Partnership Accounts-Basic Concepts
SAVITA MAHENDRU
ASST LECTURER IN COMMERCE�HRMMV
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Characteristics of Partnerships
Partnerships are an important type of organization because they offer certain advantages with their unique characteristics. We describe these characteristics in this section.
A partnership is a voluntary association between partners. Joining a partnership increases the risk to one’s personal financial position. Some courts have ruled that partnerships are created by the actions of individuals even when there is no express agreement to form one. Omar Soliman and Nick Friedman are partners who voluntarily created the company College Hunks Hauling Junk.
Forming a partnership requires that two or more legally competent people (who are of age and of sound mental capacity) agree to be partners. Their agreement becomes a partnership contract, also called articles of copartnership. Although it should be in writing, the contract is binding even if it is only expressed verbally. Partnership agreements normally include details of the partners’ (1) names and contributions, (2) rights and duties, (3) sharing of income and losses, (4) withdrawal arrangement, (5) dispute procedures, (6) admission and withdrawal of partners, and (7) rights and duties in the event a partner dies.
The life of a partnership is limited. Death, bankruptcy, or any event taking away the ability of a partner to enter into or fulfill a contract ends a partnership. Any one of the partners can also terminate a partnership at will.
A partnership is not subject to taxes on its income. The income or loss of a partnership is allocated to the partners according to the partnership agreement, and it is included in determining the taxable income for each partner’s tax return. Partnership income or loss is allocated each year whether or not cash is distributed to partners.
Mutual agency implies that each partner is a fully authorized agent of the partnership. As its agent, a partner can commit or bind the partnership to any contract within the scope of the partnership business. For instance, a partner in a merchandising business can sign contracts binding the partnership to buy merchandise, lease a store building, borrow money, or hire employees.
Unlimited liability implies that each partner can be called on to pay a partnership’s debts. When a partnership cannot pay its debts, creditors usually can apply their claims to partners’ personal assets. If a partner does not have enough assets to meet his or her share of the partnership debt, the creditors can apply their claims to the assets of the other partners. A partnership in which all partners have mutual agency and unlimited liability is called a general partnership. Mutual agency and unlimited liability are two main reasons that most general partnerships have only a few members.
Partnership assets are owned jointly by all partners. Any investment by a partner becomes the joint property of all partners. Partners have a claim on partnership assets based on their capital account and the partnership contract.
Partnership Deed:
A written document containing the terms and conditions of partnership and because of which the partnership comes into existence is known as Partnership Deed. It is a legal document signed by all the partners and has the following clauses:
i. Description of the Partners: It contains names, description and addresses of the partners. ii. Description of the Firm: It contains name and address of the firm.
iii. Principal Place of Business: It contains address of the principal place of business.
iv. Nature of Business: It specifies the nature of business that the firm shall carry on.
v. Commencement of Partnership: Date of commencement of partnership is specified in this clause. vi. Capital Contribution: It mentions the amount of capital that each partner contributes whether capital accounts are fixed or fluctuating.
vii. Interest on Capital: It specifies the interest on capital if such interest is allowed to be paid.
viii. Interest on Drawings: It specifies the rate of interest on drawings if such interest is charged on drawings.
ix. Profit-Sharing Ratio: It specifies the ratio in which the profits and losses of the firm are shared by the partners.
x. Interest on Loan: It specifies the rate of interest paid on the loan by the partner to the firm.
xi. Remuneration to Partners: It specifies the amounts of salary, commission, etc. payable to the partners.
xii. Valuation of Goodwill: It specifies the method by which the goodwill of the firm will be valued in the event of reconstitution of the partnership.
xiii. Valuation of Assets: It specifies the manner in which assets of the firm shall be valued in the event of reconstitution of the partnership.
xiv. Settlement of Accounts: It specifies the manner in which the accounts of the partner(s) shall be settled in case of partners’ retirement or death or in the event of dissolution of the firm.
xv. Accounting Period: It specifies the date on which accounts of the firm are closed every year.
xvi. Rights and Duties of Partners: It specifies the rights and duties of the partners.
xvii. Duration of Partnership: It specifies whether the partnership is for a specified period or for a venture or at will.
xviii. Bank Account Operation: It specifies how the bank accounts should be operated; whether by any of the partners or jointly by all partners.
xix. Death of a Partner: It specifies whether the firm will continue or dissolve in the event of death of a partner.
xx. Settlement of Disputes: It specifies how the disputes among the partners shall be settled, if any arises.
Importance of Partnership Deed:
Limited Liability Partnership (LLP):
i. Separate Legal Entity: An LLP has a separate legal entity and therefore, LLP and its partners are distinct from each other.
ii. Minimum Capital: Such minimum capital of an LLP is not specified and therefore, the partners of the LLP decide how much capital will be contributed by each partner.
iii. Minimum Number of Members: A minimum of 2 members are required to establish an LLP who shall also be the Designated Partners and shall have Director Identification Number (DIN). There is no limit on the maximum number of partners.
iv. Audit is not mandatory: Audit of an LLP is not compulsory except for the following:
Interest on Partner’s Loan to the firm:
Journal Entries passed are as follows:
Interest on Partner’s Loan A/c …Dr.
To Partners’ Loan A/c
ii. To close the Interest on Partners’ Loan A/c:
Profit and Loss A/c …Dr.
To Interest on Partners’ Loan A/c
Distribution of Profit among Partners:
--Meaning of Profit and Loss Appropriation Account: Such Profit and Loss Appropriation Account is an extension of the Profit and Loss Account and therefore, the credit balance of the Profit and Loss Account is transferred to Profit and Loss Appropriation Account. Such amount is then utilized for the following:
Specimen of Profit and Loss Appropriation Account:
Difference between Profit and Loss Account and Profit and Loss Appropriation Account:
Ratio of Appropriation when the Appropriations are more than Available Profit:
In case where the total amount of appropriations is more than the amount of profit available, profit available for distribution among the partners is distributed in the ratio of appropriation to be made. The ratio of such appropriation is determined as follows:
i. Calculate the amount of appropriation payable to each partner as per the Partnership Deed (ignoring the profit available for distribution among partners) like the salary, commission and interest on capital, etc.
ii. Calculate the total amount of appropriation (as per step (i) above) for each partner separately.
iii. Calculate the ratio of the Appropriations (as per step (ii) above) to be made to each partner.
iv. Lastly, ratio calculated in (iii) above shall be the ratio in which available profits shall be distributed among the partners.
v. It is important to note that no particular item like salary, commission, interest on capital, etc., has priority over other items of appropriation.
Accounting treatment of Guarantee of minimum profit to a partner in case of Loss:
In case where the firm is incurring losses and minimum guaranteed profit is to be paid to the partner who has been guaranteed minimum profit, adjustment will be made through Partners’ Capital Accounts as follows:
Guarantee of Profit:
At the time of admission of a partner, it is possible that the new partner is admitted in the firm with minimum guaranteed profits from the business. It means that the guaranteed partner shall get the minimum guaranteed profit even if the guaranteed partner’s or new partner’s share of profit is less than the guaranteed amount. When profit is guaranteed to an existing or incoming partner, it can be done in 2 ways as follows:�i. Profit may be guaranteed by all the remaining partners in an agreed ratio: In this case, following steps are followed :
Step 1: Share of profit as per profit sharing ratio is determined, and
Step 2: Minimum guaranteed profit is determined.
Step 3: Higher of the above two amounts (in step 1 and step 2) is given to the guaranteed partner.
Step 4: If the share of profit is less than the guaranteed amount, the difference in the amount of profit (i.e., minimum guaranteed profit – share of profit of the guaranteed partner) is borne by the remaining partners in the agreed ratio and where the agreed ratio is not given such difference is borne by the partners in their profit sharing ratio
ii. Profit may be guaranteed by one or more of the existing or old partners: In this case, following steps are to be followed:
Step 1: Amount of profit is to be distributed among the partners as per their profit sharing ratio.
Step 2: In case share of profit of the guaranteed partner is less than the minimum guaranteed profit, the difference is deducted from the share of profit of the partner or partners who has guaranteed and it is added to the share of profit of the guaranteed partner.
Step 3: When two or more partners guarantee, the shortfall (deficiency) is shared by them in the agreed ratio or in their profit sharing ratio as the case may be.