Accounting for partnership firms fundamentals class 12 Notes Accountancy
Fundamentals of Partnership
Definition: According to the Indian Partnership Act, 1932:
"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."
Features/Characteristics/Elements of Partnership:
-
- It can be Registered or Unregistered.
- There must be at least 2 persons.
- There must be an agreement between the people coming into a partnership firm. The agreement can be Oral or Written. A written agreement is called a Partnership Deed.
- There must be an existence of business or profit motive.
- There must be a relationship of Principal and Agent:
There exists a relationship of Principal and Agent between the Partners and the Firm AND among the partners themselves. A partner can bind the firm (other partners) by his acts, and a partner can be bound by the acts of the firm (other partners).
-
- The business is carried on by all OR any of them acting for all.
LLP
Limited Liability Partnership (LLP):
It is a form of partnership that is governed by Limited Liability Partnership (LLP) Act, 2008. The Minimum number of partners needed are two and there is no limit on the maximum number of partners.
The syllabus covers only the Partnership Act. The LLP Act is just for knowledge. Only the difference between the two is to be remembered.
Difference between an Ordinary Partnership Firm and an LLP:
S.No. |
Basis of Distinction |
Partnership |
LLP |
1 |
Registration |
Optional |
Compulsory |
2 |
Applicable Law |
Indian Partnership Act,1932 |
Limited Liability Partnership Act, 2008 |
3 |
Separate Legal Entity |
Not a separate legal entity |
It is a separate legal entity |
4 |
Perpetual Succession |
No |
Yes |
5 |
Number of Partners |
Minimum-2 Maximum-50 |
Minimum-2 Maximum- No limit |
6 |
Liability |
Unlimited |
Limited to the extent of contribution towards LLP. |
7 |
Ownership of Assets |
The partners can own the asset. The firm cannot own any asset. |
LLP can own assets in its own name. |
Partnership Deed
It is a written document which contains the clauses of the partnership agreement.
It is also called 'Articles of Partnership'.
It contains the following points:
-
- The Name of the firm
- The Address of the firm
- The Name of the partners
- The addresses of the partners
- Amount of Capital contributed by each partner.
- Whether Fixed Capital Accounts will be followed or Fluctuating Capital Accounts.
- Whether Interest on Capital will be provided or Not. If yes, then what will be the rate.
- Whether Interest will be charged on Drawings. If yes, then what will be the rate?
- The Profit Sharing Ratio between the partners.
- Whether the partners will be entitled to any Salary. If yes, then the amount of salary to be paid to each partner.
- Method of valuation of Goodwill.
- Date of Commencement of Partnership.
- How the disputes among the partners will be resolved.
- Duration of the Partnership
- And few other points….
Importance of a partnership deed:
-
- Helps Avoid Conflicts: A Partnership Agreement helps to avoid conflict which may arise between partners. Where the terms of a partnership are not clearly set out and recorded, disputes may arise over ownership division, the roles and responsibilities of the partners, and the division of assets upon termination of the partnership.
- Written Record: By entering a formal, written agreement, there is little scope left for things to get messy at a later stage into the business.
- Legally Binding: A Partnership Deed is a legally binding document.
Rules applicable in absence of a Partnership Deed
-
- The partners are entitled to share the profits or losses equally.
- Partners are not entitled to interest on their capital.
- No partner will be allowed salary, or any other remuneration or commission for any extra work done for the firm.
- No interest will be charged on partners’ drawings.
- Interest at the rate of 6 per cent per annum will be allowed to partners on any loan given to the firm by them(partners).
- Every partner has a right to take part in the working of the partnership business.
- No person can be admitted into the firm without the consent of all the existing partners.
- Every partner should use the partnership property for the benefit of the firm.
- Every partner has a right to inspect the books of accounts of the firm and can take a copy of the same.
Profit and Loss Account vs Profit and Loss Appropriation Account
Basis |
Profit and Loss Account |
Profit and Loss Appropriation Account |
Purpose |
P&L account is used to determine Net Profit or Net Loss of an organization for a given accounting period. |
P&L appropriation account is used for allocation and distribution of Net Profit among partners, reserves and dividends. |
Made by |
P&L account is prepared by all types of businesses. |
P&L appropriation account is prepared mainly by partnership firms. |
Balances |
Profit and loss account don’t have any opening or closing balance as it is prepared for a specific accounting period. |
Profit and loss appropriation account may have carry forward balance from the previous accounting period. |
Timing |
It is prepared after the trading account. |
It is made after preparation of profit and loss account. |
Nature |
Items debited are all expenses (charged against profit) |
Items debited are all appropriations of profit. (how profit is divided) |
Partnership |
Preparation of P&L account is not based on a partnership agreement (exception – interest on a loan from partners) |
Preparation of P&L account is based on a partnership agreement. |
Principle |
Matching principle is followed i.e. expenses for an accounting period are matched against related incomes. |
Matching principle is not followed while preparing a P&L appropriation account. |
Charge against Profit vs Appropriation out of profits
Basis of Distinction |
Charge against Profit |
Appropriation out of profit |
Nature |
They are the expenses to be deducted from profits. |
It is the distribution of profits to various heads. |
Recording |
Recorded in P&L A/C |
Recorded in P&L Appropriation A/C |
Necessity |
It is necessary to be recorded even if there is a loss. |
Appropriations are made only if there are profits |
Example |
Interest on Loan |
Interest on Capital |
Methods of preparation of Capital Accounts
There are 2 methods to prepare the Capital Accounts:
A.Fixed Capital Accounts. B. Fluctuating Capital Accounts
Fixed Capital Accounts:
The capitals of the partners remains fixed and don't change except in the case of permanent withdrawal of capital or bringing in of Additional Capital.
The following 2 accounts are prepared under this method:
Capital Accounts (when the capitals are fixed)
Particulars |
Partner A |
Partner B |
Particulars |
Partner A |
Partner B |
To Cash/Bank A/C (permanent withdrawal of capital) |
₹ |
₹ |
By balance b/d (opening balance) |
₹ |
₹ |
To Balance c/d (Closing balance) |
₹ |
₹ |
By Cash/Bank A/C (Additional Capital brought) |
₹ |
₹ |
TOTAL |
₹₹ |
₹₹ |
TOTAL |
₹₹ |
₹₹ |
Current Accounts
Particulars |
Partner A |
Partner B |
Particulars |
Partner A |
Partner B |
To balance b/d (in case of debit opening balance) |
₹ |
₹ |
By balance b/d (in case of credit opening balance) |
₹ |
₹ |
To Drawings |
₹ |
₹ |
By Interest on Capital |
₹ |
₹ |
To Interest on Drawings |
₹ |
₹ |
By Salary |
₹ |
₹ |
To P&L A/C (in case of loss, distributed in the profit sharing ratio) |
₹ |
₹ |
By Commission |
₹ |
₹ |
To balance c/d ( when the credit side is more than the debit side) |
₹ |
₹ |
By P&L Appropriation A/C ( in case of profit, distributed in the profit sharing ratio) |
₹ |
₹ |
By balance c/d ( when the debit side is more than the credit side) |
₹ |
₹ |
|||
TOTAL |
₹₹ |
₹₹ |
TOTAL |
₹₹ |
₹₹ |
Fluctuating Capital Accounts:
In this method only one single account is prepared. The balances of the capital accounts keep on changing.
In the absence of any instruction in the question, the Capital Accounts need to be prepared by Fluctuating Capital Accounts Method.
Methods of preparation of Capital Accounts
Capital Accounts (When capitals are fluctuating)
Particulars |
Partner A |
Partner B |
Particulars |
Partner A |
Partner B |
To balance b/d (in case of debit opening balance) |
₹ |
₹ |
By balance b/d (in case of credit opening balance) |
₹ |
₹ |
To Drawings |
₹ |
₹ |
By Interest on Capital |
₹ |
₹ |
To Interest on Drawings |
₹ |
₹ |
By Salary |
₹ |
₹ |
To P&L A/C (in case of loss, distributed in the profit sharing ratio) |
₹ |
₹ |
By Commission |
₹ |
₹ |
To balance c/d (closing balance, when the credit side is more than the debit side) |
₹ |
₹ |
By P&L Appropriation A/C ( in case of profit, distributed in the profit sharing ratio) |
₹ |
₹ |
By Cash/Bank A/C (Additional Capital brought) |
₹ |
₹ |
|||
By balance c/d (closing balance, when the debit side is more than the credit side) |
₹ |
₹ |
|||
TOTAL |
₹₹ |
₹₹ |
TOTAL |
₹₹ |
₹₹ |
Notes:
-
- ⎫All the items that increase the capital account balances, go on the credit side. And, the items that reduce the balances of the capital accounts, go on the debit side.
- ⎫If a partner brings anything in kind (asset), then, the credit side of the capital account will be credited with the Asset's name and its value. For example, if a partner brings a Machine as Capital worth ₹50,000, then the Capital account will be credited as: By Machinery A/C in the particulars column and ₹50,000 in the amount column.
Profit and Loss Appropriation Account
Particulars |
₹ |
Particulars |
₹ |
To Profit and Loss A/c (Net Loss transferred from Profit and Loss Account) |
₹ |
By Profit and Loss A/C (Net Profit transferred from Profit and Loss Account) |
₹ |
To Interest on Capitals: A_____₹_______ B_____₹_______ |
₹ |
By Interest on Drawings: A_____₹_______ B_____₹_______ |
₹ |
To Partner's Salaries |
₹ |
||
To Partner's Commissions |
₹ |
||
To Reserves (Specific or General reserve) |
₹ |
||
To Profit transferred to: A's Capital A/C (A's Current A/C) B's Capital A/C (B's Current A/C) |
₹ |
||
TOTAL |
₹₹ |
TOTAL |
₹₹ |
-
- ⎫There are only 7 entries that go in the P&L Appropriation A/c.
- ⎫It is a Nominal Account.
- ⎫Things to be paid to a partner is entered on the Debit side.
- ⎫NOTE: Whenever calculating interest on any item or the amount of salary, etc. do see whether it is per month (p.m.) or per annum (p.a.) in the question.
- ⎫NOTE: In case of loss to a firm, Profit and Loss Appropriation A/C will not be prepared and the losses will be distributed through Profit and Loss Account.
- ⎫In items like Interest on Capital, do read the question carefully, and ascertain whether the item is an appropriation out of profits or a charge against profits.
Calculation of Interest on Capital
Hence, as we can see answers from both the methods is the same. In exams, you can use any method of your choice to calculate the interest on capital.
Interest on Capital is always calculated on Opening Capital. If Closing Capital is given, you need to calculate Opening capital first.
Calculation of Manager's Commission on Net Profits:
-
- If commission is provided on profits before charging such commission:
Say, the profit is ₹1,21,000 before charging such commission and the manager is to be paid commission @10% on the profit before charging such commission, then the commission will be= 1,21,000 X 10/100 = ₹12,100
-
- If commission is provided on profits after charging such commission:
Say, the profit is ₹1,21,000 before charging such commission and the manager is to be paid commission @10% on the profit after charging such commission, then the commission will be =
1,21,000 X 10/(100+10) = 1,21,000 X 10/110 = ₹11,000
Appropriations of Net Profit
Example AP.1
A and B are 2 partners in a firm. As per the partnership deed, the partners are to get salary of ₹10,000 and ₹15,000 p.a. Also, the interest on capital @10% comes out to be ₹5,000 and ₹10,000. Total Net Profit for the year is ₹25,000.
SOLUTION:
Total Appropriations to A: 10,000+5,000=15,000
Total Appropriations to B: 15,000+10,000=25,000
Hence, TOTAL= 15,000+25,000=40,000 > 25,000 (the net profit available for distribution)
Now, the ratio of the appropriations= A:B = 15,000:25,000= 3:5
Net Profit= ₹25,000
Now, Net profit will be distributed in 3:5 =
=> A= ₹25,000 X 3/8 = ₹9,375
=> B= ₹25,000 X 5/8 = ₹15,625
Rent paid to partner:
It is a charge against profit and hence it should be debited to Profit and Loss Account and credited to rent payable account.
Rent paid to a partner is an expense incurred for using the property. Hence, it is a charge against profits and will be debited to Profit and Loss A/C, even if the firm incurs a loss.
Interest on Partner's Loan:
Rate on Interest: If a partner has advanced loan to the partnership firm, he will be entitled to receive Interest on Loan on the loan amount at the agreed rate of interest.
However, if there is no agreement as to the rate of interest, he is entitled to receive interest on loan @6% per annum.
Nature of Interest: It is a charge against profit and hence interest on partner's loan is debited to Profit and Loss A/C, even if the firm incurs a loss.
The following entries are passed to record interest on loan:
-
- For providing Interest on Partner's Loan:
Interest on Partner's Loan A/C Dr.
To Partner's Loan A/C
ii) For closing the Interest on Partner's Loan A/C:
Profit & Loss A/C Dr.
To Interest on Partner's Loan A/C
Interest on Loan taken by a Partner from the Firm:
Nature of Interest: Interest on Loan taken by a partner is a gain (since this income does not occur on regular and continuous basis) for the firm. Interest on loan taken by a partner is credited to Profit and Loss A/C.
Accounting treatment:
The following entries are passed to record interest on loan:
-
- For charging Interest on Loan to a partner:
Partner's Capital/Current A/C Dr.
To Interest on Partner's Loan A/C
-
- For closing the Interest on Partner's Loan A/C:
Interest on Partner's Loan A/C Dr.
To Profit and Loss Account
Methods of Calculating Interest on Drawings
-
- Simple Method:
Interest on Drawings= Amount of Drawings X Rate of interest/100 X Months/12
-
- Product Method:
First of all the products are computed by multiplying the each set of drawings from its duration. Then, the different products are added and the interest is calculated on the Total of products so arrived at for one month.
Interest on Drawings= Total of products X Rate of interest/100 X 1/12
-
- When a partner makes monthly drawings on regular intervals, we need to calculate Average Period then which is as follows:
Average Period = (Time left after first drawing+ Time left after last drawing)/2
Therefore, Interest on Drawings= Total Drawings X Rate of interest/100 X Average period/12
-
- Note: Average Period is to be used only when:
-
- All amounts of drawings are equal, AND
- The time gap between drawings is equal.
For example: When the drawings are of equal amount and are made during middle of each quarter:
Here, it is given that the amount of drawings is equal and the time interval between two drawing is equal (i.e. 3 months).
Hence, Average Period will be= (Time left after first drawing+ Time left after last drawing)/2
= (10.5 months+ 1.5 months)/2= 6 months
Past Adjustments (Adjustments in Closed Accounts)
As previously learnt in 11th standard, if a wrong entry is passed, we can't modify it. We have to rectify it by passing a new entry so that the net effect comes out to be like the correct entry.
Here also, similar concept is used. Sometimes, wrong entries are passed regarding to the amount of interest or any other item to be given to the partner, or sometimes, the entry is passed in wrong partner's account. In these cases, there arises a need of a rectifying entry. This process of correcting the past entries is known as Past Adjustments.
The following are the types of errors that may occur:
-
- Interest on Capitals or Drawings may get omitted.
- Interest or Salary may be credited to wrong partner's account.
- Profits and Losses have been distributed among the partners in a wrong proportion.
- When salary or commission payable to a person has been omitted.
- When the profit sharing ratio gets changed with a retrospective effect (i.e. with effect from some past date).
These errors or omissions may be rectified in two ways:
-
- By passing a single adjustment entry with the net effect of the errors and omissions (99% of the questions will be solved with this method), OR
- By passing separate adjustment entries for each error and omission.
Guarantee of Profit to a Partner
Guarantee means the surety of a particular amount of profits by one or more partners and in some cases by the firm, where the burden of guarantee is borne by the party providing such a guarantee. In other words, it is a minimum fixed amount for the partner who is given such a guarantee.
If the actual share in profits is less than the guaranteed amount then the deficit amount shall be borne either by the firm or by any partner as the case may be. There are many ‘Adjustments’ which a firm will do in such a case. If the actual share in profits is more than the minimum guarantee amount then the firm will provide the actual profits to the partner.