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Accounting For Partnership

Learning Outcomes: Understand the concept of partnership Understand the journal entries for the formation

of partnership, distributing profit or loss, admission of new partners and retirement of partners

Able to prepare financial statements for partnership

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Partnership Act 1961

“… is the relation which subsists between persons carrying on business in common with a view of profit.”

Sec 3(1)

Definition

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Separate legal personality (for the purpose of financial reporting only)

Unlimited liability Limited life Co-ownership of property Co-ownership of profits

Characteristics

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Advantages Ease of formation and dissolution Better management Greater capital compared to proprietorship

Disadvantages Easily dissolved/limited life Unlimited liability Difficulty in transferring ownership Conflict among partners Lesser capital compared to corporation

Advantages & Disadvantages

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Minimum members is 2 and should not exceed 20.

Not necessarily in the form of written agreement. Verbal agreement is accepted.

All matters related to partnership must be referred to an agreement. If no agreement exists in relation to certain issues, statutes in the Partnership Act 1961 would be applied.

Formation

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This agreement is framework which governs the formation, operations, dissolution and liquidation of the partnership

Contents: Name, nature & scope of partnership Authority, rights & duties of each partner Methods of sharing profits & losses Rates of interest for capital & drawings Salaries Provision for arbitration of disputes & liquidation of

the partnership

Partnership Agreement

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When no partnership agreement exists: Profits and losses are to be shared equally No interest allowed on capital No interest to be charged on drawings No salaries are allowed Interest 8% p.a. is charged on the advance (loan)

made by a partner to the partnership Each partner has unlimited liability.

Cont.

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Partnership vs Proprietorship

Proprietorship

Net Profit

Partnership

Net Profit

Balance Sheet

Balance Sheet

Partner’s Account

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Two methods available to present the equity in the balance sheet:

i. Fixed Capital Account

ii. Fluctuating Capital Accounts

The capital account will record the initial introduction of capital, and will normally only be adjusted if the partner introduces additional capital.

Reporting Equity in BS

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The current account will record transactions relating to partners other than transactions related to capital such as share of profits/losses, interest on withdrawals, interest on loan etc.

If the partnership maintains fluctuating capital accounts, there will be no current account, and appropriations of profit and drawings will be recorded in the capital account.

Cont.

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Fixed Capital Account

Cont.

Capital Account

Ali Abu Ali Abu

Bank 2,000 6,000

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Fixed Capital Account

Cont.

Current Account

Ali Abu Ali Abu

Int. on capital

100 300

Int. on drawings

Drawings

Bal. c/d

2,000 2,000

100 50

600 400

2,650 2,500

Profits 2,550 1,700

Salaries 500

2,650 2,500

Bal. b/d 600 400

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Fluctuating Capital Account

Cont.

Capital Account

Ali Abu Ali Abu

Int. on capital 100 300

Int. on drawings

Drawings

Bal. c/d

2,000 2,000

100 50

2,600 6,400

4,650 8,500

Profits 2,550 1,700

Salaries 5004,650 8,500

Bal. b/d 2,600 6,400

Bank 2,000 6,000

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See Illustration 1 from Siti et al (2008), PA, p. 8

Cont.

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Initial Investment

Initial investment made by partners will be credited into their respective Capital Account.

Non cash assets need to be recorded at their fair value at the date of investment.

Liabilities brought into the partnership have to be recorded at fair value.

Accounting Treatments

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Additional Investment

Similar accounting entries as to the initial investment: Record asset at it’s fair value Credit the amount to partner’s capital account

Withdrawal of Investment

The withdrawal amount needs to be debited to partner’s capital account

Accounting Treatments

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Loan

Any loan provided by a partner is a liability to the partnership. This partner is entitled to receive a certain percentage of interest on the loan given. Interest on loan will be treated as expenses of the firm & will be recorded in income statement.

Interest on capital

Interest was given for the purpose of encouraging

partners to invest in the business.

Cont.

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Other issues

All amounts received by each partner for the current period (e.g. salaries, interest on capital, profit-loss, bonus etc.) would be credited to respective partner’s Current Account.

A key point to remember is that as in a sole trader's accounts, any amounts actually paid to the owners (whether in cash or in kind) should be treated as drawings.

Cont.

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If a partner is entitled to a salary, it is dealt with as part of the appropriation of profit.

It is not an expense of the business, and should not be charged to the income statement in order to calculate profit.

Only salaries paid to employees of the business are charged to the income statement.

Cont.

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Residual Profit

Profit which is divided between the partners in the profit and loss sharing ratio.

It is the amount of profit remaining after taking into account the fact that the partners will be entitled to a proportion of the profit under the terms of the partnership agreement.

These proportions are the 'appropriations of profit'. Profit-Loss Appropriation Account is prepared to determine the current profit received by each partner.

Cont.

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It should be noted that while salaries and interest on capital will reduce the amount of residual profit to be shared between the partners, interest on drawings will increase the residual profit.

Cont.

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Comprehensive Example The net profit for the partnership between Azlan and Chong for the year ended 31 December 20X8 was RM28,500. The capital accounts and current accounts for the partnership on 1 January 20X8 were as follow:

Capital accounts:

Azlan RM40,000

Chong RM50,000

Current accounts:

Azlan RM2,160

Chong RM1,500

In the year 20X8, Azlan has withdraws RM2,000 on 31 Mac 20X8. Azlan has been paid RM10,000 for his salary.

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Cont. The contents of the partnership agreement are as follow:

i. Interest on the initial capital is 5% per year

ii. Azlan would be paid RM12,000 per year for his salary

iii. 8% interest per year would be levied on withdrawals by the partners

iv. Azlan and Chong share a profit/loss in a ratio of 2:3

Prepare:

(a) The allocation of profit-loss using Profit-Loss Separation Account or Profit-Loss Separation statement for the year ending 31 December 20X8.

(b) Capital account and current account for each partner

(c) A balance sheet (equity section) as at 31 December20X8

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Typical events that requires special treatment and may change the partnership structures:

1. Change in profit sharing ratio

2. Admission of new partners

3. Death or retirement of existing partner

If this happened, 2 issues are considered: Revaluation of assets Goodwill

Changes in Partnership Structure

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Revaluation of Assets The fair value of partnership needs to be determined whenever there is a change in the partners.

Why?

Partnerships net assets are usually recorded at historical cost, not at fair market value. But, the purchase or settlement of price is based on number of factors, including the fair value of the partnership’s net assets. Thus providing an equitable measure of each partner’s capital interest before any admission or retirement takes place.

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Cont. Revaluation Account

When assets or liabilities are revalued, the increments (credit) or decrement (debit) to an account called Revaluation Account.

The balance of this account will be transferred to the existing partner’s capital account or retained profits accounts based on the profit sharing ratios.

See Illustration 2 (Handout)

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Cont. One contentious issue is whether to value the unidentifiable assets, i.e. goodwill and to record their fair value.

Goodwill Recorded

The preferred approach is to revalue all the assets and liabilities to fair value including identifiable and unidentifiable assets and liabilities.

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Cont. Any increase or decrease in net assets is allocated to the existing partners according to profit sharing ratios.

By using this approach, the fair value of the net assets is recognised, thus providing an equitable measure of each partner’s capital interest before any admission or retirement takes place.

See Illustration 4 from Siti et al (2008), PA, p. 39

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Cont. Goodwill Not Recorded

Two arguments for this approach:

i. Even though the old partnership is dissolved, the

business activity continues without interruptions. No

justification for valuing and raising goodwill.

ii. The value of goodwill is subjective and therefore should

not be recorded.

See Illustration 3 from Siti et al (2008), PA, p. 37

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Changes to the Profit Sharing Ratio

The partners decide to change the existing profit & loss sharing ratio.

Reasons:

i. A partner cannot perform as well as before may be due to ill-

health, old age etc.

ii. The partner’s skills & competency have changed that affect

his/her performance

iii. A partner become more efficient

See Illustration 6

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Admission of a New Partner The admission of a new partner results in legal dissolution of the existing partnership and the beginning a new one.

There are three steps in the admission of a new partner:

i. Revalue identifiable assets of old partnership

ii. Resolve whether the to record the goodwill of old partnership

iii. Admit the new partner

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Cont. A person wishing to acquire an interest in an existing partner may do so by:

i. Purchasing an interest directly from an existing partner

The admission of a partner by purchase of an interest in the firm is a personal transaction between one or more existing partners and the new partner.

The price paid is negotiated and determined by the individuals involved; it may be equal to or different from the capital equity acquired.

Any money or other consideration exchanged is the personal property of the participants and not the property of the partnership.

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Cont. ii. Contributing assets (investment) to the partnership.

When a partner is admitted by investment, both the total net assets and the total partnership capital change.

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Retirement/Death of a Partner The retirement/death of a partner dissolves the partnership.

It is necessary to determine the partner’s equity at the date of retirement death.

This is done by:

1) determining the net income or loss for the year to date,2) closing the books, and3) preparing financial statements.

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Retirement of a Partner The surviving partners will agree to either:

1) purchase the deceased partner’s equity from their

personal assets or

2) use partnership assets to settle with the deceased

partner’s estate.

See illustration 8 (handout)