Accounting for Partnership Firms - Fundamentals
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Accounting for Partnership Firms - Fundamentals |
Meaning and definition of partnership
The partnership is defined by the Indian Partnership Act, 1932, Section 4, as follows: “Partnership is the relation between persons who have agreed to share the profits of a business carried on by all or any of them acting for all.
” A partnership, thus, is a business relationship among two or more persons to share profits and losses of the business, carried on by all or any of them acting for all.
Partners, Firm, and Firm Name: The persons who have entered into a partnership with one another individually are called partners and collectively a firm. The name under which the business is carried is called firm name.
Nature of Partnership
Partnership, from the legal viewpoint, is not a separate legal entity from its partners. It means the firm’s debts can be paid from the private assets of the partners if the firm is not able to pay its liabilities.
The partnership is a separate business entity from the accounting viewpoint.
Essential features or characteristics of partnership
The essential characteristics of partnership are:
1. Two or More Persons: There must be at least two persons to form a partnership and all such persons must be competent to contract. According to the Indian Contract Act, 1872, every person except the following are competent to contract:
(a) Minor,
(b) Persons of unsound mind, and
(c) Persons disqualified by any law.
Maximum Number of Partners:
The Companies Act, 2013 (Section 464) empowers the Central Government to prescribe the number of partners in a firm subject to a maximum of 100 partners. The Central Government has prescribed the maximum number of partners in a firm to be 50 vide Rule 10 of the Companies (Miscellaneous) Rules, 2014. Thus, in effect, a partnership firm cannot have more than 50 partners.
2. Agreement: Partnership comes into existence by an agreement, either written or oral. It is the basis of a relationship among partners, which may be for a particular venture, for a period, or at will. The written agreement among the partners is known as Partnership Deed.
3. Lawful Business: A partnership is established for a lawful business.
4. Profit-sharing: The agreement between/among the partners must be to share profits and losses of the business. It is not essential that all the partners must share losses.
5. Business can be carried on by All or Any of the Partners Acting for All: Business of the partnership can be carried on by all the partners or by any of them acting for all the partners. In other words, partners are agents as well as principals.
As an agent, he represents other partners and thereby, binds them through his acts.
As a principal, he is bound by the act of other partners.
Right of Partners
1. Every partner has the right to participate in the management of the business.
2. Every partner has the right to be consulted about the affairs of the business.
3. Every partner has the right to inspect the books of account and have a copy of it.
4. Every partner has the right to share profits or losses with others in the agreed ratio.
5. If a partner has an advanced loan, he has the right to receive interest thereon at an agreed rate of interest. In case the rate of interest is not agreed, interest is paid at the rate provided in the Indian Partnership Act, 1932, i.e., @ 6% p.a.
6. In case of an emergency, a partner has the right to act according to his best judgment and be indemnified for the expenses incurred by him.
7. A partner has the right not to allow the admission of a new partner.
8. After giving proper notice, a partner has the right to retire from the firm.
9. If a partner incurs expenses on the business or he pays an amount on behalf of the firm, that partner gets indemnified for the payments made by him from the firm.
Partnership Deed | Partnership Agreement
The partnership comes into existence by an oral or written agreement. It is better to have a written agreement to avoid any dispute. This written document known as Partnership Deed details the terms and conditions of the partnership. It is a legal document signed by all the partners and has clauses on the following:
(i) Description of the Partners: Names, description, and addresses of the partners.
(ii) Description of the Firm: Name and address of the firm.
(iii) Principal Place of Business: Address of the principal place of business.
(iv) Nature of Business: Nature of business that the firm shall carry on.
(v) Commencement of Partnership: Date of commencement of partnership.
(vi) Capital Contribution: The amount of capital to be contributed by each partner, whether the Capital Accounts shall be fixed or fluctuating.
(vii) Interest on Capital: Rate of interest, if allowed, on capital.
(viii) Interest on Drawings: Rate of interest, if to be charged, on drawings.
(ix) Profit-sharing Ratio: Ratio in which profits or losses are to be shared by the partners.
(x) Interest on Loan: Rate of interest on the loan by a partner to the firm.
(xi) Remuneration to Partners: Amount of salary, commission, etc., if agreed, to be paid.
(xii) Valuation of Goodwill: Method by which goodwill of the firm will be valued at the time of admission or retirement of a partner or at the time of death of a partner.
(xiii) Valuation of Assets: The manner in which assets of the firm shall be valued in the case of its reconstitution.
(xiv) Settlement of Account: The manner in which accounts of partner(s) shall be settled in case of his (their) retirement or death or at the time of dissolution of the firm.
(xv) Accounting Period: The date on which accounts shall be closed every year. Normally accounts are closed on 31st March every year because every entity must submit the return of income on 31st March every year.
(xvi) Rights and Duties of Partners: The rights and duties of partners are defined.
(xvii) Duration of Partnership: The period of the partnership, i.e., whether it is for a specified period or for a venture or at will.
(xviii) Bank Account Operation: How shall the Bank Account be operated? Whether it shall be operated by any of the partners or jointly.
(xix) Death of a Partner: Whether the firm will continue or dissolve.
(xx) Settlement of Disputes: Disputes, if any, among the partners—how they shall be settled.
Importance of Partnership Deed
Partnership Deed is an important legal document that defines relationships among the partners. It is important to have a written Partnership Deed to avoid and settle possible disputes. It is useful because:
1. It governs the rights, duties, and liabilities of each partner.
2. Disputes arising, if any, among the partners are settled on the basis of Partnership Deed, it is a written contract.
Is it essential to have a Partnership Deed / Agreement?
It is not essential but desirable to have a Partnership Deed. In the case of Partnership, Deed does not
exist, provisions of the Indian Partnership, Act, 1932 will apply
Provisions Affecting Accounting Treatment in the Absence of Partnership Deed
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Accounting Treatment in the Absence of Partnership Deed |
Liabilities of Partners
Subject to an agreement among the partners,
1. If a partner carries on a business that is similar to that of the firm in competition with the firm and earns profit from it, the profit earned from such business shall be paid to the firm.
2. If a partner earns profit for himself from any transaction of the firm or from the use of the firm’s property or business connection, the profit so earned shall be paid to the firm. For example, a partner gets commission from the buyer of goods on goods sold by the firm, the commission so earned shall be paid to the firm
Some other Important Provisions of the Indian Partnership Act, 1932
(i) If all the partners agree, a minor may be admitted for the benefit of the partnership. [Sec. 30]
(ii) A person may be admitted as a partner either with the consent of all the existing
partners or in accordance with an agreement among the partners. [Sec. 31]
(iii) A partner may retire from the firm either with the consent of all the other partners or
in accordance with an agreement among the partners. [Sec. 32]
(iv) Registration of the firm is optional and not compulsory. [Sec. 69]
(v) Unless otherwise agreed by the partners in the Partnership Deed, a firm is dissolved on the death of a partner. [Sec. 35]
Note: It should be noted that the above provisions of the Indian Partnership Act, 1932 are applied when Partnership Deed does not exist or where it exists but it does not have a clause to this effect
Charge against Profit and Appropriation of Profit
Payment made or due to a partner may be a charge against profit or an appropriation of profit. Charge against Profit means that it is an expense for the firm and is paid whether the firm earns a profit or incurs a loss. On the other hand, appropriation of profit means that they are allowed, if the firm earns profit during the year.
Interest on Loan by Partner, Rent Payable to a partner, and Manager’s Commission, etc., are charged against profit and are payable whether the firm earns a profit or incurs a loss. On the other hand, Salary/Commission to partners, interest on capital, and transfer of profit to Reserves are appropriations.
Difference between Charge Against Profit and Appropriation of Profit
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Difference between Charge Against Profit and Appropriation of Profit |
Interest on loan by the Partner and by the firm to the partner
Interest on Loan by the Partner to the Firm
If any partner has given a loan to the firm, he shall get interested at the agreed rate as written in the
Partnership Deed or as agreed otherwise. In the absence of an agreement, the Indian Partnership
Act, 1932 will apply and the lending partner will get interested @ 6% p.a. on the loan amount.
Nature of Interest on Loan by Partner
Interest on a loan by a partner is a charge against profit. It means that a partner will get interested on the loan whether the firm earns a profit or incurs a loss
Accounting Treatment
Interest on a loan by a partner is credited to his Loan Account and not to his Capital Account. Journal entries passed are:
(i) To provide Interest on Loan by Partner:
Interest on Loan by Partner A/c ...Dr.
To Loan by Partner A/c
(ii) To close the Interest on Loan by Partner A/c:
Profit and Loss A/c ...Dr.
To Interest on Loan by Partner A/c
It is important to distinguish Loan Account and Capital Account of a partner because:
1. As per the Indian Partnership Act, 1932, a loan by a partner is repayable on dissolution before repayment of capital to partners; and
2. In the absence of any agreement, partners get interest @ 6% p.a. on loan advanced whereas they are not entitled to interest on capital.
Interest on Loan by the Firm to Partner
A firm may give loan to a partner. It will charge interest on the loan given at the rate agreed among the partners. If the Partnership Deed does not provide for charging interest on loan given or agreement to charge interest does not exist, interest is not charged on the loan given.
If interest is charged on loan by the firm to a partner, interest is transferred to the credit of Profit and Loss Account and debit of Partner’s Capital Account (if Capital Accounts are maintained following Fluctuating Capital Accounts Method) or Partner’s Current Account (if Capital Accounts are maintained following Fixed Capital Accounts Method).
The Journal entries are:
(i) For Charging Interest on Loan to Partner:
Partner’s Capital/Current A/c ...Dr.
To Interest on Loan to Partner A/c (Given)
(ii) For Transfer of Interest on Loan to Partner Account:
Interest on Loan to Partner A/c ...Dr.
To Profit and Loss A/c
Rent Paid or Payable to a Partner
Rent paid or payable to a partner, is also a charge against profit and not an appropriation of profit. It is a charge on profit because rent is payable to a partner for letting the firm use his personal property for business. Rent may be paid (either in cash or by cheque) during the year to the partner or it may have become due but is not yet paid, i.e., is still payable. When it is paid or payable, it is debited to Rent Account and credited to Cash/Bank Account or Rent Payable Account. At the end of the year. Rent Account is transferred or debited to Profit and Loss Account (not to the Profit and Loss Appropriation Account).
Journal entries in this case will be as follows:
(i) When rent is paid in cash or by cheque:
Rent A/c ...Dr.
To Cash/Bank A/c
(Rent paid in cash/cheque for ...)
(ii) When rent is payable:
Rent A/c ...Dr.
To Rent Payable A/c
(Rent payable for ...)
(iii) When Rent Account is transferred to Profit and Loss Account:
Profit and Loss A/c ...Dr.
To Rent A/c
(Rent Account transferred to Profit and Loss Account)
Manager’s Commission
The manager is an employee of the firm. Therefore, the amount due to him as the commission is payable whether the firm earns profit or incurs loss. Stating differently, Manager’s Commission is a charge against profit and transferred to the debit of Profit and Loss Account.
Distribution of profit among partners: profit and loss appropriation account
A partnership firm, like a proprietorship firm, prepares Trading Account, Profit and Loss Account and Balance Sheet. In addition, a partnership firm prepares Profit and Loss Appropriation Account to which net profit or net loss as per the Profit and Loss Account is transferred to appropriate it as per the agreement among partners. This account, is an extension of the Profit and Loss Account, and is credited with the amount of Net Profit or debited with the amount of Net Loss (transferred from Profit and Loss Account). It is credited with the amount of interest on drawings of the partners (which is loss to the partners but an income for the firm) and debited with interest on the capitals of the partners, partners’ salaries and commissions, etc., (which are losses for the firm and incomes for the partners).
If the partners decide, an amount is transferred to Reserve and the balance profit (Divisible Profit) is distributed between/among the partners in their profit-sharing ratio.
It should be noted that profit is appropriated up to the amount available for distribution, i.e.,
Divisible Profit. Thus, if after transfer of net loss and credit of interest charged on drawings to Profit and Loss Appropriation Account, the balance is loss, appropriation is not made. The loss is distributed among the partners in their profit-sharing ratio. But if it results in profit, appropriation is made up to the amount of profit.
Net Profit is the profit earned by an enterprise from its operating and non-operating activities. It is the net effect of operating and non-operating revenues and expenses that are charge against profit. It is determined by preparing Profit and Loss Account. Divisible or Distributable Profit is the profit that is available for distribution among partners after allowing remuneration (Salary, Commission, etc.) to partners, interest on capitals, transfer to reserve and charging interest on drawings. It is determined by preparing Profit and loss Appropriation Account.
Profit and Loss Appropriation Account is an extension of the Profit and Loss Account. Net profit or loss as per Profit and Loss Account is transferred to Profit and Loss Appropriation Account.
Following are considered as appropriation of profit and therefore are transferred (posted) to the debit of Profit and Loss Appropriation Account:
(i) Salary/Commission to Partners;
(ii) Interest on Capitals of Partners; and
(iii) Transfer to Reserves. Interest on Drawings is transferred (posted) to the credit of Profit and Loss Appropriation Account
Specimen of the Profit and Loss Appropriation Account
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| Profit and Loss Appropriation Account |
Features of Profit and Loss Appropriation Account
1. It is an extension of the Profit and Loss Account.
2. It is prepared by the partnership firms.
3. It shows the appropriation of net profit or loss for the accounting period.
4. Entries in this account are passed giving effect to the Partnership Deed
Difference between Profit and Loss Account and Profit and Loss Appropriation Account
Difference between Profit and Loss Account and Profit and Loss Appropriation Account |
Appropriations are more than Available Profit
It is also a possibility that total amount of appropriation as per the Deed is more than the amount of profit available for appropriation. In this situation, profit available for distribution among partners is distributed in the ratio of appropriation to be made. The ratio of appropriation is determined as follows:
(i) Determine the amount payable as appropriation to each partner as per the Partnership
Deed (ignoring the profit available for distribution among partners). For example, salary
payable, commission payable and interest on capital, etc., payable to each partner is
determined.
(ii) Total the amount of appropriation (as per Step (i) above) for each partner separately.
(iii) Ratio of the Appropriations (as per Step (ii) above) is the ratio in which profit is appropriated.
It should be kept in mind that no particular item like salary, commission, interest on capital, etc., has priority over other items of appropriation.
Special Aspects of Partnership Accounts
In Partnership Accounts, there are some aspects that require discussion. They are:
1. Partners’ Capital Accounts;
2. Remuneration (Salary or Commission) to Partners;
3. Interest on Partners’ Capitals;
4. Interest on Partners’ Drawings;
5. Adjustments for Incorrect Appropriations of Profits in the Past (Past Adjustments); and
6. Guarantee of Profit. Let us discuss each of these aspects in detail.
Let us discuss each of these aspects in detail.
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