Accounting for Partnership Firms

The One Thing

Partnership accounting records how profits, goodwill, revaluation changes, capital claims, and settlement amounts are allocated among partners. The partnership deed is the primary basis for treatment; where it is silent, applicable partnership law and prescribed rules apply.

Definitions and Results

• Partnership: An agreement between persons to share the profits of a business carried on by all or any one of them acting for all. Essential features are an agreement, two or more persons, a lawful business, profit-sharing, and mutual agency.
• Partners: Persons who enter into a partnership agreement and contribute capital, skills, or services to the business.
• Partnership Firm: The collective name for all partners conducting the business together.
• Partnership Deed: A written agreement containing the terms and conditions governing the relationship among partners. It commonly specifies the firm’s name, nature of business, capital contributions, profit-sharing ratio, drawings, interest on capital, interest on drawings, salaries or commissions, admission and retirement rules, goodwill treatment, and dispute settlement.
• Mutual Agency: Every partner is both an agent and a principal of the firm and can bind the firm through business activities.
• Profit-Sharing Ratio: The agreed proportion in which partners share profits and losses.
• Fixed Capital Method: Partners’ capital accounts remain unchanged except for permanent changes. Separate current accounts record drawings, interest, salary, commission, and share of profit or loss.
• Fluctuating Capital Method: All adjustments, including profit, drawings, interest, salary, commission, and losses, are recorded directly in partners’ capital accounts. Separate current accounts are generally not required.
• Profit and Loss Appropriation Account: An account showing the distribution of net profit among partners after interest on capital, salary, commission, interest on drawings, and other appropriations.
• Goodwill: The value of a firm’s reputation and other advantages that enable it to earn higher profits than a normally expected business.
• Sacrificing Ratio: The ratio in which existing partners give up future profit share in favour of an incoming partner.

Sacrificing Ratio = Old Ratio − New Ratio.

• Gaining Ratio: The ratio in which continuing partners gain the share of a retiring or deceased partner.

Gaining Ratio = New Ratio − Old Ratio.

• Revaluation Account: An account recording increases or decreases in the values of assets and liabilities when a partner joins, retires, or dies.
• Memorandum Revaluation Account: An account used when the effect of revaluation is to be adjusted among partners without changing the book values of assets and liabilities.
• Reserve and Accumulated Profits: Undistributed profits or reserves transferred to partners’ capital or current accounts in the old profit-sharing ratio.
• Admission of a Partner: Entry of a new partner into an existing firm with the consent of all existing partners.
• Retirement of a Partner: Withdrawal of an existing partner while the remaining partners continue the business.
• Death of a Partner: Cessation of membership through death, requiring settlement of the amount due to the deceased partner’s executor or legal representative.
• Dissolution of Partnership: A change in the relationship among partners that may or may not result in closure of the business.
• Dissolution of Firm: Complete closure of the business, followed by settlement of assets, liabilities, and partners’ claims.
• Realisation Account: An account prepared at dissolution to record the transfer and sale of assets, payment of liabilities, and profit or loss on realisation.
• Partner’s Loan Account: An account recording the amount payable to a partner who has advanced a loan to the firm, especially during dissolution.
• Rules in the absence of agreement: Profits and losses are generally shared equally; no interest is allowed on capital; no interest is charged on drawings; a partner is not entitled to salary or commission; and interest on a partner’s loan is allowed at 6% per annum, subject to applicable law and curriculum rules.
• Interest on Capital:

Interest on Capital = Capital × Rate × Time. It is allowed only when authorised by the agreement and only out of available profits unless the agreement provides otherwise.

• Interest on Drawings: Calculated according to the amount withdrawn, rate, and period for which the money was used. For equal monthly drawings, the average period is generally 6 months when drawings occur at the beginning or end of each month, with the exact period depending on timing.
• Partner’s Salary or Commission: An appropriation of profit recorded only when authorised by the partnership agreement.
• Goodwill under Average Profit Method:

Goodwill = Average Profit × Number of Years’ Purchase.

• Goodwill under Super Profit Method:

Goodwill = Super Profit × Number of Years’ Purchase, where Super Profit = Average Profit − Normal Profit.

• Normal Profit:

Normal Profit = Capital Employed × Normal Rate of Return ÷ 100.

• Goodwill under Capitalisation of Average Profit Method:

Goodwill = Average Profit × 100 ÷ Normal Rate of Return.

• Goodwill under Capitalisation of Super Profit Method:

Goodwill = Super Profit × 100 ÷ Normal Rate of Return.

• Rights and duties of partners: Partners have the right to participate in management, inspect the books, and share profits. They must act honestly, maintain proper accounts, and compensate the firm for losses caused by fraud or misconduct.
• Dissolution of partnership: May occur by agreement, compulsory circumstances, specified events, notice in a partnership at will, or court order, subject to applicable law.

Worked Methods

1. Recording profit distribution and appropriations

• Begin with the partnership deed.
• Determine the profit-sharing ratio.
• Calculate interest on capital using:

Interest on Capital = Capital × Rate × Time.

• Calculate interest on drawings according to the amount, rate, and period of use. For equal monthly drawings, use an average period generally of 6 months where the drawings occur at the beginning or end of each month, subject to the exact timing.
• Record authorised partner salary or commission.
• Prepare the Profit and Loss Appropriation Account to distribute net profit after these appropriations.
• Under the fixed capital method, post the adjustments to partners’ current accounts. Under the fluctuating capital method, post them directly to partners’ capital accounts.
• If there is no agreement, apply equal profit-sharing, no interest on capital, no interest on drawings, no salary or commission, and interest on a partner’s loan at 6% per annum, subject to applicable rules.

2. Valuing goodwill

Average profit method

• Determine the average profit.
• Determine the number of years’ purchase.
• Apply:

Goodwill = Average Profit × Number of Years’ Purchase.

Super profit method

• Calculate average profit.
• Calculate normal profit:

Normal Profit = Capital Employed × Normal Rate of Return ÷ 100.

• Calculate super profit:

Super Profit = Average Profit − Normal Profit.

• Calculate goodwill:

Goodwill = Super Profit × Number of Years’ Purchase.

Capitalisation of average profit method

• Determine average profit.
• Determine the normal rate of return.
• Apply:

Goodwill = Average Profit × 100 ÷ Normal Rate of Return.

Capitalisation of super profit method

• Determine super profit.
• Determine the normal rate of return.
• Apply:

Goodwill = Super Profit × 100 ÷ Normal Rate of Return.

3. Admission of a partner

• Obtain the consent of all existing partners.
• Determine the incoming partner’s share of future profits.
• Calculate the existing partners’ sacrifice:

Sacrificing Ratio = Old Ratio − New Ratio.

• Unless another agreement is made, take the new partner’s share from the existing partners in their sacrificing ratio.
• Record the incoming partner’s capital and goodwill, where applicable.
• If goodwill is brought in cash and retained in the firm, credit the old partners’ capital or current accounts in the sacrificing ratio.
• If goodwill is withdrawn, pay it to the sacrificing partners.
• Prepare the Revaluation Account to record increases or decreases in asset and liability values.
• Adjust undistributed profits or losses and reserves among the old partners in their old profit-sharing ratio.
• Prepare partners’ capital or current accounts and the revised balance sheet.
• Ensure that the accounting entries preserve equality between the firm’s assets and the total claims of outsiders and partners.

4. Retirement of a partner

• Determine the retiring partner’s revised entitlement.
• Calculate the gaining ratio:

Gaining Ratio = New Ratio − Old Ratio.

• Calculate the retiring partner’s share of goodwill.
• Charge the gaining partners for that goodwill in their gaining ratio.
• Prepare the Revaluation Account and transfer the resulting profit or loss to the partners entitled to it before the change.
• Transfer reserves and accumulated profits or losses to partners’ capital or current accounts in the old profit-sharing ratio.
• Determine the retiring partner’s amount due, including:

- capital balance; - share of goodwill; - share of revaluation profit or loss; - accumulated profits or losses; and - profit up to the date of retirement where applicable.

• Transfer any unpaid amount to the retiring partner’s Partner’s Loan Account.
• Prepare the revised balance sheet.

5. Death of a partner

• Determine the deceased partner’s capital balance.
• Calculate the deceased partner’s share of goodwill.
• Include the deceased partner’s share of reserves, revaluation profit or loss, and other accumulated items.
• Calculate profit up to the date of death using the time basis or sales basis, according to the agreement or available information.
• Determine the total amount due to the deceased partner.
• Transfer the amount due to the deceased partner’s executor or legal representative.
• If payment is not immediate, transfer the amount to an appropriate loan account.
• Adjust the continuing partners’ gaining ratio where required and prepare the revised accounts.

6. Dissolution of the firm

• Transfer all assets except cash or bank to the Realisation Account at book value.
• Transfer external liabilities to the Realisation Account.
• When an asset is sold, debit cash or bank and credit the Realisation Account.
• When a liability is paid, debit the Realisation Account and credit cash or bank.
• Record any profit or loss on realisation.
• Transfer the profit or loss on realisation to partners’ capital accounts in their profit-sharing ratio.
• Settle claims in the following order:

1. outside liabilities; 2. partners’ loans; 3. partners’ capitals.

• Distribute any remaining surplus in the profit-sharing ratio.
• Close the firm after assets, liabilities, and partners’ claims have been settled.

Where It Goes Wrong

• Applying partnership law without first checking the partnership deed; the deed is the primary basis for accounting treatment.
• Treating partner salary, commission, or interest on capital as ordinary business expenses when they are appropriations requiring authorisation and available profit conditions.
• Confusing the fixed capital method with the fluctuating capital method: fixed capital requires separate current accounts, whereas fluctuating capital records adjustments directly in capital accounts.
• Using the wrong ratio: admission requires the sacrificing ratio, while retirement or death requires the gaining ratio.
• Forgetting to adjust revaluation profit or loss and reserves among the partners entitled to them before the admission, retirement, or death.
• Omitting the required dissolution order: outside liabilities are paid first, followed by partners’ loans and then partners’ capitals.

What Gets Asked

• Define partnership, partnership deed, mutual agency, goodwill, revaluation account, realisation account, and dissolution of firm.
• State the essential features of partnership and the rights and duties of partners.
• Explain the contents of a partnership deed and the rules applicable when no agreement exists.
• Distinguish between the fixed capital method and the fluctuating capital method.
• Calculate interest on capital, interest on drawings, partner salary, commission, and distributions through the Profit and Loss Appropriation Account.
• Calculate goodwill using the average profit, super profit, capitalisation of average profit, and capitalisation of super profit methods.
• Calculate sacrificing ratio and prepare accounts on admission of a partner.
• Calculate gaining ratio and prepare accounts on retirement of a partner.
• Determine the amount due to a deceased partner, including profit up to the date of death using time basis or sales basis.
• Prepare a Memorandum Revaluation Account where book values are to remain unchanged.
• Prepare a Realisation Account and settle assets, liabilities, partners’ loans, and partners’ capitals on dissolution.
• Explain the difference between dissolution of partnership and dissolution of firm.
• Identify the accounting records required for partnership changes, including the revaluation account, partners’ capital or current accounts, balance sheet, and other supporting accounts.