What Is A Partnership?: Two or More Individuals
What Is A Partnership?: Two or More Individuals
What Is A Partnership?: Two or More Individuals
As such, it covers
all of the outcomes in Section H of the Study Guide for FA2. It also provides underpinning knowledge for candidates studying
FFA/FA, Financial Accounting but it is not intended to comprehensively cover the Study Guides for those exams.
What is a partnership?
There are a number of ways in which a partnership may be defined, but there are four key elements.
Business arrangement
A partnership exists to carry on a business.
Profit motive
As it is a business, the partners seek to generate a profit.
Therefore, candidates need to be aware that there is a distinction to be made between the profit for the year (income minus expenses),
which is calculated in exactly the same way as for a sole trader and residual profit (the remaining profit after profit for the year has been
adjusted by the appropriations in accordance with the partnership agreement).
It’s worth pointing out that when a question states the profit or loss sharing ratio, that the proportions are always applied to the residual profit
– not the profit for the year.
Appropriations of profit
As there is no requirement for all of the appropriations considered below to be included by a specific partnership, exam questions may only
include some of them. That means that you only need to deal with the appropriations referred to in the question.
Another point to remember is that the Appropriation Account is an additional accounting statement that is required for a partnership. For a
sole trader, the profit for the year is simply transferred to the credit side of the proprietor’s capital account (the double entry is completed by a
debit entry in the income statement, resulting in a nil balance on that statement). In the case of a partnership, the income statement will still
be debited, but the profit will be credited to the appropriation account, rather than the capital account. As each appropriation is dealt with, the
double entry is completed through entries in both the appropriation account and the partner’s current account (if current accounts are not
maintained by the partnership, the entries will be made in the capital accounts).
Partners’ salaries
In some ways, the term ‘salaries’ is a misleading description. The salaries of employees are business expenses that are written off to the
income statement, thereby reducing profit for the year. However, as partners are the owners of the business, any amounts that are paid to
them under the partnership agreement are part of their share of the profit. As the amount is guaranteed, it must be dealt with through a credit
entry in the partner’s account (usually the current account) before the residual profit is shared.
Paying interest on capital is a means of rewarding partners for investing funds in the partnership as opposed to alternative investments. As
such, it reduces the amount of profit available for sharing in the profit and loss sharing ratio. This means that a debit entry is needed in the
Appropriation Account. The double entry is completed by a credit entry in the current account of the partner to whom the salary is paid.
Interest on drawings
Charging interest on drawings is a means of discouraging partners from withdrawing excessive amounts from the business. From this, it
follows that interest on drawings is a debit entry in the partners’ current accounts and a credit entry in the Appropriation Account.
Depending on what the question is testing, it will either provide the amounts of interest on capital and drawings or give details of how to
calculate the amounts.
Remember to deal with each of these appropriations before sharing the residual profit between the partners.
A final point in this context is that, if the total of the appropriations is greater than the profit for the year, the amount to be shared between the
partners will be a loss. This will mean that the entries for the share of the residual profit will be a credit in the Appropriation Account (thus
resulting in a nil balance) and debits in the partners’ current accounts.
In practice, however, it is convenient to separate the amount invested by the partner (the capital account) from the amount they have earned
through the trading activities of the partnership (the current account). Therefore, the capital account is usually fixed, while the current account
is the current total of appropriations and the share of residual profit/loss, less drawings.
Remember that a partner’s drawings will be a debit entry in the partner’s current account.
The admission of a new partner will also mean that the profit/loss sharing ratio will change.
The question will provide either the value of goodwill, or information to allow it to be calculated without much difficulty (see Example (ii)).
The first step is to create the asset of goodwill. This is a debit entry for the value of the goodwill in the goodwill account. The double entry is
completed with credit entries in the old partners’ capital accounts. The value of each entry is calculated by sharing the value of the goodwill
between the partners in the old profit and loss sharing ratio.
If goodwill is to be retained in the partnership (sometimes referred to as ‘carried in the books’) no further entries are required.
If goodwill is not to be carried in the books, it is eliminated by a credit entry in the goodwill account. The double entry is completed with debit
entries in the partners’ capital accounts. The value of each entry is calculated by sharing the value of the goodwill between the new partners
in the new profit and loss sharing ratio.
If a partner is contributing (or withdrawing) capital, the relevant amount will be recorded in both the partner’s capital account and the bank
account. A contribution will be a credit entry in the capital account and a debit entry in the bank account, and a withdrawal will be a debit
entry in the capital account and a credit entry in the bank account.
The interest on the loan will be a business expense and should therefore be debited to the income statement.
Examples
Amit and Burton are in partnership sharing profits in the ratio 3:2. The partnership’s profit for the year was $65,460. The partnership
agreement provides for:
interest to be paid on the partners’ opening capital balances at a rate of 5% per annum
interest on drawings at a rate of 8% per annum on all drawings during the year
partners’ salaries of Amit, $9,000; Burton, $5,000.
At the beginning of the year, the partners’ capital and current account balances were:
Capital Current
During the year, Amit’s drawings were $18,000 and Burton’s drawings were $31,000.
Solution
Amit – $38,443 Cr
Burton – $10,465 Dr
(ii) – Change in partnership
Amit and Binta have been in partnership, sharing profits and losses in the ratio 4:3. They agreed to admit
Chen to the partnership, with profits and losses being shared between Amit, Binta and Chen in the ratio
3:2:1. On the date of the change in partnership, the partners’ capital and current account balances
were:
Capital Current
It was agreed that, at the date of Chen’s admission, the partnership was to be valued at $164,300.
This value is credited to the old partners in the old profit and loss sharing ratio – ie 4/7 (or $24,000) to Amit and 3/7 (or $18,000) to Binta.
If goodwill is to be carried in the books, no further entries are needed, as the only change is that a new asset of goodwill has been created,
and the capital balances of the old partners have increased by the same value.
For example, the question may require the new partner to contribute cash so that the opening capital balance is nil.
In this case, a credit of $7,000 is needed in Chen’s capital account, so this is the amount of cash that must be contributed.