Partnership A partnership is a business organization in which two or more persons combine their assets and liabilities to carry on as co-owners, and agree to share in the profits or losses of the business. REASONS FOR THE FORMATION OF A PARTNERSHIP Combined Capital one person may not have enough capital to carry on the business, but additional capital from another partner would make this possible. Combined Skills Partnerships among professionals are quite common where the partners have different specialties. For example, a gynecologist may combine with an obstetrician, an obstetrician or a pediatrician, and a criminal lawyer with one who specializes in divorce law or civil law. Very often an older person teams up with a youngster person. The younger person has the energy and new ideas; the older person has the experience and the expertise. Social Reasons A sole trader rarely has free time for social activities because he is solely responsible for running the business and keeping records. In a partnership the responsibility is shared and the partners can have some free time to devote to their families and social activities. ADVANTAGES OF A PARTNERSHIP 1. Unlike a limited company, a partnership can be created without any legal formalities and is less expensive. 2. More capital can be raised than by a sole trader. 3. Special skills can be combined. 4. Unlike the shareholders (owners) of a limited company, the owners of a partnership have the freedom and flexibility to make their own business decisions and to withdraw money. DISADVANTAGES OF A PARTNERSHIP 1. A partnership is ended on the death, retirement or withdrawal of any one of the partners. 2. Each partner is personally responsible for the liabilities of the partners. 3. Each partner is an agent of the business. Hence the firm is bound by any contract made by any one of the partners, if it is within the scope of the business’s operations. 4. If the business requires a large amount of capital, a partnership may not be able to raise it. THE PARTNERSHIP DEED When a partnership is formed, it is usually governed by a partnership deed which is drawn up by the partners and which states the conditions of the partnership. The conditions may specify: 1. The amount of capital that is to be contributed by each partner. 2. The amount of interest that is to be paid on capital, drawings and loans to and from partners. 3. The ratio in which profits or losses are to be shared among partners. 4. The amount of the salaries that should be paid to partners. If a partnership deed is not made up, the partnership must adhere to the legislation of the country in which the partnership is operating. However, it is usually more advantageous for the partners to draw up their own partnership deed. ACCOUNTING ASEPECTS OF A PARTNERSHIP The partnership, like any sole proprietorship, follows the accounting cycle in recording transactions. The final accounts, however, are slightly different from those of the sole trader. They consist of: 1. 2. 3. 4. Trading and profit and loss accounts. An appropriation account. The current accounts of partners. The balance sheet. TRADING AND PROFIT AND LOSS ACCOUNTS These accounts are completed as for a sole trader. APPROPRIATION ACCOUNT This account shows how the net profit or net loss of the partnership is to be distributed. Credit entries in the appropriation account 1. Net profit if there is a profit to be apportioned. 2. Interest on drawings. If the partnership deed states that the partners must pay interest on drawings, this would be credited in the appropriation account. Debit entries in the appropriation account 1. Net loss if there is a loss to be apportioned. 2. Reduction of goodwill. The double entry to record this would be: Debit appropriation account Credit goodwill This entry, of course, reduces the value of the asset on the balance sheet. 3. Salaries to partners, if this is stated in the partnership deed. 4. Interest on capital, if the partnership deed states that the partners should receive interest on capital. If a partner introduces capital during the year, the interest on capital is paid only for part of the year from the date of the investment to the end of the year. From the following year the annual interest is paid. 5. Share of residue of profits. After the above deductions have been made from the net profit, the residue (remainder) is divided among the partners in the profit-sharing ratio stated in the partnership deed. If a partner loans money to the business, the interest is normally recorded as an expense in the profit and loss account but it is credited to his current account. APPROPRIATING NET PROFIT The figure below shows the appropriation account when there is a net profit. The following are the steps in calculating the share of residue: 1. Add the credit entries. 2. Add the debit entries. 3. The credit total less the debit total gives the balance, which is to be divided among the partners in the profit-sharing ratio. EXAMPLE: appropriating net profit J and K are in partnership, sharing profits and losses in the ratio of 3:2 respectively. During the year ended 31 December 1988 the business made a net profit of $4800, which is to be appropriated as follows: 1. 2. 3. 4. Goodwill is to be reduced by $250. J is to receive an annual salary of $1200. Interest is to be paid on capital at the rate of 5% per annum. On 1 January 1988 the capital accounts were: J $12,000 K $8,000 You are required to prepare the appropriation account of the partnership for the year ended 31 December 1988. Solution The residue is calculated as follows: The share of residue is: π½: 3⁄ ππ $2350 = $1410 5 πΎ: 2⁄ ππ $2350 = $940 5 The appropriation account is shown below. APPROPRIATING NET LOSS If the business suffers a net loss instead of making a net profit, then the entries in the appropriation account are slightly different (shown in the figure below). The partners must share the loss in the profit-sharing ratio. The net loss will be transferred to the debit side of the appropriation account. There will be no share pf the residue of profits, but rather a share of the loss. This share will be calculated by adding all the debit entries in the appropriation account, subtracting the credit entries if there are any, and sharing the loss in the profit-sharing ratio. The following are the steps in calculating the share of loss: 1. Add the debit entries. 2. Add the credit entries. 3. The debit total less the credit total gives the balance, which is to be divided among the partners in the profit-sharing ratio. EXAMPLE: appropriating net loss Harold and Helen are in partnership, sharing profits and losses in the ratio of 5:3 respectively. On 1 January 1988 their capital accounts were: Harold $16,000 Helen $12,000 During the year ended 31 December 1988 the business suffered a loss of $2880. On 1 July 1988 Helen introduced $2,000 capital into the business. You are to prepare the appropriation account, taking into consideration the following: 1. Goodwill is to be reduced by $300. 2. Harold is to be paid a salary of $3,600 per annum. 3. Interest is to be paid on capital at the rate of 6% per annum. Solution The calculation of interest on capital is as follows: Harold: 6% ππ $16,000 = $960 Helen: 6% ππ $12,000 + (1⁄2)(6% ππ $2,000) $720 + $60 = $780 The $2,000 was introduced on 1 July, and therefore interest on capital is paid for half of the year. The calculation of the share of loss is as follows. The total of the debit entries is $2,880 + $300 + $3,600 + $1,740 = $8,520. Since there are no credit entries, the share of loss is: Harold: 5⁄8 ππ $8,520 = $5,325 Helen: 3⁄8 ππ $8,520 = $3,195 The appropriation account is shown below EXAMPLE: interest on drawings Des and Don are in a partnership, sharing profits and losses in the ratio of 1:4 respectively. From the following information, prepare the appropriation account for the year ended 31 December 1988. 1. Balances in capital account on 1 January 1988: Des $28,000 Don $45,000 2. Interest on capital is paid at the rate of 4% per annum. 3. Salaries are to be paid as follows: Des $4,500 Don $2,400 4. Net profit for the year is $16,003. 5. The drawings account of the partners is shown below: 6. Interest on drawings is to be paid at the rate of 3% per annum. Solution The calculation of interest on drawings is as follows. Interest is apportioned on an annual basis, and so the actual date on which the withdrawal was made is very important. The annual interest must be multiplied by the fraction of the year from the drawing to the completion of the account. The appropriation account is shown below: