Accounting for Partnership: Basic Concepts

Written and reviewed by Devendra Dubey, Mathematics & Commerce faculty at UniDrill (M.Sc. Mathematics, Osmania University · 10 years teaching). Based on NCERT Accountancy Class XII (Accountancy Part I), Chapter 1.

Three friends, one bakery, and no written agreement

Asha, Bilal and Chetan open a bakery. Asha puts in ₹6,00,000, Bilal ₹3,00,000 and Chetan ₹1,00,000, but Chetan bakes every morning from five. At the end of the first year the profit is ₹90,000, and an argument begins. Asha says profit should follow capital. Chetan says it should reward work. Bilal says nobody ever decided.

If they had no agreement about it, the law decides for them: three equal shares of ₹30,000, no extra reward for Asha's bigger capital and no salary for Chetan. Accounting for partnerships is mostly the story of how to record what the partners agreed, and what the law assumes when they agreed nothing.

What a partnership is

Section 4 of the Indian Partnership Act, 1932 defines a partnership 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. The persons are individually partners, together a firm, and the name of the business is the firm's name. A firm is not a separate legal person apart from its partners.

Beyond the textbook. For the exam: a partnership firm is not a legal person apart from its partners, and the partners' liability is unlimited. In reality: the Limited Liability Partnership, set up under a separate Act of 2008, is a distinct legal entity in which each partner's liability is limited. Why it matters: the features above describe the traditional partnership of the 1932 Act, and an LLP is a different kind of business form.

The partnership deed and what happens when it is silent

The partnership deed is the written agreement. It should be drawn up as the Stamp Act requires and preferably registered with the Registrar of Firms. A good deed covers the following.

When the deed does not address a point, the Partnership Act supplies a default.

Pause and predict: Asha, Bilal and Chetan have no deed. The profit is ₹90,000. How much does each get, and does Asha receive interest on her larger capital?

Check your answer: each gets ₹30,000. Asha receives no interest, since interest on capital is nil without an agreement, and Chetan gets no salary.

Capital accounts: fixed or fluctuating

There are two ways to keep a partner's capital account.

The Profit and Loss Appropriation Account

After the Profit and Loss Account gives the net profit, the Profit and Loss Appropriation Account shows how that profit is divided. It is an extension of the Profit and Loss Account. The key idea is the difference between a charge against profit and an appropriation of profit.

The account is debited with interest on capital, partners' salary or commission, and finally the share of profit given to partners. It is credited with the net profit and with interest charged on partners' drawings, because this is income for the firm. If the firm made a loss, no interest on capital, salary or commission is allowed, because they come out of profit.

Interest on capital

Interest on capital is allowed only if the deed says so. It is worked out on the capital of each partner for the period the money was in the business.

$$\text{Interest on capital} = \text{Capital} \times \dfrac{\text{Rate}}{100} \times \dfrac{\text{Months}}{12}$$

Additional capital counts from the day it is brought in. A withdrawal stops earning interest from the day it is taken out. Interest is allowed only out of profit.

Worked example: interest on capital with changes in the year. Anil's capital on 1 April is ₹3,00,000. He brings ₹60,000 more on 1 July and withdraws ₹40,000 of capital on 1 January. Interest is 12% a year, and the year ends on 31 March. Find the interest.

Common wrong step. Charging the ₹60,000 for the whole year, which gives ₹7,200 instead of ₹5,400. Interest runs only from 1 July.

What if profit is too small? Interest on capital cannot create a loss. If the profit available is less than the interest due, it is shared among the partners in the ratio of the interest, not in the profit-sharing ratio. If there is a net loss, no interest is paid.

Worked example: profit less than interest due. Meena and Naveen have capitals of ₹2,00,000 and ₹1,00,000, share profits equally, and the deed allows interest at 10%. The profit is ₹24,000. How is it shared?

Common wrong step. Dividing the ₹24,000 equally between the two partners, ₹12,000 each, because the profit-sharing ratio is 1 : 1. When profit is short, the interest ratio governs, and the profit sharing ratio does not come into play at all.

Interest on drawings

If the deed provides for it, partners are charged interest on money withdrawn. The firm gains this interest, so it is a credit to the Profit and Loss Appropriation Account and a debit to the partner.

The time period depends on when the drawings are made. For equal amounts at regular intervals, use the average period.

When the amounts or dates differ, use the product method.

$$\text{Interest on drawings} = \text{Sum of products} \times \dfrac{\text{Rate}}{100} \times \dfrac{1}{12}$$

where each product is the amount drawn multiplied by the months from the date of drawing to the year end. If only the total is given with no dates, the drawings are assumed to be spread evenly through the year, so use 6 months.

Worked example: interest on drawings. The year ends on 31 March. (a) Bhavna withdraws ₹10,000 at the end of every month, interest at 8%. (b) Chirag withdraws ₹24,000 on 1 April, ₹36,000 on 1 July and ₹12,000 on 1 December, interest at 12%. Find the interest for each.

Common wrong step. Using 6½ months for drawings made at the end of each month. That figure is for the beginning of each month. At the beginning the same drawings would cost 1,20,000 × 8% × 6.5 ÷ 12 = ₹5,200, which is ₹800 more.

Interest on a partner's loan

If a partner lends money to the firm, the loan earns interest at the agreed rate, or at 6% a year if the deed is silent. This interest is a charge against profit. It is debited to the Profit and Loss Account, before net profit is reached, and it is paid even if the firm has made a loss.

Pause and predict: a partner lent ₹50,000 to the firm at the start of the year, and the deed is silent. How much interest is due, and where is it debited?

Check your answer: 50,000 × 6% = ₹3,000, debited to the Profit and Loss Account as a charge. It is not an appropriation.

Putting it together: a full appropriation account

Worked example: appropriation and current accounts. A and B share profits 3 : 2 and keep fixed capitals of ₹3,00,000 and ₹2,00,000. The deed allows interest on capital at 10%, a salary of ₹20,000 to A, a commission of ₹6,000 to B, and interest on drawings (A ₹4,000, B ₹2,000). A also lent ₹50,000 to the firm at the start of the year. The deed is silent on loan interest. The profit before charging loan interest is ₹1,00,000. A drew ₹40,000 and B ₹20,000. Prepare the appropriation account and the current accounts.

Under the fluctuating method, the same entries go to the single capital account. A's capital would close at 3,00,000 + 22,200 = ₹3,22,200 and B's at 2,00,000 + 14,800 = ₹2,14,800.

Common wrong step. Placing interest on drawings on the debit side of the appropriation account. It is charged to the partner, so the partner's account is debited and the appropriation account, representing the firm, is credited. Putting it on the debit side would reduce the profit instead of increasing it.

Beyond the textbook. For the exam: interest on capital, partner's salary and commission are appropriations of profit, not expenses of the firm. In reality: for income tax, a firm's deduction for interest and remuneration paid to partners is allowed only within limits set by the Income Tax Act. Why it matters: the accounts record what the partners agreed, but the tax return follows the tax rules.

Guarantee of a minimum profit

A partner may be guaranteed a minimum profit share, usually by one or more of the other partners or by the firm. If the share by ratio falls short of the guarantee, the deficiency is made up by the guarantors, in the agreed ratio, or in their profit-sharing ratio if none is stated.

Worked example: guarantee of profit. X, Y and Z share profits in the ratio 2 : 2 : 1. X and Y guarantee Z a minimum profit of ₹40,000 a year, bearing any deficiency equally. The profit for the year is ₹1,50,000. Show the final shares.

If X had alone given the guarantee, X would bear the full ₹10,000 and receive ₹50,000, with Y keeping ₹60,000.

Common wrong step. Taking the deficiency from Z or from all three partners. Z is the one being protected, so Z's share rises to the guarantee, and the guarantors' shares fall by exactly that amount.

Pause and predict: in the year above, suppose the profit is only ₹1,00,000 and Z's share by ratio is ₹20,000. How much does Z receive?

Check your answer: ₹40,000, because the guarantee holds whatever the profit. The deficiency of ₹20,000 is borne by X and Y.

Past adjustments: fixing a mistake after the accounts are closed

Sometimes a firm finds that interest on capital, interest on drawings, salary or some other item was left out, or wrongly dealt with, after the profits were distributed. The correction is made either through a Profit and Loss Adjustment Account or by a single entry between the partners' accounts. The single entry compares what each partner should have received with what he actually received.

Worked example: omitted interest on capital. Rameez and Zaheer are equal partners with capitals of ₹50,000 and ₹1,00,000. Last year's profit was ₹60,000, shared equally. The deed provided for interest on capital at 6%, which was left out. Rectify.

Rameez received too much and Zaheer too little, so Rameez's account is debited and Zaheer's credited with ₹1,500.

The same result by the other route:

Rameez ends up with 3,000 − 4,500 = a net debit of ₹1,500. Zaheer gets 6,000 − 4,500 = a net credit of ₹1,500. It is the same answer.

Common wrong step. Giving Rameez ₹3,000 and Zaheer ₹6,000 and stopping there. That ignores the fact that the profit was already shared equally, so the interest has to come out of the profit that was divided.

Exam traps

Formats and formula sheet

Profit and Loss Appropriation Account at a glance.

60-second revision

Where this chapter connects

• Earlier idea reused: Financial Statements I built the Profit and Loss Account and the transfer of net profit to Capital, which here becomes the Appropriation Account.
• Also revisit: Financial Statements II treated interest on capital as an adjustment, and Trial Balance and Rectification of Errors introduced the Profit and Loss Adjustment Account used for past mistakes.
• Next: Reconstitution of a Partnership Firm: Admission of a Partner changes the profit sharing ratio, and guarantee of profit and past adjustments come back there.
• Later: Retirement or Death of a Partner and Dissolution of Partnership Firm use the same capital accounts and the same deed rules.