PARTNERSHIP ACCOUNTS – FUNDAMENTALS

BCOM(MARGHAM PUBLICATION), CLASS 12th, CMA(PAPER-5: STUDY NOTE 6), CA, CS, UGC NET/SET

INTRODUCTION

According to Section -4 of the Indian Partnership Act, 1932:

“Partnership is the relations between two or more persons who have agreed to share the profits of a business carried on by all or any one of them acting for all”

Features of Partnership

1. Two or more persons: There must be at least two persons to form a valid partnership. The maximum number of partners cannot exceed the number of partners prescribed by Companies Act, 2013 which is 50 in any business whether banking or non- banking.

2. Agreement: Partnership comes into existence by an agreement (either written or oral among the partners. The written agreement among the partners is called Partnership Deed.

3. Existence of business and profit motive: A partnership can be formed for the purpose of carrying on legal business with the intention of earning profits. A joint ownership of some property by itself cannot be called a partnership.

4. Sharing of Profits: An agreement between the partners must be aimed at sharing the profits. If some persons join hands to run some charitable activity, it will not be called partnership. Further, if a partner is deprived of his right to share the profits of the business, he cannot be called as partner.

5. Business carried on by all or any of them acting for all: It means that each partner can participate in the conduct of business and each partner is bound by the acts of other partners in respect to the business of the firm.

6. Relationship of Principal and Agent: Each partner is an agent ad well as a partner of the firm. An agent, because he can bind the other partners by his acts and principal, because he himself can be bound by the acts of the other partners.

Partnership Deed

Since partnership is the outcome of an agreement, it is essential that there must be some terms and conditions agreed upon by all the partners. Such terms and conditions mat be either written or oral. The law does not make it compulsory to have a written agreement. However, in order to avoid all misunderstandings and disputes, it is always the best course to have a written agreement duly signed and registered under the Act.

The partnership deed is a written agreement among the partners which contains the terms of agreement. It is also called ‘ Articles of Partnership’. A partnership deed should contain the following points:

  1. Name and address of the firm as well as partners.
  2. Name and addresses of the partners.
  3. Nature and place of the business.
  4. Duration, if any of partnership.
  5. Capital contribution by each partner.
  6. Interest on capital.
  7. Drawings and interest on drawings.
  8. Profit sharing ratio.
  9. Interest on loan.
  10. Partner’s Salary/commission etc.
  11. Method for valuation of goodwill and assets.
  12. Accounting period of the firm and duration of partnership
  13. Rights and duties of partners how disputes will be settled.
  14. Decisions taken if some partner becomes insolvent.
  15. Opening of Bank Account – whereas it will be in the name of firm or partners.
  16. Rules to be followed in case of admission & Settlement of accounts or retirement or death of partner.
  17. Revaluation of assets & liabilities, if any to be done.
  18. Method of recording of firm’s accounts
  19. Auditing
  20. Date of commencement of partnership

Benefits of Partnership Deed

(1) It regulates the rights, duties and liabilities of each partner.

(2) It helps to avoid any misunderstanding amongst the partners because all the terms and conditions of partnership have been laid down beforehand in the deed.

(3) Any dispute amongst the partners may be settled easily as the partnership deed may be readily referred to.

Hence, it is always best course to have a written partnership deed duly signed by all the partners and registered under the Act.

 

Absence of Partnership Deed

 

If there is no partnership deed or when there is no express statement in the partnership deed,

then the following provisions of the Act will apply:

(i) Remuneration to partners

No salary or remuneration is allowed to any partner. [Section 13(a)]

(ii) Profit sharing ratio

Profits and losses are to be shared by the partners equally. [Section 13(b)]

(iii) Interest on capital

No interest is allowed on the capital. Where a partner is entitled to interest on capital

contributed as per partnership deed, such interest on capital will be payable only out of

profits. [Section 13(c)]

(iv) Interest on loans advanced by partners to the firm

Interest on loan is to be allowed at the rate of 6 per cent per annum. [Section 13(d)]

(v) Interest on drawings

No interest is charged on the drawings of the partners.

Illustration on No Partnership Deed

 

A, B, C and D are partners in a firm. There is no partnership deed. How will you deal with the

following?

(i) A has contributed maximum capital. He demands interest on capital at 12% per annum.

(ii) B has withdrawn ` 1,000 per month. Other partners ask B to pay interest on drawings

@ 10% per annum to the firm. But, B does not agree to it.

(iii) Loan advanced by C to the firm is ` 10,000. He demands interest on loan @ 9% per

annum. A and B do not agree with this.

(iv) D demands salary at the rate of ` 5,000 per month as he spends full time for the business.

B and C do not agree with this.

(v) A demands the profit to be shared in the capital ratio. But, B, C and D do not agree.

Solution:

Since there is no partnership deed, provisions of the Indian Partnership Act, 1932 will apply.

(i) No interest on capital is payable to any partner. Therefore, A is not entitled to interest

on capital.

(ii) No interest is chargeable on drawings made by the partner. Therefore, B need not pay

interest on drawings.

(iii) Interest on loan is payable at 6% per annum. Therefore, C is to get interest at 6% per

annum on ` 10,000.

(iv) No remuneration is payable to any partner. Hence, D is not entitled to salary.

(v) Profits should be distributed equally.

Accounts of Partnership:

1.       Interest on Capital

Interest on capital is allowed to compensate partners for contributing capital to the firm in excess of profit-sharing ratio.

Interest on capital is credited to the partners at the agreed rate with reference to the time period for which the capital remained in business during a financial year.

The two situations under which interest on capital is generally provided are:

  1. When the partner contributes unequal amounts of capital but shares profits.
  2. When capital contribution is the same but the share of profits is unequal.

Accounting Treatment for Interest on Capital

Interest on capital is considered as an expense for the business and is added to the owner’s capital, which increases the overall capital of the owner in the business. Two accounts are involved in the accounting for interest on capital which is Capital A/c and Interest on Capital A/c.

 

The following journal entries are made to account for interest on capital

 

Interest on Capital A/c Dr.

To Capital A/c

Calculation of Interest of Capital:

Interest on capital is to be calculated on the capitals at the beginning for the relevant period. If there is any additional capital introduced or capital withdrawn during the year, it will cause change in the capitals and interest is to be calculated proportionately on the changed capitals for the relevant period.

Interest on capital is generally calculated on the opening balance of Partner’s capital. If the opening capital is not given it is to be calculated with those items which have been added to the capital and adding those items which have been subtracted. 

Accounting Treatment for Interest on Drawings:

The amount withdrawn by the partners for personal use is termed as drawings. It is the amount which withdrawn against profit. It is the temporary withdrawn made, which is to be returned by the partners with interest.

Interest on drawings is the amount of interest paid by the partners, calculated with reference to the time period for which the money was withdrawn.

It is an income for the firm and hence is credited to the Profit and Loss Appropriation

Account.

It is an expense to the partners, hence is debited to the Partner’s Capital Account.

Interest on drawing is charged from the partners, if it mentioned in the Partnership Deed.

 

1.       For charging interest on a partner’s drawings:

Partner’s Capital/Current A/c.Dr.

To Interest on Drawings A/c

(Being interest on drawings charged @ % p.a.)

2. For transferring interest on drawings to Profit and Loss Appropriation A/c

Interest on Drawings A/cDr.

To Profit and Loss Appropriation A/c

(Being interest on drawings transferred to P&L appropriation A/c)

 

Calculation of interest on drawings

 

Interest on drawings can be computed by following either direct method or product method. Also, if the partners withdraw fixed amount at fixed time interval, interest on drawings may be calculated on the basis of the average period method. Based on the dates of drawings and the number of drawings, different methods can be followed for calculating interest on drawings.

 

 

 

(i) Direct method

Interest is calculated on drawings for the period from the date of drawings to the date of closing date of the accounting year. The following formula is used to compute the interest on drawings:

 

Interest on drawings = Amount of drawings x Rate of interest x Period of interest

 

Period of interest refers to the period from the date of drawings to the closing date of the accounting year. This method is suitable when different amounts are withdrawn at different time intervals.

 

(ii) Product method

Under product method, interest is calculated on the total of the products, that is, the product of number of drawings and the period for which the amount remained withdrawn. If the product is calculated in terms of months, then interest is calculated on the total of products at the rate per month. If the product is calculated in terms of days, then interest is calculated on the total of products at the rate per day. This method can be used in all situations as an alternative to direct method.

 

The procedure for calculating interest on drawings under product method is as follows:

 

a)     Multiply each amount withdrawn by the relevant period (in months) to find out the individual product.

 

b)    Find out the sum of all the individual products.

 

c)     Calculate interest at the prescribed rate for one month by using the following formula.

 

Interest on drawings = Sum of products x Rate of interest p.a. × 1/12

 

Tutorial Note

 

If the period of interest is taken in days, each amount withdrawn is to be multiplied by the relevant period (in days) to find out the individual product and the following formula is to be used to find out the interest on drawings.

 

Interest on drawings = Sum of products x Rate of interest p.a. ×1/365

 

(iii) Average period method

If the partners withdraw fixed amount at fixed time interval, interest on drawings may be calculated on the basis of the average period. Fixed time interval refers to withdrawal made monthly, quarterly, half-yearly, once in 2 months and once in 4 months.