Accounting Articles for Students

Accounting for partnerships

by Christopher J Pyke | Published on 2/28/2003

A partnership is defined as a relationship between two or more individuals in which they agree to operate as a joint business and share the risks and rewards. A partnership must comply with the Partnership Act of 1932 in Pakistan and the Partnership Act of 1890 in Britain and if there is a limited partner then the Limited Partnership Act of 1907 is also relevant for Britain.

When a partnership is established the partners will usually draw up a partnership agreement. The Partnership Act does not specify the content of a partnership agreement but it might include:

-    the name and nature of the partnership business;
-    the amount of capital that will be contributed by each partner;
-    how the profits (and losses) will be shared;
-    the interest rate that will be applied to capital before profits are shared;
-    the interest rate that will be charged to partners on drawings;
-    the salaries that will be paid to partners;
-    the arrangements for the admission of new partners;
-    the procedures to be carried out when a partner retires or dies.

If there is no formal agreement between the partners then the Act contains certain provisions that are presumed to apply:

-    residual profits and losses are shared equally between the partners;
-    there are no partners’ salaries;
-    partners receive no interest on capital;
-    partners are entitled to interest of 5% per annum on any loans to the business.

Preparing partnership accounts
Partnership accounts are very similar to sole trader accounts. The assets of the partnership are brought together in a balance sheet and the net profit is calculated in the same way as a sole trader. The obvious difference between a sole trader and a partnership is that in a partnership the owners’ equity needs to be divided between the partners. Indeed, most partnerships will divide the owners’ equity of each partner between capital and current accounts.

Capital and current accounts
The capital account represents the amount which the partners have invested in the partnership and is sometimes referred to as fixed capital. The amount of the fixed capital can be changed by agreement between the partners.

The current accounts represent the balance of the partners’ equity and in general represent each partner’s accumulated share of profits less any amounts withdrawn to date (see Box 1 at the bottom of the page). Separate ledger accounts, for capital and current accounts are maintained for each partner.

Drawings accounts
During the year partners will usually withdraw cash for personal use. To keep the current accounts simple a separate drawings account will be used for each partner, then at the end of each year the balances on the drawing accounts will be transferred to the current accounts.

The appropriation of profit
Partnership accounts need to include a statement that shows how the profit or loss for the year is divided between the partners. This statement is usually called the profit and loss appropriation account (see Box 2 at the bottom of the page).

Unless the partnership is operating in accordance with the Partnership Act, the partners will have to agree on how the profits and losses will be shared between them, i.e., they must agree a profit sharing ratio. The profit sharing ratio will depend on a number of factors such as the:

-    amount of capital introduced by the partners;
-    amount of time each partner devotes to the business;
-    skills and experience of the partners.

Some partnership agreements attempt to take specific account of these factors by using a more complex approach, i.e., basing the apportionment of profit on the following three considerations:

-    interest on capital (and possibly on current accounts);
-    salaries;
-    share of the balance.

Interest on capital
An amount is normally paid to partners based on a rate of interest on capital. This is intended to compensate partners in proportion to the amount of capital they have contributed. The interest rate is usually fixed in the partnership agreement and will therefore not reflect changes in the market rate of interest which have occurred since the partnership was established.

The partners may also agree to give interest on credit balances, or an average of credit balances over the year, that are on the individual current accounts. This will be particularly appropriate when there are large credit balances and when they differ substantially between partners.

Salaries
A salary paid to a partner is not charged against the profit and loss account, but is drawn against a partner’s share of the profits. Using a salary component in a profit sharing arrangement is a good way of rewarding partners who provide more valuable services to the partnership either through the amount of time they spend on the business or because of the particular skills they can contribute.

Partners’ loan account
Sometimes partners make advances to the partnership in addition to their capital contributions. In these circumstances the partners’ loan is treated the same as any other loan to the business and is kept separate from the partners’ capital and current accounts. Interest on the loan is charged against the profit and loss account and not debited to the appropriation account. If the partnership was dissolved for any reason the partnership loan would be paid before the partners’ capital, but would rank after the amounts due to outside creditors.

Retirement or death of a partner
Any changes in a partnership require a new partnership agreement, as the arrangements relating to appropriation of profits etc. are likely to be changed. Legally the old partnership is dissolved and a new partnership created, but from the accounting point of view it is more realistic to make appropriate adjustments in the existing partnership books, rather than close them off and start afresh.

When an existing partner dies or retires from the partnership, their share of the partnership assets must be calculated and transferred to them. Unless all the partnership assets and liabilities are correctly valued in the books, the partners’ capital and current account total will not show their actual entitlement.

Normally the true worth of the partnership will exceed the book figure of net assets, and so various assets/liabilities will have to be re-valued and goodwill taken into account, if only on a temporary basis. When the assets are re-valued, any profit or losses on revaluation are entered, in the profit sharing ratio, in the partners’ capital accounts. Usually since a number of items are affected, a revaluation account is used to arrive at a total balance of profit and loss on revaluation. This balance is then divided between the partners in profit sharing ratio in their capital accounts.

Calculating goodwill
The goodwill of a partnership is defined as the difference between the value of the business as a whole and the sum of the values of the identifiable assets less the sum of its liabilities. Goodwill, whether internally generated or purchased, is dependent on a number of factors such as business location, reputation of the business, staff and personalities and the ability to earn profits.

There are many ways of arriving at a value for goodwill and most of them are related to the profit generated by the business.

Average profit method — Goodwill is calculated by multiplying the average profit for x number of years by y. Both x and y would need to be agreed by the partners, or specified in the partnership agreement.

Average revenue method — The same method as above but using average revenue (i.e., sales) instead of average profit.

Future profits — Goodwill is based on some estimate of the future cash flows generated by the business less the value of assets and liabilities.

Conclusion
This article has briefly outlined some of the accounting features of partnerships. There are many good accounting textbooks that explain in more detail the accounting treatment necessary in preparing partnership accounts.


Box 1 — Example of a partners’ current account
 

Box 2 — Example of a Profit and Loss Appropriation Account

Article courtesy of ACCA Accountant