Accounting for Partnership

A partnership agreement or Deed of partnership is an agreement between two or more persons who wish to do business in form of a partnership. The aim of the partnership agreement is to lay down terms and conditions for the smooth operation of the partnership business. A person who has entered into a partnership with one another is called collectively a "firm"

1. Profit sharing ratio between the partners.
2. Loans and advances from the partners and the rate of interest thereon.
3. Drawings allowed to the partners and the rate of interest thereon.
4. Amount of salary and commission, if any, payable to the partners.
5. Duties, powers and obligations of partners.
6. Maintenance of accounts and arrangement for their audit.
7. Mode of valuation of goodwill in the event of admission, retirement and death of a partner.
8. Settlement of accounts in the case of dissolution of the firm.

Each partner is an agent of the partnership within the scope of normal operations. This mutual agency means that each partner is personally liable for the partnership's debts. Unlimited liability distinguishes a partnership from a corporation. Property invested in the partnership is jointly owned. Each partner shares in the income or losses of the partnership according to the distribution specified in the partnership agreement. If the agreement states how income should be shared but doesn't mention losses, the losses are distributed the same way as income. If partners fail to describe the method of income and loss distribution in the agreement, the law states that income and losses must be shared equally. Mutual agency is an important one, as this allows one partner to enter into contract that bind the entire partnership.

1. Losses and liability are shared among the partners
2. Duties may be allocated according to the expertise or skills of the partners; this allows effective running of the business.
3. Relatively few legal requirements are fulfilled to form a partnership.
4. Better decisions arrived due to consultations among the partners.
5. Capital is contributed by partners, thus have more possibility of having enough capital to start and operate a business, and thus enables a business to expand as compared to sole proprietorship.
6. Easy to form
7. Limited government control

1. Partners have unlimited liability except for the limited partners, where the law requires at least one partner should be general.
2. Decision – making may take long time due to consultations or discussions among partners, this may cause the partnership to lose some opportunities.
3. A partnership does not have perpetual life (has a limited life) as its life depend on the relationship that exists among the partners.
4. Any mistake made by one partner in the cause of running the business affects all the partners
5. There is possibility of conflicts among the partners since each may have different interest, altitudes and needs.

Partnership form of business organization is quite similar to a sole proprietorship form of business, but there are certain exceptions to this form of business organization that needs to be taken into consideration while preparing accounts for the partnership firms.

Special aspects of partnership accounts

1. Maintenance of Partners Capital Accounts
2. Distribution of Profit and Loss among the partners.
3. Adjustment for Wrong Appropriation of Profit
4. Reconstitution of the Partnership Firm
5. Dissolution of the Partnership Firm

Maintenance of Partners Capital Accounts

Most of the transactions relating to the partners of the firm are recorded in the books of the firm through their capital accounts. This includes various transactions like money brought in by the partner, withdrawal of the capital, the share of profit, interest on drawings, interest on capital, etc.

There are 2 methods by which the capital of the partners is maintained. These special aspects accounts are:

1. Fixed Capital Method: Under this method, a firm maintains 2 capital accounts in order to keep the capital account balance stable from regular capital related transactions. These 2 accounts are as follows: Capital Account and Current Account. Capital Account only includes transactions like Initial investment, an addition of capital and permanent withdrawal of capital.
2. Fluctuating Capital Method: Under this method, a firm records all the capital related transaction (Permanent as well as non-Permanent) under a single account and that is Capital Account.

Distribution of Profit and Loss Among Partners

Profit is not a new term under the Partnership form of business organization but its distribution becomes a new thing. It is very special as well as very important for the firm to distribute the profits carefully as there is more than one owner of the firm who will share the benefit/profit arising from the firm. Hence, there is a Special Account which is prepared for it which is known as Profit and Loss Appropriation Account.

Format of profit and loss appropriation account

Adjustment for Wrong Appropriation of Profit

One of the special aspects of partnership is the adjustment of partnership accounts whenever there is any adjustment or correction that needs to be made for any events in the past. It may happen that profit was shared in the wrong ratio between partners in the past, in such case the firm makes adjustments to perform rectification of the error.

Reconstitution of the Partnership Firm

Reconstitution is referred to as the changes that occur in terms of partnership or in the partnership deed which leads to creation of new terms of agreement between the partners.

Following situations lead to the reconstitution of partnership firm:

1. Admission of a new partner
2. Retirement of a partner/ Death of a partner
3. Insolvency of a partner
4. Dissolution of Partnership Firm
5. Admission of a new partner

When a firm requires additional capital or managerial help or both for the expansion of its business a new partner may be admitted supplementing its existing resources. According to the Partnership Act 1932, a new partner can be admitted into the firm only with the consent of all the existing partners unless otherwise agreed upon. With the admission of a new partner, the partnership firm is reconstituted, and a new agreement is entered into to carry on the business of the firm.

A newly admitted partner acquires two main rights in the firm: –

1. Right to share the assets of the partnership firm; and
2. Right to share the profits of the partnership firm.

For the right to acquire a share in the assets and profits of the partnership firm, the partner brings an agreed amount of capital either in cash or in kind. Moreover, in the case of an established firm which may be earning more profits than the normal rate of return on its capital the new partner is required to contribute some additional amount known as premium or goodwill. This is done primarily to compensate the existing partners for the loss of their share in the superprofits of the firm.

Following are the other important points which require attention at the time of admission of a new partner:

1. New profit-sharing ratio.
2. Valuation and adjustment of goodwill.
3. Revaluation of assets and Reassessment of liabilities.
4. Distribution of accumulated profits (reserves); and
5. Adjustment of partners' capitals.

New profit-sharing ratio

When a new partner is admitted he acquires his share in profits from the old partners. In other words, on the admission of a new partner, the old partners sacrifice a share of their profit in favor of the new partner. But what will be the share of the new partner and how he will acquire it from the existing partners is decided mutually among the old partners and the new partner. However, if nothing is specified as to how the new partner acquires his share from the old partners; it may be assumed that he gets it from them in their profit-sharing ratio. In any case, on the admission of a new partner, the profit-sharing ratio among the old partners will change keeping in view their respective contributions to the profit-sharing ratio of the incoming partner. Hence, there is a need to ascertain the new profit-sharing ratio among all the partners. This depends upon how the new partner acquires his share from the old partners for which there are many possibilities. Let us understand it with the help of the following illustrations.

Example

If partner Z is admitted and the former profit-sharing ratio was X:3 and Y:2 How will the profit-sharing ratio be if Z will be given

Solution

Z's share is 1/3 of the total profit. Therefore, partners X and Y will share the remaining profit 2/3

The shares of the two partners will therefore be:

Valuation and adjustment of goodwill

Goodwill is also one of the special aspects of partnership accounts which requires adjustment (also valuation if not specified) at the time of reconstitution of a firm viz., a change in the profit-sharing ratio, the admission of a partner or the retirement or death of a partner.

Over a period of time, a well-established business develops the advantage of a good name, reputation and wide business connections. This helps the business to earn more profits as compared to a newly set up business. In accounting, the monetary value of such an advantage is known as "goodwill".

The main factors affecting the value of goodwill are as follows:

1. Nature of business: A firm that produces high value-added products or has a stable demand is able to earn more profits and therefore has more goodwill.
2. Location: If the business is centrally located or is in a place having heavy customer traffic, the goodwill tends to be high.
3. Efficiency of management: A well-managed concern usually enjoys the advantage of high productivity and cost efficiency. This leads to higher profits and so the value of goodwill will also be high.
4. Market situation: The monopoly condition or limited competition enables the concern to earn high profits which leads to a higher value of goodwill.
5. Special advantages: The firm that enjoys special advantages like import licenses, low rate and assured supply of electricity, long-term contracts for the supply of materials, well-known collaborators, patents, trademarks, etc. enjoys a higher value of goodwill.

Normally, the need for the valuation of goodwill arises at the time of the sale of a business. But, in the context of a partnership firm it may also arise in the following circumstances:

1. Change in the profit-sharing ratio amongst the existing partners.
2. Admission of new partner.
3. Retirement of a partner.
4. Death of a partner; and
5. Dissolution of a firm involving the sale of the business as a going concern.
6. Amalgamation of partnership firms.

Since goodwill is an intangible asset, it is very difficult to accurately calculate its value. Various methods have been advocated for the valuation of goodwill of a partnership firm. Goodwill calculated by one method may differ from the goodwill calculated by another method. Hence, the method by which goodwill is to be calculated may be specifically decided between the existing partners and the incoming partner.

The important methods of valuation of goodwill are as follows:

Revenue-based method

In more than one type of retail business, it has been the custom to value goodwill at the average weekly sales for the past year multiplied by the given figure. This given figure will, of course, differ between different types of business, and eventually, change in the same types of business in the long term.

Example:

Assume that year 1 sales were Tshs 1,000,000

Year 2 sales Tshs 1,500,000

Year sales Tshs 2,500,000

Calculate goodwill by using two-year sales

Solution

Goodwill = Average sales × 2

=

Profit-based method

The procedure is similar to the one used in (1) above. However here we use profit instead of sales

Goodwill = average profit × given number

Purchase of super profit

Goodwill = average super profit × a given number

Inferred or implied method

Assume that we have stock 10,000,000 premises 45,000,000 debtors 35,000,000 and creditors 20,000,000

Therefore, the value of net assets = total assets – liabilities

= 10,000,000 + 45,000,000 + 35,000,000

Total assets – creditors

= 90,000,000 – 20,000,000

= 70,000,000

Assume that the purchase consideration = 75,000,000

Goodwill = purchases consideration – Net assets

= 75,000,000 – 70,000,000

= 5,000,000

As stated earlier, the incoming partner who acquires his share in the profits of the firm from the existing partners brings in some additional amount to compensate them for the loss of their share in super profits. It is termed as his share of goodwill (also called a premium). Alternatively, he may agree that a goodwill account is raised in the books of the firm by giving the necessary credit to the old partners. Thus, when a new partner is admitted, goodwill can be treated in two ways:

By Premium Method

This method is followed when the new partner pays his share of goodwill in cash. The amount of premium brought in by the new partner is shared by the existing partners in their ratio of sacrifice. If this amount is paid to the old partners directly (privately) by the new partner, no entry is made in the books of the firm. But, when the amount is paid through the firm, which is generally the case, the following journal entries are passed:

Amount brought by a new partner as premium

DR: Cash Account

CR: Goodwill Account

Goodwill distributed among the existing partners in their sacrificing ratio

DR: Goodwill A/c

CR: Existing Partners Capital A/c (Individually)

By Revaluation Method

This method is followed when the new partner does not bring in his share of goodwill in cash. In such a situation, the goodwill account is raised in the books of account by crediting the old partners in the old profit-sharing ratio. When goodwill account is to be raised in the books of account there are two possibilities,

1. No goodwill appears in books at the time of admission

   When no goodwill exists in the books at the time of the admission of a new partner, the goodwill account must be raised at its full value. This can be done by debiting the goodwill account with its full value and crediting the old partners' capital accounts in their profit-sharing ratio. The journal entry will be:

   Goodwill raised at full value in the old ratio

   DR: Goodwill A/c Dr. CR: Old Partners' Capitals A/c (individually)

   The goodwill thus raised shall appear on the balance sheet of the firm at its full value.

2. Goodwill already exists in books at the time of admission

   If the books already show some balance in the Goodwill Account, the adjustment for goodwill in the old partner's capital accounts shall be made only for the difference between the agreed value of goodwill and the amount of goodwill appearing in books. The amount of goodwill appearing in the books may be less than its agreed value or it may be more than the agreed value. If it is less than the agreed value, the difference between the agreed value of goodwill and the amount of goodwill appearing in the books will be debited to the goodwill account and credited to the old partner's capital accounts in their old profit-sharing ratio. If, however, it is more than the agreed value, the difference will be debited to the old partners' capital accounts in their old profits sharing ratio and credited to the goodwill account.

Thus, the journal entries will be as under:

i. When the value of goodwill appearing in the books is less than the agreed value.

DR: Goodwill Account CR: Old Partners' Capital Account (individually) (Goodwill raised to its agreed value)

ii. When the value of goodwill appearing in the books is more than the agreed value.

DR: Old Partners' Capital Account (individually) CR: Goodwill Account (Goodwill brought down to its agreed value)

At the time of admission of a new partner, it is always desirable to ascertain whether the assets of the firm are shown in books at their current values. In case the assets are overstated or understated, these are revalued. Similarly, a reassessment of the liabilities is also done so that these are brought into the books at their correct values. At times there may also be some unrecorded assets and liabilities of the firm. These also have to be brought into the books of the firm.

For this purpose, the firm has to prepare the Revaluation Account. The gain or loss on revaluation of each asset and liability is transferred to this account and finally, its balance is transferred to the capital accounts of the old partners in their old profit-sharing ratio. In other words, the revaluation account is credited with an increase in the value of each asset and a decrease in its liabilities because it is a gain and is debited with a decrease in the value of assets and an increase in its liabilities is debited to the revaluation account because it is a loss. Similarly, unrecorded assets are credited and unrecorded liabilities are debited to the revaluation account. If the revaluation account finally shows a credit balance, then it indicates net gain and if there is a debit balance then it indicates a net loss. Which will be transferred to the capital accounts of the old partners in the old ratio.

The journal entries recorded for revaluation of assets and reassessment of liabilities are as follows:

1. For an increase in the value of an asset DR: Asset Account CR: Revaluation Account (Gain)
2. For reduction in the value of an asset DR: Revaluation A/c Dr. CR: Asset Account (Loss)
3. For appreciation in the amount of a liability DR: Revaluation Account CR: Liability Account (Loss)
4. For reduction in the amount of a liability DR: Liability Account CR: Revaluation Account (Gain)
5. For an unrecorded asset DR: Cash Account CR: Revaluation Account (Gain)
6. For an unrecorded liability DR: Revaluation Account CR: Cash account (Loss)
7. For transfer of gain on Revaluation if a credit balance DR: Revaluation Account CR: Old Partners Capital accounts (Old ratio) (individually)
8. For transferring loss on revaluation DR: Old partner's Capital Accounts (Individually) (Old ratio) CR: Revaluation Account

Note: Entries (i), (ii), (iii) and (iv) are recorded only with the amount increase and decrease in the value of assets and liabilities.

Example 1

Esau, Chuwa and Linus are in partnership sharing profits and losses in the ratio of 3:2:1 respectively. The following is a trial balance of the partnership as of 31st December 2017.

The following information was also provided:

i. Stock at 31^st December,2017 TZS 600,000.

ii. Non-current assets are written off at the following rates: Land and buildings at 5% per annum on cost and Motor vehicles at 20% per annum on cost.

iii. Rates prepaid on 31^st December 2017 TZS 40,000

iv. Bad debts amounting to TZS 10,000 were written off and the bad debts provision to be adjusted to 5% of the outstanding debtors at 31^st December 2017.

v. On 31^st December 2017 TZS 35,500 was outstanding in respect of selling expenses

vi. According to the partnership agreement:

Linus is to get a salary of Tsh 120,000 per annum. The interest of 10% per annum is to be allowed on the partners' capital accounts. No interest is to be allowed on partners' current accounts and no interest is to be charged on partners' drawings.

Using the information provided, prepare:

i. Partners Trading, Profit and Loss Appropriation Account for the year ending 31^st December 2017.

ii. Partners' current Accounts for the year ending 31^st December 2017 and bring down the balances at 1^st January 2018.

PARTNERS TRADING, PROFIT AND LOSS A/C FOR THE YEAR ENDED 31^ST DEC 2017

PARTNERS PROFIT AND LOSS A/C FOR THE YEAR ENDED 31^st DEC 2017

BALANCE SHEET AS AT 1^st JANUARY 2018

Example 2

Show how the following transactions will be recorded in the capital accounts of the partners Tenga and Natengile when their capitals are fluctuating:

DR PARTNERS' CAPITAL A/C CR