loss Appropriation Account

This account is an extension of the firm's Profit and Loss Account. Its sole purpose is to show how the net profit (or loss) is appropriated or distributed among the partners.

It starts with the net profit or loss from the P&L Account. The following adjustments are made here:

• Debited (items that reduce the distributable profit):
  • Interest on Capital
  • Salary to a Partner
  • Commission to a Partner
• Credited (items that increase the distributable profit):
  • Interest on Drawings

After making these adjustments, the final balance (divisible profit or loss) is transferred to the partners' capital or current accounts in their profit-sharing ratio.

Interest on Capital

Interest on capital is only allowed if it is explicitly mentioned in the Partnership Deed. It is a way to compensate partners for contributing capital to the firm, especially when:

• Partners contribute unequal amounts of capital but share profits equally.
• Partners contribute equal capital but have an unequal profit-sharing ratio.

Interest is calculated on the amount of capital and for the time period it has been used in the business. This means adjustments must be made for any additional capital introduced or capital withdrawn during the year.

How to Calculate Interest on Capital:

1. Calculate interest on the opening capital balance for the entire year.
2. Calculate interest on any additional capital from the date it was introduced until the end of the financial year.
3. If capital is withdrawn, calculate interest on the opening balance up to the date of withdrawal, and then on the reduced balance for the rest of the year.

Important Rules for Interest on Capital:

• If the firm has a loss: No interest on capital is allowed.
• If profit is less than the interest: If the firm's profit is not enough to cover the full interest on capital for all partners, the interest will be paid only up to the amount of available profit. In this case, the available profit is distributed among partners in the ratio of their interest on capital, not their profit-sharing ratio.

Interest on Drawings

The Partnership Deed may also require charging interest on money that partners withdraw for personal use (drawings). The purpose of charging interest on drawings is to discourage partners from withdrawing excessive amounts from the firm. If the deed is silent, no interest is charged.

The calculation method depends on the pattern of withdrawals.

When Fixed Amounts are Withdrawn Every Month

If a partner withdraws a fixed amount every month, we can use an average period to simplify the calculation. The average period depends on whether the withdrawal is made at the beginning, middle, or end of the month.

• Beginning of every month: Interest is calculated for an average period of 6.5 months.
• Middle of every month: Interest is calculated for an average period of 6 months.
• End of every month: Interest is calculated for an average period of 5.5 months.

Formula: Interest = Total Drawings × Rate/100 × Average Period/12

When a Fixed Amount is Withdrawn Quarterly

Similarly, for fixed quarterly withdrawals:

• Beginning of each quarter: Interest is calculated for an average period of 7.5 months.
• End of each quarter: Interest is calculated for an average period of 4.5 months.

When Varying Amounts are Withdrawn at Different Intervals

If a partner withdraws different amounts at different dates, the product method is used.

1. Calculate the Period: For each withdrawal, determine the number of months from the date of withdrawal to the end of the financial year.
2. Calculate the Product: Multiply the amount of each withdrawal by its corresponding period.
3. Sum the Products: Add up all the products.
4. Calculate Interest: Apply the interest formula for one month on the total of the products.

Formula: Interest = Total of Products × Rate/100 × 1/12

When Dates of Withdrawal are Not Specified

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

Guarantee of Profit to a Partner

Sometimes, a new or existing partner is given a guarantee of a minimum amount of profit. This means that if their actual share of profit is less than the guaranteed amount, the difference (deficiency) will be covered by the other partners.

This guarantee can be given by:

• All the other partners in their existing profit-sharing ratio.
• One or more of the old partners individually.

How it works:

1. Calculate the new partner's actual share of profit based on the profit-sharing ratio.
2. Compare this share with the guaranteed amount.
3. If the actual share is less than the guarantee, the difference is the deficiency.
4. This deficiency is then borne by the guaranteeing partner(s) according to their agreement. Their own share of profit is reduced by the amount of deficiency they cover.

• Kanishka's actual share = 1/6 of Rs. 1,20,000 = Rs. 20,000.
• Deficiency = Rs. 25,000 (guaranteed) - Rs. 20,000 (actual) = Rs. 5,000.
• This deficiency is borne by Madhulika and Rakshita in their ratio of 2:3.
  • Madhulika bears: 2/5 of Rs. 5,000 = Rs. 2,000.
  • Rakshita bears: 3/5 of Rs. 5,000 = Rs. 3,000.
• Final Profit Distribution:
  • Madhulika: Rs. 40,000 - Rs. 2,000 = Rs. 38,000.
  • Rakshita: Rs. 60,000 - Rs. 3,000 = Rs. 57,000.
  • Kanishka: Rs. 20,000 + Rs. 5,000 = Rs. 25,000.

Past Adjustments

Sometimes, after the final accounts have been prepared and profits distributed, errors or omissions are discovered. These might include forgetting to account for interest on capital, interest on drawings, or a partner's salary.

Instead of redoing all the old accounts, these errors can be corrected by making a single adjustment entry at the beginning of the next financial year. This is done by first calculating the net effect of the error on each partner's capital account.

Steps for Making an Adjustment:

1. Create a statement or table showing what each partner should have received (e.g., interest on capital, salary) and what they should have paid (e.g., interest on drawings).
2. Calculate the total effect on the firm's profit. For instance, omitting interest on capital means the profit distributed was higher than it should have been.
3. Determine the profit that was wrongly distributed and calculate how much of it each partner received. This is treated as a debit to their account.
4. Compare what each partner should have been credited/debited with versus what they were actually credited/debited.
5. The net effect will show which partner received too much (and needs to be debited) and which partner received too little (and needs to be credited).
6. Pass a single journal entry to rectify the error, debiting the partner(s) who received excess and crediting the partner(s) who received less.