When two or more persons enter into an agreement for setting up a business, running it, and sharing its profits and losses, it is called partnership. The persons who have entered into a partnership with one another are called individually ‘partners’, and collectively a ‘firm’.
Definition of partnership
The Indian Partnership Act, 1932, defines partnership as follows :
“Partnership is the relationship between the persons who have agreed to share a profit of a business carried on by all or any one of them acting for all.”
According to the above definition, the five essential features of partnership are as follows :
More than one person : Partnership is an association of more than one person. No person can make an agreement with himself. Therefore, at least two persons are required for partnership. The Partnership Act does not say anything about the maximum number of partners. But section 11 of the Companies Act fixes the maximum number at 20 for banking business and 10 for a partnership carrying on any other type of business. If, in a partnership, the number exceeds the statutory limits, the firm is considered to be an illegal association unless it is registered as a company under the Companies Act or is formed in pursuance of some other Indian Law.
Agreement : There should be an agreement among all the partners regarding partnership. Members of a partnership firm should possess a healthy mind as a mad person cannot become a partner. A minor also cannot become a (full-time) partner. He can, however, share only in profits of the firm with unanimous decision of partners.
Carry on a Business : The agreement should be to conduct some business.
Legal Object : The aim of partnership business should be within the framework of constitution, otherwise the partnership will be termed as illegal.
Business Carried on by All or Anyone of Them Acting for All: The firm’s business may be carried on by all the partners or any one of them acting for all. This means that each partner can participate in the conduct of business and act for the firm, and each partner is bound by the acts of other partners with regard to the business of the firm. In fact partnership is based on the concept of mutual agency and relationship. A partner is both an agent (he can, by his acts, bind the partners) and a principal (He can be bound by the acts of the other partners.)
Profit Sharing Moto : The main aim of partnership is earning and sharing of profit. If some persons join hands to carry on some charitable activity, it will not be termed as partnership. Of course the ratio, in which the partners will share profits, is determined by other agreement and if there is no specific agreement on the sharing of profits and losses of the firm, they will share them equally.
If any characteristic of partnership is lacking in a business, it will not be treated as partnership. In case of death of a partner, if any member of his family runs business, it will not be treated to be partnership, because there has been no unanimity among the partners. The rights and duties of a partners are decided by an agreement among the partners. In the absence of an agreement, the following rules will be applicable:
1. Every partner is entitled to share profits equally.
2. Every partner is entitled to check the accounts of the partnership firm and obtain a copy of the same.
3. Every partner can take part in running the business.
4. Every partner has a right to give his views in connection with business matters.
5. Every partner can prevent the entry of a new partner.
6. If a partner invests excess amount to his share of capital he is entitled to interest @ 6% per annum on additional capital.
7. Every partner has a right to retire after giving due notice.
8. If a partner spends something or pays for some liability with the aim of running business properly, he can seek proper compensation for that.
9. In emergency, every partner has right to act according to his wisdom.
Partnership deed
A partnership is formed by an agreement. This agreement may be oral or in writing. Though the law does not expressly require that the partnership agreement should be in writing, it is desirable to have it in writing. A document which contains the terms of partnership as agreed to by the partners is called partnership deed.
A partnership deed should contain the following information:
1. Name under which the business of the firm is to be carried out.
2. Nature and place of business.
3. Name and address of each partner.
4. Date of commencement of partnership and its duration.
5. The capital of the firm and the proportion in which it is to be contributed by each partner.
6. Rules regarding operation of bank account.
7. Ratio in which profits and losses are to be shared.
8. The rate of interest to be allowed to each partner on his/her capital and on his/her loan to the firm, an interest to be charged on his/her drawings.
9. The amount to be allowed for domestic expenses of the partners.
10. The amount of allowances, salaries, commission, etc. if payable to any partner.
11. The safe custody of books of accounts and other documents of the firm.
12. Mode of auctioneers’s appoint-ment, if any.
13. Rules to be followed in case of admission, retirement, death, etc. of a partner.
14. The circumstances under which the firm will be dissolved and settlement of accounts at the time of dissolution.
15. Whether the Capital Accounts be fixed or fluctuating.
16. The method, how further capital, if necessary is to be introduced.
17. The method of determining goodwill at the time of admission, retirement or death of a partner.
18. The method of ascertaining the amount due to the retiring partner or representative of a deceased partner in respect of capital and the accrued profits since the last accounts and the manner in which the liability is to be settled.
19. The manner of treating premium on the insurance policies which may be taken out to provide further capital required on the death or retirement of a partner and the method of treating the division of the policy money.
In the absence of partnership deed
In the absence of a deed or an express agreement, the relevant provisions of the Partnership Act will become applicable. It is, therefore, necessary to know the provisions of the Act which have a direct bearing on the accounting treatment of certain items. These provision are as follows :
Profit Sharing : The partners shall share the profits and losses of the firm equally, irrespective of their capital contribution.
Interest on Loan : If any partner, apart from the share of his capital, advances any money to the firm as a loan, he or she is entitled to interest on such amount @ 6% per annum. Such interest will be paid, even if there are losses.
Interest on Capital : No interest will be allowed to the partners on the capital contributed by them. Where, however, the agreement provides for interest on capital, such interest is payable only out of profits of the business. In other words, if there are losses, interest on capital will not be allowed, even if the agreement so provides.
Interest on Drawings : No interest will be charged on drawings made by the partners.
Remuneration to Partners : No partner is entitled to any salary or commission for participating in the business.
Partners’ account
The account of partners are maintained in the same manner as the case of a proprietor. The transactions relating to the proprietor are recorded in capital account. Similarly in the case of partnership, the transactions relating to the partners should also be recorded in respective accounts. Normally, capital account of each partner is prepared separately. But these accounts can also be shown in tabular from under special circumstances, such as admission, retirement or death of a partner, dissolution of partnership firm etc. Accounting procedure of sole proprietorship is different from partnership accounting.
Profit and loss appropriation account
In case of sole proprietorship, Trading and Profit and Loss Account are prepared. But in a partnership, Profit and Loss Appropriation Account is also prepared in order to divide profit among the partners of the firm. The format of Profit and Loss Appropriation Account follows :
Format of Profit & Loss Appropriation Account
Dr. Cr
Particulars Amt. Particulars Amt.
Rs. Rs.
To Profit A/c By Profit & Loss
(Loss before A/c (Profit
adjustment) Before Adjustment)
To Partners’ By Partners Capital/
Capital/current Current A/c
A/c (Salaries) By Partners Capital/
To Partners’ Capital/ Current A/c
Current A/c (Distribution of Loss)
(Commission)
To Partners Capital/
Current A/cs
(Distribution of Profit)
Capital accounts
In a partnership business, as many capital accounts are prepared as many partners are there in the firm. For example, if there are four partners in a partnership firm, four capital accounts will be prepared.
The following journal entries are passed to prepare profit and loss appropriation account and partnership accounts of partners :
When Capital is Received from Partners:
Cash/Bank A/c Dr
To Capital A/c of Partners
(By Name)
(Being Capital received from partners)
When Loan is Received from Partners
Cash/Bank A/c Dr
To Loan from (By Name)
(Being loan received from
(By name)
When Interest is due on Capital
Profit & Loss A/c Dr.
To Capital/Current Account
of Partners (By Name)
(Being interest due on capital)
When Interest is Due on Drawings
Partners Capital/Current A/c
(By Name) Dr
To Profit & Loss Appropriation A/c
(Being interest charged on drawings)
For Commission to the Partners:
Profit & Loss Dr.
Appropriation A/c
To Partners Capital/Current A/c
(By Name)
(Being Commission due to them)
For Net Profit :
Profit & Loss Dr.
Appropriation A/c
To Partner’s Capital/Current
A/cs (By Name)
(Being profit transferred to capital account of partners)
For Net Loss
Capital/Current A/cs of Partners
(By Name)
To Profit & Loss Appropriation A/c
(Being loss transferred to capital Accounts of Partners)
When Interest is Due on Loan from Partners :
Profit & Loss Dr.
Appropriation A/c
To Loan A/c
(Being interest on loan)
When Partners Bring Further Capital
Cash/Bank A/c Dr
To Partners’ Capital A/c
(Being further capital brought in by partners)
When Partners Bring Some Assets Other than Cash :
Assets A/c (By Name) Dr
To Partner’s Capital
(Being assets (other than cash) brought in by Partners)
When Assets are Taken over by Partners :
Partners’ Capital/ A/c
To Assets A/c (By Name)
(Being assets taken over by partners)
Fixed capital
Under fixed capital method, the capital of partners will remain fixed unless some additional capital is introduced or some amount of capital is withdrawn by an agreement among the partners. Therefore, all items like interest on capital, interest on drawings, interest on loan, commission on shares of profit or loss are not shown in their capital accounts.
A separate account, called ‘Partners’ Current Account is opened for this purpose. Thus under fixed capital method, two accounts are maintained for each partner, viz.
(i) Capital Account and (ii) Current Account. It may be noted that the capital account will continue to show the balance from year to year unless some amount of capital is introduced or withdrawn.
Current Account : The balance of current account fluctuates. It is due to profit or loss, interest on capital, interest on drawings, salary, commission, etc. It may be kept in mind that in case of fixed capital, current account of partners are opened.
Drawings Account : According to partnership deed, every partner can draw a certain amount in cash or kind for domestic use. Hence, there will be as many drawings accounts in partnership business as many partners are there to record the amount of cash or goods withdrawn by partners. Balance of drawings accounts are transferred to respective capital accounts at the end the year.
Calculation of interest on drawings
Interest on drawings can be calculated by the following two methods:
Simple Interest Method
Product Method
Simple Interest Method : Under this method, interest is charged for the period from the date of drawings to date of closing of the account at predetermined rate on each and every withdrawal. The following is the formula to calculate interest :
Amount of Drawings × Rate of Interest × Months
If equal drawings are made every month, the interest is charged on the total drawings for six months.
Product Method : Under this method, calculation of interest is easy if equal drawings are made on 1st or last of each month. The monthly account of drawings is multiplied by the number of months, the amount remained out of business.
For example, if in a particular year, a drawing was made on 31st January, 2004, the amount will be multiplied by eleven, the amount remained out of business for remaining eleven months. Accordingly, if a drawing is made on 31st May, 2004, the amount of drawing will be multiplied by seven because the partner will pay interest for the remaining 7 months. Similarly, if a drawing is made on 1st January, the amount will be multiplied by 12 because this amount will be with the partner for 12 months. An amount withdrawn on 1st June will be multiplied by 7 or the interest calculated for the particular period will be based on the total product by the respective amounts of withdrawal. This method is suitable in the following cases:
1. When the date of withdrawal is not given and only equal amounts of withdrawal every month by each partner for domestic use, are available, interest is calculated on the amount of equal installments for 6 months.
2. When each partner draws equal amounts on the first of each month for domestic purpose, interest is calculated on the amount of equal installment interest is calculated for 6½ months.
3. When each partner withdraws equal amounts every month, interest is calculated on the amount of equal instalments for 5½ months.
4. When each partner withdraws money in the last of every month, interest is calculated on the amount of equal instalments for 6 months.
5. If the drawings are made on different dates, instead of a definite date, the amounts are calculated from the date of withdrawal to the last date. The number of days, thus calculated, are multiplied by the amount of withdrawal each month and the total of product is obtained. Interest is calculated for one day on the sum total of products. This is the amount of interest on drawings.
Calculation of opening capital
Capital at the end of the year
Add : Loss
Add : Drawing
Add : Interest on Drawings
Less : Additional Capital
Less : Interest on Capital
Less : Profit
\ Capital in the beginning of the year.
Capital Ratio
Partners, generally, divide profit or loss according to their capital sharing ratio. In case of fixed capital, profit or loss can be calculated easily. Suppose, Ram and Shyam are partners in a firm and the capitals invested by them are
Rs. 1,00,000 and Rs. 2,00,000 respec-tively. The profit will be divided between them in the ratio of 1:2. If the capitals of partners are fluctuating, additional capital is added, and withdrawal is deducted to calculate ratio of capitals. Under the circumstances, profits sharing ratio can be decided neither on the basis of capital in the beginning nor capital at the end. In such cases, profit sharing ratio of partners is established on the basis of period and for this weighted average or product method is adopted. The capital thus arrived at becomes the basis of ratio and profit and loss are divided accordingly.
Re-adjustment of profit sharing ratios for the last year
Normally, accounts once closed are not reopened. But, sometimes mistakes in profit sharing ratio are discovered after closing the partnership account. Under certain circumstances, it becomes necessary to rectify these mistakes and adjustment entries are made in profit divisible among the partners. Such adjustment becomes necessary for division of profit among partners as it was not done in profit ratio.
Guarantee of partners to a partner
Sometimes, a new partner is admitted with the firm and offered a certain profit. It means that in case his share (new partner’s) of profit in the profits of the firm, and he is also guaranteed a minimum amount of profit is less than the guaranteed profit, the same will be compensated. When the guarantee is given by an individual partner, the difference is made good from his share. But if this guarantee is given by all the partners, the deficit is made good by all the partners. For example, Raju and Kaju admit Bhaju into partnership and offer him 1/5th share of profit and guarantee that Bhaju will receive a minimum of Rs. 60,000 every year as his share of profit. Suppose in a particular tear, the total profit of the firm is 1,50,000 only. Bhaju’s share come to Rs. 30,000. Under such circumstances. Bhaju will be paid guaranteed sum of Rs. 60,000 and the balance profit Rs. (60,000–30,000 = Rs. 30,000) will be divided between Raju and Kaju.
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