Chapter 1 Accounting for Partnership: Basic Concepts

Summary of Chapter 1 Accounting for Partnership: Basic Concepts

1. Definition of Partnership

Partnership is defined as the relationship 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 a partnership include:

• At least two persons to form a partnership.
• Creation by an agreement.
• Carrying on some legal business.
• Sharing of profits and losses.
• Mutual agency among the partners.

2. Partnership Deed

A document containing the terms of partnership as agreed among the partners. It includes details about the objective of the business, capital contribution by each partner, profit and loss sharing ratio, interest on capital, and other rules regarding admission, retirement, death, and dissolution of the partnership.

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;
• Mode of auditor’s appointment, if any;
• 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;
• Method of settlement of disputes among the partners;
• Rules to be followed in case of admission, retirement, death of a partner; and
• Any other matter relating to the conduct of business.

3. Provisions of Partnership Act 1932

If the partnership deed is silent on certain aspects, the relevant provisions of the Indian Partnership Act, 1932, become applicable. Key provisions include:

• Equal sharing of profits among partners.
• No entitlement to remuneration for any partner.
• No interest on capital allowed.
• No interest on drawings charged.
• Interest on loans given by partners at 6% per annum.

4. Capital Accounts

Capital accounts can be maintained using either the fluctuating capital method or the fixed capital method. The document explains both methods:

• Fluctuating Capital Method: All transactions related to a partner are recorded directly in the capital account.
• Fixed Capital Method: The amount of capital remains fixed, and transactions like interest on capital, drawings, interest on drawings, salary, commission, and share of profit or loss are recorded in a separate account called the Partner’s Current Account.

5. Distribution of Profit and Loss

The distribution of profits among partners is shown through a Profit and Loss Appropriation Account, which extends the Profit and Loss Account. It includes items like interest on capital, partner’s salary/commission, interest on drawings, and the balance profit or loss distributed among the partners.

6. Past Adjustments

Adjustments for omissions or errors found after final accounts have been prepared can be made either through a Profit and Loss Adjustment Account or directly in the partners’ capital accounts. This section provides examples of how to handle such adjustments.

Terms Introduced in the Chapter

• Partnership
• Partnership Firm
• Partnership Deed
• Fixed Capital Account
• Fluctuating Capital Account
• Profit and Loss Appropriation Account
• Profit and Loss Adjustment Account
• Partner’s Current Account
• Interest on Capital
• Interest on Drawings
• Average Period

Practice Questions and Answers

1. Explain the nature of a partnership.

   A partnership is a formal arrangement by two or more parties to manage and operate a business and share its profits.

2. What are the essential features of a partnership?

   Essential features include agreement, sharing of profits, mutual agency, lawful business, and unlimited liability.

3. How does the Indian Partnership Act 1932 define a partnership?

   Partnership is defined as 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.

4. List the provisions of the Indian Partnership Act 1932 that are relevant for accounting.

   Provisions include the formation of a partnership, rights and duties of partners, registration of firms, and dissolution of firms.

5. What are the different methods of preparing partners’ capital accounts?

   The two main methods are the Fixed Capital Method and the Fluctuating Capital Method.

6. Describe the fixed capital method.

   Under the Fixed Capital Method, the capital of partners remains constant unless additional capital is introduced or withdrawn.

7. Describe the fluctuating capital method.

   Under the Fluctuating Capital Method, the capital of partners changes with every transaction affecting capital, like interest on capital, salary, share of profits, and drawings.

8. Explain how profits and losses are distributed among partners.

   Profits and losses are distributed among partners according to the profit-sharing ratio agreed upon in the partnership deed.

9. What is a Profit and Loss Appropriation Account?

   A Profit and Loss Appropriation Account is prepared to show the distribution of profits among partners, after adjusting for interest on capital, interest on drawings, partner's salary, and commission.

10. List the adjustments made through the Profit and Loss Appropriation Account.

    Adjustments include interest on capital, interest on drawings, partner’s salary, partner’s commission, and distribution of remaining profit or loss among partners.

11. How is interest on capital treated in partnership accounts?

    Interest on capital is treated as an appropriation of profits and is credited to the partners' capital accounts.

12. How is interest on drawings treated in partnership accounts?

    Interest on drawings is treated as a charge against the partner’s share of profit and is debited to the partner’s capital account.

13. What are the implications of mutual agency in a partnership?

    Mutual agency implies that each partner is both a principal and an agent, meaning any partner can bind the partnership and the other partners by his or her actions within the scope of the business.

14. What is the significance of a partnership deed?

    A partnership deed is a written agreement among partners outlining the terms and conditions of the partnership, helping to avoid disputes by clearly stating the rights and responsibilities of each partner.

15. List the typical contents of a partnership deed.

    Typical contents include the name of the firm, names and addresses of partners, nature of business, capital contributions, profit-sharing ratio, and procedures for admission, retirement, and dissolution of partners.

16. How can the clauses of a partnership deed be altered?

    Clauses of a partnership deed can be altered with the consent of all partners, and such changes should be documented in writing.

17. What is the difference between fixed and fluctuating capital methods?

    Under the Fixed Capital Method, capital remains unchanged except for additional capital introduced or withdrawn. Under the Fluctuating Capital Method, the capital balance changes with every transaction affecting capital.

18. How are partners’ salaries treated in partnership accounts?

    Partners’ salaries are treated as an appropriation of profits and are credited to the partners' capital accounts.

19. What are the implications of the liability of partners?

    Partners have unlimited liability, meaning they are personally responsible for the debts of the partnership to the full extent of their personal assets.

20. Explain the process of admitting a new partner into a partnership.

    Admitting a new partner requires the consent of all existing partners and involves revaluing assets and liabilities, adjusting capital accounts, and creating a new partnership deed.

21. What adjustments are required on the retirement of a partner?

    Adjustments include revaluing assets and liabilities, determining the retiring partner’s share of goodwill, and settling the retiring partner’s capital account.

22. How is the death of a partner accounted for in partnership accounts?

    Upon a partner’s death, the partnership revalues assets and liabilities, calculates the deceased partner’s share of goodwill, and settles the deceased partner’s capital account with his or her legal heirs.

23. Describe the process of dissolving a partnership firm.

    Dissolution involves settling the firm’s debts, realizing assets, and distributing the remaining assets among partners according to their capital and profit-sharing ratios.

24. How are the accounts settled upon the dissolution of a partnership firm?

    Accounts are settled by paying off liabilities first, then returning any remaining funds to partners based on their capital balances and profit-sharing ratios.

25. What is the significance of profit-sharing ratio in partnership accounts?

    The profit-sharing ratio determines how profits and losses are distributed among partners. It is usually agreed upon in the partnership deed.

26. Explain the concept of interest on partners’ loans.

    Interest on partners’ loans is treated as a charge against profit and is credited to the loan account of the partner who provided the loan.

27. How is remuneration to partners handled in partnership accounts?

    Remuneration to partners is treated as an appropriation of profits and is credited to the partners' capital accounts.

28. What is the treatment of goodwill in partnership accounts?

    Goodwill is valued and recorded in partnership accounts during changes in the partnership structure, such as admission, retirement, or death of a partner.

29. Describe the reconstitution of a partnership firm.

    Reconstitution involves changes in the partnership agreement, such as admission, retirement, or change in profit-sharing ratio, and requires revaluation of assets and liabilities.

30. What are the common reasons for the reconstitution of a partnership firm?

    Common reasons include admission of a new partner, retirement of an existing partner, change in profit-sharing ratio, and the death of a partner.

31. How is the capital account balance affected by additional capital introduced?

    When additional capital is introduced, the partner’s capital account is credited with the amount of additional capital.

32. What are the differences between joint ownership and partnership?

    Joint ownership does not involve a business operation and profit-sharing, whereas a partnership involves running a business and sharing profits among partners.

33. Explain how the partnership agreement can impact the distribution of profits.

    The partnership agreement outlines the profit-sharing ratio and any other terms regarding the distribution of profits among partners.

34. What happens if there is no partnership agreement?

    If there is no partnership agreement, the provisions of the Indian Partnership Act 1932 apply, and profits and losses are shared equally among partners.

35. Describe the process of resolving disputes among partners.

    Disputes among partners can be resolved through mutual discussion, mediation, arbitration, or legal action as per the terms of the partnership deed or applicable laws.

36. What is the role of an auditor in a partnership firm?

    An auditor reviews and verifies the financial statements of the partnership firm to ensure accuracy and compliance with accounting standards and regulations.

37. How does the insolvency of a partner affect the partnership accounts?

    Insolvency of a partner leads to the dissolution of the partnership firm, and the insolvent partner's capital account is adjusted for losses, liabilities, and distribution of remaining assets.

38. Explain the term ‘guarantee for a minimum amount of profit’ in partnership accounts.

    Guarantee for a minimum amount of profit ensures that a partner receives at least a certain amount of profit, and any shortfall is compensated by other partners.

39. What are the steps involved in preparing final accounts of a partnership firm?

    Steps include preparing the Trading Account, Profit and Loss Account, Profit and Loss Appropriation Account, and the Balance Sheet, along with necessary adjustments for accruals, prepayments, and adjustments for partners' transactions.

40. How are errors rectified in partners' capital accounts?

    Errors in partners' capital accounts are rectified through journal entries to correct the balances and reflect accurate information.

41. Describe the significance of the accounting period in partnership accounts.

    The accounting period is the time frame for which financial statements are prepared, ensuring consistency in reporting and enabling comparison of financial performance over time.

42. What are the rules regarding the operation of bank accounts in a partnership firm?

    Bank accounts of a partnership firm are operated as per the terms of the partnership deed, with authorized partners able to sign checks and manage transactions.

43. How is profit-sharing ratio determined if the partnership deed is silent?

    If the partnership deed is silent, the profit-sharing ratio is determined as equal among all partners as per the Indian Partnership Act 1932.

Examples with Solutions

Example 1: Calculation of Interest on Drawings

Verma and Kaul are partners in a firm. The partnership agreement provides that interest on drawings should be charged at 6% p.a. Verma withdraws Rs. 2,000 per month starting from April 01, 2019, to March 31, 2020. Kaul withdrew Rs. 3,000 per quarter, starting from April 01, 2019. Calculate interest on partner’s drawings.

Solution

When Dates of Withdrawal are not specified:

When the total amount withdrawn is given but the dates of withdrawals are not specified, it is assumed that the amount was withdrawn evenly throughout the year. For example, Shakila withdrew Rs. 60,000 from the partnership firm during the year ending March 31, 2020, and the interest on drawings is to be charged at the rate of 8% per annum. For calculation of interest, the period would be taken as six months, which is the average period assuming that the amount is withdrawn evenly in the middle of the month, throughout the year. The amount of interest on drawings works out to be Rs. 2,400 as follows:

Interest = Rs. 60,000 × (8/100) × (6/12) = Rs. 2,400

Example 2: Guarantee of Profit to a Partner

Mohit and Rohan share profits and losses in the ratio of 2:1. They admit Rahul as a partner with a 1/4 share in profits with a guarantee that his share of profit shall be at least Rs. 50,000. The net profit of the firm for the year ending March 31, 2015, was Rs. 1,60,000. Prepare the Profit and Loss Appropriation Account.

Solution

Books of Mohit, Rohan, and Rahul

Working Notes:

New profit sharing Ratio will be calculated as follows:

Rakesh to share 1/10 of the profits. The remaining profit 9/10 will be shared by Mahesh and Dinesh in the ratio of 2:1.

Mahesh’s share in profit will be 2/3 of 9/10 = 6/10 = 60%.

Dinesh’s share in profit will be 1/3 of 9/10 = 3/10 = 30%.

The New ratio becomes 6:3:1.

Mahesh’s share in profit = 1,20,000 × 6/10 = Rs. 72,000,

Dinesh’s share in profit = Rs. 36,000,

Rakesh’s share in profit = Rs. 12,000.

Deficiency of Rakesh (Rs. 13,000) will be shared by Mahesh and Dinesh in the ratio of 3:2.

Mahesh will bear 3/5 of 13,000, i.e., Rs. 7,800 and Rakesh, 2/5 of Rs. 13,000, i.e., Rs. 5,200.

Thus, the profits of the firm will be shared as follows:

Mahesh will get Rs. 72,000 – Rs. 7,800 = Rs. 64,200.

Dinesh will get Rs. 36,000 – Rs. 5,200 = Rs. 30,800

Rakesh will get Rs. 12,000 + Rs. 7,800 + Rs. 5,200 = Rs. 25,000.

Example 3: Interest on Capitals

Sameer and Yasmin are partners with capitals of Rs. 15,00,000 and Rs. 10,00,000 respectively. They agreed to share profits in the ratio of 3:2. Show how the following transactions will be recorded in the capital accounts of the partners in case:

1. the capitals are fixed, and
2. the capitals are fluctuating.

The books are closed on March 31, every year.

Fixed Capital Method

Partner’s Capital Accounts

Partner’s Current Accounts

Fluctuating Capital Method