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CHAPTER 16
PARTNERSHIP ACCOUNTS
We have learnt about the preparation of final accounts for a sole proprietary concern. As the business expands, one needs more capital and larger number of people to manage the business and share its risks. In such a situation, people usually adopt the partnership form of organisation.
When two or more individuals engage in enterprise as co-owners, the organization is known as a partnership.
In India, we have a definite law that covers all aspects and functioning of a partnership, “The Indian Partnership Act 1932”.
The act defines a partnership as “the relation between two or more persons who have agreed to share the profits from a business carried on by either all of them or any of them on behalf of/acting for all”.
The entity is collectively called a “Partnership Firm” and all the individual members are the “Partners”.
Thus, the essential features of partnership are:
1. Two or More Persons:
In order to form partnership, there should be at least two persons coming together for a common goal. In other words, the minimum number of partners in a firm can be two.
There is however, a limit on their maximum number. By virtue of Section 464 of the Companies Act 2013, the Central Government is empowered to prescribe maximum number of partners in a firm but the number of partners cannot be more than 100.
The Central government has prescribed the maximum number of partners in a firm to be 50.
2. Agreement:
Partnership is the result of an agreement between two or more persons to do business and share its profits and losses.
The agreement becomes the basis of relationship between the partners.
It is not necessary that such agreement is in written form. An oral agreement is equally valid. But in order to avoid disputes, it is preferred that the partners have a written agreement.
3. Business:
The agreement should be to carry on some business. Mere co-ownership of a property does not amount to partnership.
For example, if Rohit and Sachin jointly purchase a plot of land, they become the joint owners of the property and not the partners.
But if they are in the business of purchase and sale of land for the purpose of making profit, they will be called partners.
4. Mutual Agency:
The business of a partnership concern may be carried on by all the partners or any of them acting for all.
This statement has two important implications.
First, every partner is entitled to participate in the conduct of the affairs of its business.
Second, that there exists a relationship of mutual agency between all the partners.
Each partner carrying on the business is the principal as well as the agent for all the
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other partners.
He can bind other partners by his acts and also is bound by the acts of other partners with regard to business of the firm.
Relationship of mutual agency is so important that one can say that there would be no partnership, if the element of mutual agency is absent.
5. Sharing of Profit:
Another important element of partnership is that, the agreement between partners must be to share profits and losses of a business.
6. Liability of Partners:
Each partner is liable jointly with all the other partners and also severally to the third party for all the acts of the firm done while he is a partner.
Not only that the liability of a partner for acts of the firm is also unlimited.
This implies that his private assets can also be used for paying off the firm’s debts.
Partnership Deed
Partnership comes into existence as a result of agreement among the partners.
The agreement can be either oral or written.
The Partnership Act does not require that the agreement must be in writing.
But wherever it is in writing, the document, which contains terms of the agreement is called ‘Partnership Deed’.
It generally contains the details about all the aspects affecting the relationship between the partners including the objective of business, contribution of capital by each partner, ratio in which the profits and the losses will be shared by the partners and entitlement of partners to interest on capital, interest on loan, etc.
The clauses of partnership deed can be altered with the consent of all the partners.
The deed should be properly drafted and prepared as per the provisions of the ‘Stamp Act’ and preferably registered with the Registrar of Firms.
Contents of the Partnership Deed
The Partnership Deed usually contains the following details:
• Names and Addresses of the firm and its main business;
• Names and Addresses of all partners;
• Amount of capital to be contributed by each partner;
• The accounting period of the firm;
• The date of commencement of partnership;
• Rules regarding operation of Bank Accounts;
• Profit and loss sharing ratio;
• Rate of interest on capital, loan, drawings, etc.
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• Salaries, commission, etc, if payable to any partner;
• The rights, duties and liabilities of each partner;
• Treatment of loss arising out of insolvency of one or more partners;
• Settlement of accounts on dissolution of the firm;
Provisions of Partnership Act in case Deed is Silent on these issues or deed is not available
The important provisions affecting partnership accounts are as follows:
(a) Profit Sharing Ratio:
If the partnership deed is silent about the profit-sharing ratio, the profits and losses of the firm are to be shared equally by partners, irrespective of their capital contribution in the firm.
(b) Interest on Capital:
No partner is entitled to claim any interest on the amount of capital contributed by him in the firm as a matter of right.
However, interest can be allowed when it is expressly agreed to by the partners.
Thus, no interest on capital is payable if the partnership deed is silent on the issue.
(c) Interest on Drawings:
No interest is to be charged on the drawings made by the partners, if there is no mention in the Deed.
(d) Interest on Loan:
If any partner has advanced loan to the firm for the purpose of business, he/she shall be entitled to get an interest on the loan amount at the rate of 6 per cent per annum.
(e) Remuneration/Salary for Firm’s Work:
No partner is entitled to get salary or other remuneration for taking part in the conduct of the business of the firm unless there is a provision for the same in the Partnership Deed
Special Aspects of Partnership Accounts
Accounting treatment for partnership firm is similar to that of a sole proprietorship business with the exception of the following aspects:
• Maintenance of Partners’ Capital Accounts;
• Distribution of Profit and Loss among the partners;
• Adjustments for Wrong Appropriation of Profits in the Past;
• Reconstitution of the Partnership Firm; and
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• Dissolution of Partnership Firm
Maintenance of Capital Accounts of Partners
There are two methods by which the capital accounts of partners can be maintained.
These are: (i) fixed capital method, and (ii) fluctuating capital method.
The difference between the two lies in whether or not the transactions other than addition/withdrawal of capital are recorded in the capital accounts of the partners
(a) Fixed Capital Method:
Under the fixed capital method, the capitals of the partners shall remain fixed unless additional capital is introduced or a part of the capital is withdrawn as per the agreement among the partners.
All items like share of profit or loss, interest on capital, drawings, interest on drawings, etc. are recorded in a separate account called Partner’s Current Account.
The partners’ capital accounts will always show a credit balance, which shall remain the same (fixed) year after year unless there is any addition or withdrawal of capital.
The partners’ current account on the other hand, may show a debit or a credit balance.
Thus, under this method, two accounts are maintained for each partner viz., capital account and current account.
(b) Fluctuating Capital Method:
Under the fluctuating capital method, only one account, i.e. capital account is maintained for each partner.
All the adjustments such as share of profit and loss, interest on capital, drawings, interest on drawings, salary or commission to partners, etc are recorded directly in the capital accounts of the partners.
This makes the balance in the capital account to fluctuate from time to time.
That’s the reason why this method is called fluctuating capital method.
In the absence of any instruction, the capital account should be prepared by this method.
Distinction between Fixed and Fluctuating Capital Accounts
The main points of differences between the fixed and fluctuating capital methods can be summed up as follows:
| Basis of Distinction | Fixed Capital | Fluctuating Capital |
|---|---|---|
| (i) Number of accounts | Under this method, two separate accounts are maintained for each partner viz., ‘capital account’ and ‘current account’. | Each partner has one account, i.e. capital account, under this method. |
| (ii) Items related to deed | Drawings, salary, interest on capital, etc. are posted (transferred) in the current accounts and not in the capital accounts. | All adjustments for drawings, salary, interest on capital, etc., are posted (transferred) in the capital accounts. |
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The comparison table continues:
| Basis of Distinction | Fixed Capital | Fluctuating Capital |
|---|---|---|
| (iii) Fixed balance | The capital account balance remains unchanged unless there is addition to or withdrawal of capital. | The balance of the capital account fluctuates from year to year |
| (iv) Credit balance | The capital accounts always show a credit balance | The capital account may sometimes show a debit balance |
Distribution of Profit among Partners
The profits and losses of the firm are distributed among the partners in an agreed ratio.
However, if the partnership deed is silent, the firm’s profits and losses are to be shared equally by all the partners.
Profit and Loss Appropriation Account
You know that in the case of sole partnership the profit or loss, as ascertained by the profit and loss account is transferred to the capital account of the proprietor.
In case of partnership, however, certain adjustments such as interest on drawings, interest on capital, salary to partners, and commission to partners are required to be made.
For this purpose, it is customary to prepare a Profit and Loss Appropriation Account of the firm and ascertain the final figure of profit and loss to be distributed among the partners, in their profit-sharing ratio.
Profit and Loss Appropriation Account is merely an extension of the Profit and Loss Account of the firm.
It shows how the profits are appropriated or distributed among the partners.
It starts with the net profit/net loss as per Profit and Loss Account.
Interest on Capital
No interest is allowed on partners’ capitals unless it is expressly agreed among the partners.
When the Deed specifically provides for it, interest on capital is credited to the partners at the agreed rate with reference to the time period for which the capital remained in business during a financial year.
It must be remembered that the interest on capital is allowed only when the firm has earned profit during the accounting year.
Hence, no interest will be allowed during the year the firm has incurred net loss and if in a year, the profit of the firm is less than the amount due to the partners as interest on capital, the payment of interest will be restricted to the amount of profits.
In that case, the profit will be effectively distributed in the ratio of interest on capital of each partner.
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How to calculate: -
Interest = Principle x Rate x Time
Interest on Drawings
The partnership agreement may also provide for charging of interest on money withdrawn out of the firm by the partners for their personal use.
As stated earlier, no interest is charged on the drawings if there is no express agreement among the partners about it.
However, if the partnership deed so provides for it, the interest is charged at an agreed rate, for the period for which drawings have been made.
Remained outstanding from the partners during an accounting year.
Charging interest on drawings discourages excessive amounts of drawings by the partners.
How to calculate: -
Interest = Principle x Rate x Time
Reconstitution of a Partnership Firm
Partnership is an agreement between two or more persons (called partners) for sharing the profits of a business carried on by all or any of them acting for all.
Any change in the existing agreement amounts to reconstitution of the partnership firm.
This results in an end of the existing agreement and a new agreement comes into being with a changed relationship among the members of the partnership firm and/or their composition.
However, the firm continues.
The partners often resort to reconstitution of the firm in various ways such as:
-
admission of a new partner,
-
change in profit sharing ratio,
-
retirement of a partner,
-
death or insolvency of a partner.
Dissolution of Partnership Firm
The dissolution of a firm implies the discontinuance of partnership business and termination of economic relations between the partners.
In the case of a dissolution of a firm, the firm closes its business altogether and realises all its assets and pays all its liabilities.
The payment is made to the creditors first out of the assets realised and, if necessary, next out of the contributions made by the partners in their profit-sharing ratio.
When all accounts are settled and the final payment is made to the partners for the amounts due to them, the books of the firm are closed.
Realisation Account
The Realisation Account is prepared at the time of Dissolution of Firm to record the transactions relating to sale and realisation of assets and settlement of creditors.
Any profit or
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loss arising act of this process is shared by partners’ in their profit-sharing ratio.
Partners’ accounts are also settled, and the Cash or Bank account is closed.
Summary
1. Definition of partnership and its essential features:
Partnership is defined as “Relation between persons who have agreed to share the profits of a business carried on by all or any one of them acting for all”.
The essential features of partnership are :
(i) To form a partnership, there must be at least two persons;
(ii) It is created by an agreement;
(iii) The agreement should be for carrying on some legal business;
(iv) sharing of profits and losses; and
(v) relationship of mutual agency among the partners.
2. Meaning and contents of partnership deed:
A document which contains the terms of partnership as agreed among the partners is called ‘Partnership Deed’.
It usually contains information about all aspects affecting relationship between partners, including objective of business, contribution of capital by each partner, ratio in which profit and losses will be shared by the partners, entitlement of partners to interest on capital, interest on loan and the rules to be followed in case of admission, retirement, death, dissolution, etc.
3. Provisions of Partnership Act 1932 applicable to accounting:
If partnership deed is silent in respect of certain aspects, the relevant provisions of the Indian Partnership Act, 1932 become applicable.
According to the Partnership Act, the partners share profits equally, no partner is entitled to remuneration, no interest on capital is allowed and no interest on drawings is charged.
However, if any partner has given some loan to the firm, he is entitled to interest on such amount @ 6% per annum.
4. Preparation of capital accounts under fixed and fluctuating capital methods:
All transactions relating to partners are recorded in their respective capital accounts in the books of the firm.
There can be two methods of maintaining Capital Accounts.
These are; (i) fluctuating capital method, (ii) fixed capital method.
Under fluctuating capital method, all the transactions relating to a partner are directly recorded in the capital account.
Under fixed capital method, however the amount of capital remains fixed, the transactions like interest on capital, drawings, interest on drawings, salary, commission, share of profit or loss are recorded in a separate account called ‘Partner’s Current Account’.
5. Distribution of profit and loss:
The distribution of profits among the partners is shown through a Profit and Loss Appropriation Account, which is merely an extension of the Profit and Loss Account.
It is usually debited with interest on capital and salary/commission allowed to the partners and credited with net profit as per Profit and Loss Account and the interest on
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drawings.
The balance being profit or loss is distributed among the partners in the profit-sharing ratio and transferred to their respective capital accounts.
YouTube Link for Lecture:
Channel Name:
Lateef’s Commerce Academy
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VISUAL / TABLE CONTENT FROM THE PDF
The main visual element is the “Distinction between Fixed and Fluctuating Capital Accounts” table spanning pages 69–70.
Distinction between Fixed and Fluctuating Capital Accounts
| Basis of Distinction | Fixed Capital | Fluctuating Capital |
|---|---|---|
| (i) Number of accounts | Under this method, two separate accounts are maintained for each partner viz., ‘capital account’ and ‘current account’. | Each partner has one account, i.e. capital account, under this method. |
| (ii) Items related to deed | Drawings, salary, interest on capital, etc. are posted (transferred) in the current accounts and not in the capital accounts. | All adjustments for drawings, salary, interest on capital, etc., are posted (transferred) in the capital accounts. |
| (iii) Fixed balance | The capital account balance remains unchanged unless there is addition to or withdrawal of capital. | The balance of the capital account fluctuates from year to year. |
| (iv) Credit balance | The capital accounts always show a credit balance. | The capital account may sometimes show a debit balance. |
The page image shows this as a three-column comparison table headed Basis of Distinction / Fixed Capital / Fluctuating Capital.
Key formulas appearing in the PDF
Interest = Principle x Rate x Time
This formula appears under both Interest on Capital and Interest on Drawings.
