Chapter 006

Accounting for Partnerships

What is Partnership?A partnership can be defined as the relationship exists between two or more persons carrying on a business in a common with a view of profit.

Partnership Features

Partnership Agreement

Voluntary Association

Limited Life

Taxation

Unlimited Liability

Advantages of a partnership over a sole trader It shares business risks between

more than one person Each partner can develop special

skills upon which the other partners can rely

Greater resources will be available since more individuals will be the contributing to the business

Disadvantages of a partnership over a sole trader There may be disputes in the

running of the business Partners are jointly and severally

liable for their partners. Thus if one partner is being sued in relation to business, all partners share responsibility and potential liability.

Advantages of a partnership over a Company The arrangement is less formal

than setting up a company which requires the issue of shares and appointment of directors.

If the partners wish to dissolve the business, this is easier to achieve by a partnership than a company.

Disadvantages of a partnership over a Company The partners are not protected from

the creditors of business. Unless the partnership is set up as limited liability partnership, Partners have unlimited liability.

The life of partnership is short as compare to company.

Company can raise funds at a large scale than a partnership.

The partnership agreement A partnership agreement may be oral or

written, will govern the relationship amongst the partners. Important matters to be covered to be : Name of firm, type of business, and duration Capital to introduced by partners Distribution of profit amongst partners Drawings by partners Arrangement of dissolution, or on death or

retirement of partners Setting disputes

In the Absence of a Partnership Agreement in the UK, the Partnership Act 1890 states that profits should be shared as follows: No partner should receive salary No interest on capital should allowed Profits should be shared equally Where partners advance funds in excess

of agreed capital amount as loan, they are entitled interest on the excess at 5% pa.

Organizing a PartnershipPartners can invest both assets and liabilities in the

partnership.

Assets and liabilities are recorded at an agreed-upon value, normally fair market value.

Asset contributions increase the partner’s capital account.

Withdrawals from the partnership decrease the partner’s capital account.

Organizing a PartnershipOn 2/15/08, Smith and Jones form a

partnership. Smith contributes $80,000 cash. Jones contributes land

valued at $40,000.Feb. 15 Cash 80,000

Land 40,000 Smith, Capital 80,000 Jones, Capital 40,000

To record initial investment in partnership

Dividing Income or Loss

Three frequently used methods to divide income or loss are allocation on:

1. Stated ratios.2. Capital balances.3. Services, capital and stated ratios.

Partners are not employees of the partnership but are its owners. This means there are no salaries reported as expense on the income statement. Profits or losses of the partnership are divided on some agreed upon ratio.

Allocation Based on Stated Ratios

Smith and Jones agree to divide profits or losses ¾ for Smith and ¼ for Jones. For 2008, the partnership reported net income of $60,000.Dec. 31 Income Summary 60,000

Smith, Capital 45,000 Jones, Capital 15,000

To record division of 2008 net income.

$60,000 × ¾ = $45,000

Allocation Based on Capital Balances

Smith’s capital balance, before division of profits or losses is $80,000 and Jones’s capital balance is $40,000. The partnership agreement calls for income or loss to be allocated based on the relative capital balances. Net income for 2008 is $60,000.

Balance Ratio Income AllocationSmith, Capital 80,000$ 66.67% 60,000$ 40,000$ Jones, Capital 40,000 33.33% 60,000 20,000 Totals 120,000$ 100.00% 60,000$

Allocation Based on Capital Balances

Smith’s capital balance, before division of profits or losses is $80,000 and Jones’s capital balance is $40,000. The partnership agreement calls for income or loss to be allocated based on the relative capital balances. Net income for 2008 is $60,000.

Dr. Cr. Dec. 31 Income Summary 60,000

Smith, Capital 40,000 Jones, Capital 20,000

To record division of 2008 net income.

Allocation Based on Services, Capital, and

Stated Ratios Smith and Jones have a partnership

agreement with the following conditions:

Smith receives $15,000 and Jones receives $10,000 as annual salaries.

Each partner is allowed an annual interest allowance of 5% on the beginning-of-year capital balance.

Any remaining balance of income or loss is allocated equally.

Net income for 2008 is $60,000.

Smith Jones Remainder60,000$

15,000$ 10,000$ 35,000 4,000 2,000 29,000

14,500 14,500 - 33,500 26,500

SalariesNet income

Income Distribution

InterestEqual allocationIncome to each partner

Allocation Based on Services, Capital, and

Stated RatiosSmith Jones Remainder

60,000$ 15,000$ 10,000$ 35,000 4,000 2,000 29,000

14,500 14,500 - 33,500 26,500

SalariesNet income

Income Distribution

InterestEqual allocationIncome to each partner

Smith Jones Remainder60,000$

15,000$ 10,000$ 35,000 4,000 2,000 29,000

14,500 14,500 - 33,500 26,500

SalariesNet income

Income Distribution

InterestEqual allocationIncome to each partner

Smith Jones Remainder60,000$

15,000$ 10,000$ 35,000 4,000 2,000 29,000

14,500 14,500 - 33,500 26,500

InterestEqual allocationIncome to each partner

Net income

Income Distribution

Salaries

$80,000 × 5% = $4,000

$29,000 × ½ = $14,500

P2

Allocation Based on Services, Capital, and Stated Ratios

Smith and Jones have a partnership agreement with the following conditions:

Smith receives $15,000 and Jones receives $10,000 as annual salaries.

Each partner is allowed an annual interest allowance of 5% on the beginning-of-year capital balance.

Any remaining balance of income or loss is allocated equally.

Net income for 2008 is $30,000.

Allocation on Services, Capital, and Stated Ratios

Smith Jones Remainder30,000$

15,000$ 10,000$ 5,000 4,000 2,000 (1,000) (500) (500) -

18,500 11,500

SalariesNet income

Income Distribution

InterestEqual allocationIncome to each partner

($1,000) × ½ = $500

Partnership Accounts Profit and Loss Appropriation

Account: In this account profit or loss is distributed among partners according to agreement.

Partners’ Capital Account: In this account the amount of capital invested by owner is recorded. It is kept constant.

Partners’ current Account: In this account all changes in the business due to financial transaction are recorded.

Profit and Loss Appropriation AccountNet Profit : xAdd: Interest on drawings xLess: Salaries to partners (x)

Interest on Capital (x) Commission to partners (x)

Balance Profit: xA: 3 xB: 2 x

Capital Account

Date Narrative Ref A B Date Narrative Ref A B

2008         2008        

          1-Jan Balance b/d   x  x

                   

31-Dec Balance c/d   (x) (X)          

                   

   Total    x x    Total   x  x

Current Account

Date NarrativeRef A B Date Narrative Ref A B

2008         2008        

31-Dec Drawings   X x 1-Jan Balance b/d x x

 Interest on Drawings   X x 31-Dec

Interest on Capital X x

31-Dec Balance c/d  (X) (X)   Salaries X x

            Profit share   x  x

  Total     x x    Total   x  x

ExampleC, S and N are partners in a music business, sharing profits in the

ratio of 5:3:2 respectively. Their capital and current account balances on January 1,2005 are as:

CapitalCurrent AccountC 24000 2000S 18,000 (1000)N 13,000 1500

Interest on fixed capital is 10% per annum and salaries of $8,000 P.A are credited to S and N.C made a personal loan of $20,000 on July 1, 2005. the loan was to be repaid in full on June 30,2008 and loan interest is at the rate of 15% per annum was to be credited C’s every half year.The partnership profit before charging interest on loans for the year ended December 31, 2005 was $63,000 and partners’ drawings were C $16000, S $16,500 and N $19,000 during the year.

Required: Prepare Appropriation Account, Capital Account and Current account of partners.

SolutionAppropriation Account

For the year ended December 31,2005

$ $Net Profit : (63000-1500) 61,500

Less: Interest on Capital:C: (24,000 x 10%) 2400S (18,000 x 10%) 1800N (13,000 x 10%) 1300SalariesS 8000N 8000 (21,500)

Balance Profit 40,000Partner’s ShareC: 5/10 x 40,000 = 20,000S: 3/10 x 40,000 = 12,000N: 2/10 x 40,000 = 8,000

Capital Account

DateNarrative

Ref C S N

Date

Narrative

Ref C S N

2005          200

5          

           1-

JanBalance b/d   2400

01800

01300

0

                       

31-Dec

Balance c/d   2400

01800

0 13000            

                       

      24000

18000 13000       2400

01800

01300

0

Current Account

DateNarrative

Ref C S N Date

Narrative

Ref C S N

2005          2005 1-Jan

Balance b/d   2000   1500

1-JanBalance c/d     1000  

31-Dec

Interest on Capital   2400 1800 1300

  Drawings   16000

16500

19000

31-Dec

Interest on Loan   1500

31-Dec

Balance c/d   9900

4300     Salaries  

8000 8000

             Profit share 20,00

012,00

0 8,000

             Balance c/d       (200)

      25900

21800

19000     2590

02180

0 19000

Example: Financial Statements

The Trial Balance of two partners Ken and Barbie at 30 June 2006

Accounts $ $ Irrecoverable debts 2350Rent and rates 35,000Motor expenses 17,400Allowance for receivables 5,450Motor vehicle- cost 32,750Accumulated Dep- Motor vehicle 15,578Cash at bank 467Drawings – Ken 13,500Drawings- Barbie 15,000Inventory 3,000

Fixtures and fittings- cost 27,000Accumulated Dep- Fixtures& Fittings 13,500Sundry Expenses 14,780Sales 157,000Payables 9,800Receivables 16,000Purchases 96,000Current account- Ken, 7,655Current account – Barbie 9,264Capital Account – Ken 35,000Capital Account – Barbie 20,000Total 273,247 273,247

Adjustments:1. Closing Inventory is valued $4,500.2. Fixtures and Fittings have not yet been

depreciated , the applicable rate is 10% straight line.

3. Prepayments at the year end were $2,500 in respect of Rates.

4. On the last day of the year Ken paid $13,000 to the business bank account as loan.

5. Barbie is allowed a salary of $7,500.6.Interest on capital is provided at 8% per annum.7. The balance of profits is split equally.Required: 1. Prepare income statement2. Statement of division of profits3. Partners’ current accounts 4. Balance sheet

Solution1. Inventory For closing inventory:

Dr: Inventory 4,500 Cr: Income Statement 4,500

For Opening Inventory: Dr: Income Statement 3,000 Cr: Inventory 3,000

2. Non Current Assets:Depreciation of Fixtures and

fittings for June 30 2006:Cost $27,000 x 10% = $2,700

3. For Ken loan entry would be:Dr: Cash $13,000Cr: Ken’s Loan $13,000

4. Rent and rates: Prepaid Expenses:Total Rent Paid = $35,000Less: Prepaid Rent: =($2,500)Rent Expense = $32,500

Ken and Barbie Income Statement

For the year ended June 30, 2006

$ $ Revenues:Sales 157,000Less: Cost of Goods Sold:

Opening Inventory

3,000 Add: Purchases 96,000 Less: Closing inventory

(4,500) (94,500)

Gross Profit 62,500

Less: Expenses:Irrecoverable debts 2,350

Rent and rates 32,500

Motor expenses 17,400

Sundry expenses 14,780

Depreciation expenses 2,700 (69,730)

Net Profit (Loss) (7,230)

Statement of Division of Profit

KEN BARBIE Balance

$ $ $

Net Loss (7,230)

Salary 7,500 (14,730)

Interest on capital

2,800 1,600 (19,130)

Loss share

(9,565) (9,565) (19,130)

Total (6765) (465)

Current Account

Date Narrative Ref Ken Barbie Date Narrative Ref Ken Barbie

         

June30, 06

Share of loss   6,765 465

1-Jul,05

Balance b/d   7,655 9,264

  Drawings   13,500 15,000June

30, 06Balance c/d   12,610 6,201

  20,265 15,465     20,265 15,465

Ken and Barbie Balance Sheet

As on June 30, 2006AssetsNon Current Assets: $ $ $

Motor Van 32,750

Less: Accum Dep: (15,578) 17,172

Fixtures and Fittings 27,000

Less: Accum Dep: (16,200) 10,800 27,972

Current Assets $ $ $

Inventory 4,500

Receivables 16,000

Less: Allowance for Receivables (5,450) 10,550

Prepayments 2,500

Cash at Bank (467 + 13,000) 13,467 31,017

Total Assets 58,989

Capital and Laibilities $ $Capitals: $Ken:Capital 35,000

Current Account (12,610) 22,390Barbie:Capital account 20,000 Current account (62,01) 14,799 37189

Current Liabilities

Payables 9,800

Loans 13,000 21,800

Total Capital and Liabilities 58,989

Chapter End