ICAI Notes 8.1: Introduction to Partnership Accounts - 2 - CA Foundation PDF Download

6. ACCOUNTS

There is not much difference between the accounts of a partnership firm and that of sole proprietorship (provided there is no change in the firm itself). The only difference to be noted is that instead of one Capital Account there will be as many Capital Accounts as there are partners. If, for instance, there are three partners; A, B, and C, then there will be a Capital Account for each one of the partners; A’s Capital Account will be credited by the amount contributed by him as capital and similarly B’s and C’s Capital Accounts will be credited with the amounts brought in by them respectively as capital.

When a partner takes money out of the firms for his domestic purpose, either his Capital Account can be debited or a separate account, named as Drawings Account, can be opened in his name and the account may be debited. In a Trial Balance of a partnership firm, therefore, one may find Capital Accounts of partners as well as Drawings Accounts. Finally the Drawings Account of a partner may be transferred to his Capital Account so that a net figure is available. But, often the Drawings Account or Current Account (as it is usually called) remains separate.

6.1 Profit and Loss Appropriation : During the course of business, a partnership firm will prepare Trading Account and a Profit and Loss Account at the end of every year. This is done exactly on the lines already given in the chapter 6. This is to say that final accounts of a sole proprietorship concern will not differ from the accounts of a partnership firm. The Profit and Loss Account will show the profit earned by the firm or loss suffered by it. This profit or loss has to be transferred to the Capital Accounts of partners according to the terms of the Partnership Deed or according to the provisions of the Indian Partnership Act (if there is no Partnership Deed or if the Deed is silent on a particular point). Suppose the Profit and Loss Account reveals a profit of Rs 90,000. There are two partners, A and B. A devotes all his time to the firm; B does not. A’s capital is Rs 50,000 and B’s is Rs 20,000. There is no Partnership Deed. In such a case the profit will be distributed among A and B equally. This is irrespective of the fact that B does not work as much as A does and B’s capital is much less than that of A. But if the Partnership Deed lays down that A is to get a salary and interest is to be allowed on the capital, then first of all, from the profit earned, A’s salary must be deducted and interest on the Capital Accounts of both partners will be deducted. The remaining profit will be divided equally between A and B. Further if the Partnership Deed says that profits are to be divided in the ratio of, say, three-fourth to A and one-fourth to B, then this will be the ratio to be adopted.

The student can see for himself that if a salary is to be allowed to a partner, the Profit and Loss Appropriation Account will be debited and the Partner’s Capital Account will be credited. Similarly, if interest is to be allowed on capital, the Profit and Loss Appropriation Account will be debited and the respective Capital Accounts will be credited.  

Let us take an illustration to understand how to divide profits among partners. 

Illustration 1

A and B start business on 1st January, 2011, with capitals of Rs 30,000 and Rs 20,000. According to the Partnership Deed, B is entitled to a salary of Rs 500 per month and interest is to be allowed on capitals at 6% per annum. The remaining profits are to be distributed amongst the partners in the ratio of 5:3. During 2011 the firm earned a profit, before charging salary to B and interest on capital amounting to Rs 25,000. During the year A withdrew Rs 8,000 and B withdrew Rs 10,000 for domestic purposes.

Give journal entries relating to division of profit.

Solution

Journal Entries

Now, let us learn the preparation of profit and loss appropriation account with the help of same illustration of partnership firm consisting of partners A and B.

Illustration 2

Ram, Rahim and Karim are partners in a firm. They have no agreement in respect of profit-sharing ratio, interest on capital, interest on loan advanced by partners and remuneration payable to partners. In the matter of distribution of profits they have put forward the following claims :

(i) Ram, who has contributed maximum capital demands interest on capital at 10% p.a. and share of profit in the capital ratio. But Rahim and Karim do not agree.
(ii) Rahim has devoted full time for running the business and demands salary at the rate of Rs 500 p.m. But Ram and Karim do not agree.
(iii) Karim demands interest on loan of Rs 2,000 advanced by him at the market rate of interest which is 12% p.a.

How shall you settle the dispute and prepare Profit and Loss Appropriation Account after transferring 10% of the divisible profit to Reserve. Net profit before taking into account any of the above claims amounted to Rs 45,000 at the end of the first year of their business.

Solution

There is no partnership deed. Therefore, the following provisions of the Indian Partnership Act are to be applied for settling the dispute.

(i) No interest on capital is payable to any partner. Therefore, Ram is not entitled to interest on capital.
(ii) No remuneration is payable to any partner. Therefore, Rahim is not entitled to any salary.
(iii) Interest on loan is payable @ 6% p.a. Therefore, Karim is to get interest @ 6% p.a. on Rs 2,000 instead of 12%.
(iv) The profits should be distributed equally.

Profit and Loss Appropriation Account for the year ended…

Illustration 3

A and B start business on 1st January, 2011, with capitals of Rs 30,000 and Rs 20,000. According to the Partnership Deed, B is entitled to a salary of Rs 500 per month and interest is to be allowed on opening capitals at 6% per annum. The remaining profits are to be distributed amongst the partners in the ratio of 5:3. During 2011 the firm earned a profit, before charging salary to B and interest on capital amounting to Rs 25,000. During the year A withdrew Rs 8,000 and B withdrew Rs 10,000 for domestic purposes.

Prepare Profit and Loss Appropriation Account.

Solution

Profit and Loss Appropriation Account

Let us also learn the preparation of capital accounts of partners with the help of same illustration of partnership firm consisting of partners A and B.

Illustration 4

A and B start business on 1st January, 2011, with capitals of Rs 30,000 and Rs 20,000. According to the Partnership Deed, B is entitled to a salary of Rs 500 per month and interest is to be allowed on opening capitals at 6% per annum. The remaining profits are to be distributed amongst the partners in the ratio of 5:3. During 2011, the firm earned a profit, before charging salary to B and interest on capital amounting to Rs 25,000. During the year A withdrew Rs 8,000 and B withdrew Rs 10,000 for domestic purposes.

Prepare Capital Accounts of Partners A and B.

Solution

B’s Capital Account

6.2 Fixed and Fluctuating Capital : You have seen in the above example that the Capital Account of A has changed from Rs 30,000 at the beginning to Rs 33,800 and B’s Capital A/c from Rs 20,000 to Rs 23,200. This is because we have made entries in respect of interest, salary, profit earned during the year and money taken out by the partners in the Capital Account itself. If the Capital Accounts are prepared on this basis, capitals are said to be fluctuating. Some firms, however prefer to continue to show the Capital Accounts of the partners at the same old figure. This means that no entry is to be made in the Capital Account in respect of interest, salary, profit and drawings etc. A separate account is to be opened for this purpose. This account is known as the Current Account or even as Drawings Account. Under this system interest on capital if allowed, should be calculated only on the amount of the fixed capital. If the capital Accounts are prepared on this basis, capitals are said to be fixed.

6.2.1 Interest on Capital : Interest is generally allowed on capitals of the partners. Interest on capital of partners is calculated for the relevant period for which the amount of capital has been used in the business. Normally, it is charged for full year on the balance of capital at the beginning of the year unless some fresh capital is introduced during the year. On the additional capital introduced, interest for the relevant period of utilisation is calculated. For example, A has Rs 30,000 capital in the beginning of the year and introduces Rs 10,000 during the year. If rate of interest on capial is 20 % p.a., interest on A’s capital is calculated as follows:

In case of fixed capital accounts, interest is calculated on the balance of capital accounts only and no interest is payable / chargeable on the balance of current accounts.

Net loss and Interest on Capital : Subject to contract between the partners, interest on capitals is to be provided out of profits only. Thus in case of loss, no interest is provided. But in case of insufficient profits (i.e., net profit less than the amount of interest on capital), the amount of profit is distributed in the ratio of capital as partners get profit by way of interest on capital only. 

6.2.2 Interest on Drawings : Sometimes interest is not only allowed on the capitals, but is also charged on drawings. In such a case, interest will be charged according to the time that elapses between the taking out of the money and the end of the year. Suppose X, a partner, has drawn the following sum of money –

Accounts are closed on 31st December every year. Interest is chargeable on drawings at 6% per annum. The interest on X’s drawings will be calculated as shown below :

Alternatively, it can be calculated as follows :

If the dates on which amounts are drawn are not given, the student will do well to charge interest for six months on the whole of the amount on the assumption that the money was drawn evenly through out the year. In the above example, the total drawings come to Rs 2,300; and at 6% for 6 months, the interest comes to Rs 69. The entry to record interest on drawings is- debit the Capital Account of the partner concerned (or his Current Account if the capital is fixed) and credit the Profit and Loss Appropriation Account.

If withdrawals are made evenly in the beginning of each month, interest can be calculated easily for the whole of the amount of 6-1/2 months; if withdrawals are made at the end of each month, interest should be calculated for 5-1/2 months.

6.2.3 Guarantee of Minimum Profit : Sometimes, one partner can enjoy the right to have minimum amount of profit in a year as per the terms of the partnership agreement. In such case, allocation of profit is done in a normal way if the share of partner, who has been guaranteed minimum profit, is more than the amount of guaranteed profit. However, if share of the partner is less than the guaranteed amount, he takes minimum profit and the excess of guaranteed share of profit over the actual share is borne by the remaining partners as per the agreement. 

There are three possibilities as far as share of deficiency by other partners is concerned. These are as follows :

• Excess is payable by one of the remaining partners.
• Excess is payable by atleast two or all the partners in an agreed ratio.
• Excess is payable by remaining partners in their mutual profit sharing ratio.

If the question is silent about the nature of guarantee , the burden of guarantee is borne by the remaining partners in their mutual profit sharing ratio.

Illustration 5

A and B are partners sharing profits and losses in the ratio of their effective capital. They had Rs 1,00,000 and Rs 60,000 respectively in their Capital Accounts as on 1st January, 2011.

A introduced a further capital of Rs 10,000 on 1st April, 2011 and another Rs 5,000 on 1st July, 2011. On 30th September, 2011 A withdrew Rs 40,000.

On 1st July, 2011, B introduced further capital of Rs 30,000.

The partners drew the following amounts in anticipation of profit.

A drew Rs 1,000 per month at the end of each month beginning from January, 2011. B drew Rs 1,000 on 30th June, and Rs 5,000 on 30th September, 2011.

12% p.a. interest on capital is allowable and 10% p.a. interest on drawings is chargeable. Date of closing 31.12.2011. Calculate: (a) Profit-sharing ratio; (b) Interest on capital; and (c) Interest on drawings.

Solution

(a) Calculation of Effective Capital

(b) Calculation of Interest on Capital

A = Rs 12,00,000 x 12/100 x 1/12 = Rs 12,000     B = Rs 9,00,000 x 12/100 x 1/12 = Rs 9,000

(c)  Calculation of Interest on Drawings

A = Rs 12,000 x 10/100 x 5.5/12 = Rs 550     B = Rs 1,000 x 10/100 x 6/12 = Rs 50 Rs 5,000 x 10/100 x 3/12 = Rs 125

Illustration 6

Ram and Rahim start business with capital of Rs 50,000 and Rs 30,000 on 1st January, 2011. Rahim is entitled to a salary of Rs 400 per month. Interest is allowed on capitals and is charged on drawings at 6% per annum. Profits are to be distributed equally after the above noted adjustments. During the year, Ram withdrew Rs 8,000 and Rahim withdrew Rs 10,000. The profit for the year before allowing for the terms of the Partnership Deed came to Rs 30,000. Assuming the capitals to be fixed, prepare the Profit and Loss Appropriation Account and the Capital and Current Accounts relating to the partners.

Solution

Profit & Loss (Appropriation) Account

Illustration 7

With the help of same information given in illustration 6, let us prepare the Capital and Current Accounts of Ram and Rahim.

Solution

Ram’s Capital Account

Rahim’s Capital Account

Ram’s Current Account

Rahim’s Current Account

Illustration 8

Weak, Able and Lazy are in partnership sharing profits and losses in the ratio of 2:1:1. It is agreed that interest on capital will be allowed @ 10% per annum and interest on drawings will be charged @ 8 % per annum. (No interest will be charged/allowed on Current Accounts).

The following are the particulars of the Capital and Drawings Accounts of the partners:

The draft accounts for 2011 showed a net profit of Rs 60,000 before taking into account interest on capitals and drawings and subject to following rectification of errors :

(a) Life Insurance premium of Weak amounting to Rs 750 paid by the firm on 30th June, 2011 has been charged to Miscellaneous Expenditure A/c.

(b) Repairs of Machinery amounting to Rs 10,000 has been debited to Plant Account and depreciation thereon charged @ 20%.

(c) Travelling expenses of Rs 3,000 of Able for a pleasure trip to U.K. paid by the firm on 30th June, 2011 has been debited to Travelling Expenses Account.

You are required to prepare the Profit and Loss Appropriation Account for the year ended 31st December, 2011. 

Solution

WEAK, ABLE & LAZY

Profit and Loss Appropriation Account for the year ended 31st December, 2011

Working Notes :

1. Adjusted Profit

2. Interest on Drawings :

Illustration 9

After preparation of Profit and Loss Appropriation Account for the year ended 31st December, 2011 let us prepare Current Accounts of partners Weak, Able and Lazy for the year ended 31st December, 2011.

Solution

Partners’ Current Accounts

Illustration 10

Ram and Rahim are in partnership sharing profits and losses in the ratio of 3:2. As Ram, on account of his advancing years, feels he cannot work as hard as before, the chief clerk of the firm, Ratan, is admitted as a partner with effect from 1st January, 2011, and becomes entitled to 1/10th of the net profits and nothing else, the mutual ratio between Ram and Rahim remaining unaltered.

Before becoming a partner, Ratan was getting a salary of Rs 500 p.m. together with a commission of 4% on the net profits after deducting his salary and commission.

It is provided in the partnership deed that the share of Ratan’s profits as a partner in excess of the amount to which he would have been entitled if he had continued as the chief clerk, should be taken out of Ram’s share of profits.

The net profit for the year ended December 31, 2011 is Rs 1,10,000. Show the distribution of net profit amongst the partners.

Profit and Loss Appropriation Account for the year ended 31.12.2011