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chapter
41
Partnership accounts:
an introduction
Learning objectives
After you have studied this chapter, you should be able to:
l
explain what a partnership is and how it differs from a joint venture
l
explain the rules relating to the number of partners
l
distinguish between limited partners and general partners
l
describe the main features of a partnership agreement
l
explain what will happen if no agreement exists on how to share profits or losses
l
draw up the the ledger accounts and financial statements for a partnership
Introduction
In this chapter, you’ll learn about the nature of partnerships and the regulations
governing them. You’ll learn that there are two types of partner, limited and general, and about the difference between them, and about the difference between
those that are limited partnerships and those that are not. Finally, you’ll learn how
to prepare partnership ledger accounts and how to prepare partnership financial
statements.
41.1
The need for partnerships
So far we have mainly considered businesses owned by only one person. We’ve also looked at
joint ventures, which are temporary projects involving two or more parties where they work
together to make a profit and then disband the venture. When a more permanent possibility
exists, two or more people may form themselves into a partnership. This is a long-term commitment to operate in business together. The people who own a partnership are called partners.
They do not have to be based or work in the same place, though most do. However, they maintain one set of accounting records and share the profits and losses.
Activity
41.1
From your general knowledge, can you think of any well-known partnerships
where the partners are located, not just in different cities, but in different
countries? What line of business are they in?
There are various reasons for multiple ownership of a business.
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Activity
41.2
Think about this for a minute and then write down as many reasons as you can
for people wanting to form a partnership.
In addition to the reasons suggested in the answer, there is also the fact that many business
ventures carry financial risk should they fail. By forming a partenership, the level of risk is
reduced. Firstly, any loss can be shared by all the partners and, secondly, by involving more than
one person’s expertise, the chances of failure are reduced.
There are two types of multiple ownership: partnerships and limited companies. This chapter
deals only with partnerships. Limited companies will be the subject of Chapter 45.
41.2
Nature of a partnership
A partnership has the following characteristics:
1 It is formed to make profits.
2 It must obey the law as given in the Partnership Act 1890. If there is a limited partner (as
described in Section 41.3 below), it must also comply with the Limited Partnership Act of
1907.
3 Normally there can be a minimum of two partners and a maximum of twenty partners.
Exceptions are banks, where there cannot be more than ten partners; and there is no maximum for firms of accountants, solicitors, stock exchange members, surveyors, auctioneers,
valuers, estate agents, land agents, estate managers, or insurance brokers.
4 Each partner (except for limited partners described below) must pay their share of any debts
that the partnership could not pay. If necessary, they could be forced to sell all their private
possessions to pay their share of the debts. This can be said to be unlimited liability.
5 Partners who are not limited partners are known as general partners.
41.3
Limited partnerships
Limited partnerships are partnerships containing one or more limited partners. Limited partnerships must be registered with the Registrar of Companies. Limited partners are not liable for the
debts as in Section 41.2 (4) above. Limited partners have the following characteristics and
restrictions on their role in the partnership:
1 Their liability for the debts of the partnership is limited to the capital they have put in. They
can lose that capital, but they cannot be asked for any more money to pay the debts unless
they contravene the regulations relating to their involvement in the partnership (see 2 and 3
below).
2 They are not allowed to take out or receive back any part of their contribution to the partnership during its lifetime.
3 They are not allowed to take part in the management of the partnership or to have the power
to make the partnership take a decision. If they do, they become liable for all the debts and
obligations of the partnership up to the amount taken out or received back or incurred while
taking part in the management of the partnership.
4 All the partners cannot be limited partners, so there must be at least one general partner with
unlimited liability.
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Chapter 41 l Partnership accounts: an introduction
Activity
41.3
41.4
What advantages do you think there might be to general partners in having a
limited partner?
Partnership agreements
Agreements in writing are not necessary. However, it is better if a written agreement is drawn
up by a lawyer or an accountant. Where there is a proper written agreement there will be fewer
problems between partners. A written agreement means less confusion about what has been
agreed.
41.5
Contents of partnership agreements
The written agreement can contain as much, or as little, as the partners want. The law does not
say what it must contain. The usual accounting contents are:
1
2
3
4
5
6
7
The capital to be contributed by each partner.
The ratio in which profits (or losses) are to be shared.
The rate of interest, if any, to be paid on capital before the profits are shared.
The rate of interest, if any, to be charged on partners’ drawings.
Salaries to be paid to partners.
Arrangements for the admission of new partners.
Procedures to be carried out when a partner retires or dies.
Activity
41.4
Some partnerships don’t bother drawing up a partnership agreement. How do
the partners in those partnerships know what rights and responsibiities they
have?
Points 1 to 5 in the list above are considered below. Points 6 and 7 will be taken up in later chapters.
1 Capital contributions
Partners need not contribute equal amounts of capital. What matters is how much capital each
partner agrees to contribute. It is not unusual for partners to increase the amount of capital they
have invested in the partnership.
2 Profit (or loss) sharing ratios
Partners can agree to share profits/losses in any ratio or any way that they may wish. However,
it is often thought by students that profits should be shared in the same ratio as that in which
capital is contributed. For example, suppose the capitals were Allen £40,000 and Beet £20,000.
Some would assume that the partners would share the profits in the ratio of two-thirds to onethird, even though the work to be done by each partner is similar. The division of the first few
years’ profits on such a basis might be:
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Years
Net profits
Shared:
Allen 2/3
Beet 1/3
1
2
3
4
5
Total
£
36,000
£
48,000
£
60,000
£
60,000
£
72,000
£
276,000
24,000
12,000
32,000
16,000
40,000
20,000
40,000
20,000
48,000
24,000
184,000
92,000
Overall, Allen would receive £184,000, i.e. £92,000 more than Beet. As the duties of the partners are the same, in order to treat each partner fairly, the difference between the two shares
of profit should be adequate to compensate Allen for putting extra capital into the firm.
It should not be excessive. It is obvious that £92,000 extra profits is excessive, as Allen only put
in an extra £20,000 as capital.
Consider too the position of capital ratio sharing of profits if one partner puts in £99,000 and
the other puts in £1,000 as capital.
To overcome the difficulty of compensating fairly for the investment of extra capital, the concept of interest on capital was devised.
3
Interest on capital
If the work to be done by each partner is of equal value but the capital contributed is unequal, it
is reasonable to pay interest on the partners’ capitals out of partnership profits. This interest is
treated as a deduction prior to the calculation of profits and their distribution among the partners according to the profit sharing ratio.
The rate of interest is a matter of agreement between the partners, but it should equal the
return which they would have received if they had invested the capital elsewhere.
Taking Allen and Beet’s firm again, but sharing the profits equally after charging 5 per cent
per annum interest on capital, the division of profits would become:
Years
Net profit
Interest on capitals
Allen
Beet
Remainder shared:
Allen 1/2
Beet 1/2
Summary
Interest on capital
Balance of profits
1
2
3
4
5
£
36,000
£
48,000
£
60,000
£
60,000
£
72,000
2,000
1,000
2,000
1,000
2,000
1,000
2,000
1,000
2,000
1,000
16,500
16,500
22,500
22,500
28,500
28,500
28,500
28,500
34,500
34,500
Allen
Beet
£
10,000
130,500
140,500
£
5,000
130,500
135,500
Total
£
276,000
=
=
10,000
5,000
= 130,500
= 130,500
Allen has thus received £5,000 more than Beet, this being adequate return (in the partners’ estimation) for having invested an extra £20,000 in the firm for five years.
4 Interest on drawings
It is obviously in the best interests of the firm if cash is withdrawn from the firm by the partners
in accordance with the two basic principles of: (a) as little as possible, and (b) as late as possible.
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Chapter 41 l Partnership accounts: an introduction
The more cash that is left in the firm the more expansion can be financed, the greater the
economies of having ample cash to take advantage of bargains and of not missing cash discounts
because cash is not available and so on.
To deter the partners from taking out cash unnecessarily the concept can be used of charging
the partners interest on each withdrawal, calculated from the date of withdrawal to the end of
the financial year. The amount charged to them helps to swell the profits divisible between the
partners. The rate of interest should be sufficient to achieve this without being too harsh.
Suppose that Allen and Beet have decided to charge interest on drawings at 5 per cent per
annum, and that their year end was 31 December. The following drawings are made:
Allen
Drawings
1 January
1 March
1 May
1 July
1 October
Interest
£
2,000
4,800
2,400
4,800
1,600
£2,000 × 5% × 12 months
£4,800 × 5% × 10 months
£2,400 × 5% × 8 months
£4,800 × 5% × 6 months
£1,600 × 5% × 3 months
Interest charged to Allen
=
=
=
=
=
=
£
100
200
80
120
20
520
Beet
Drawings
1 January
1 August
1 December
Interest
£
1,200
9,600
4,800
£1,200 × 5% × 12 months
£9,600 × 5% × 5 months
£4,800 × 5% × 1 month
Interest charged to Beet
£
= 60
= 200
= 20
= 280
5 Partnership salaries
One partner may have more responsibility or tasks than the others. As a reward for this, rather
than change the profit and loss sharing ratio, the partner may have a partnership salary which
is deducted before sharing the balance of profits.
6 Performance-related payments to partners
Partners may agree that commission or performance-related bonuses be payable to some or all
the partners linked to their individual performance. As with salaries, these would be deducted
before sharing the balance of profits.
41.6
An example of the distribution of profits
Taylor and Clarke have been in partnership for one year sharing profits and losses in the ratio
of Taylor 3/5, Clarke 2/5. They are entitled to 5 per cent per annum interest on capitals, Taylor
having £20,000 capital and Clarke £60,000. Clarke is to have a salary of £15,000. They charge
interest on drawings, Taylor being charged £500 and Clarke £1,000. The net profit, before any
distributions to the partners, amounted to £50,000 for the year ended 31 December 20X7.
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£
Net profit
Add Charged for interest on drawings:
Taylor
Clarke
£
£
50,000
500
1,000
1,500
51,500
Less Salary: Clarke
Interest on capital:
Taylor
Clarke
15,000
1,000
3,000
4,000
Balance of profits
Shared:
Taylor 3/5
Clarke 2/5
(19,000)
32,500
19,500
13,000
32,500
The £50,000 net profits have therefore been shared:
Balance of profits
Interest on capital
Salary
Clarke
£
13,000
3,000
15,000
31,000
( 1,000)
30,000
1
2
3
Less Interest on drawings
Taylor
£
19,500
1,000
–
20,500
( 500)
20,000
£50,000
41.7
The financial statements
If the sales, stock and expenses of a partnership were exactly the same as that of a sole trader,
then the trading and profit and loss account would be identical with that as prepared for the sole
trader. However, a partnership would have an extra section shown under the profit and loss
account. This section is called the profit and loss appropriation account, and it is in this account
that the distribution of profits is shown. The heading to the trading and profit and loss account
for a partnership does not normally include the words ‘appropriation account’. It is purely an
accounting custom not to include it in the heading. (Sometimes examiners ask for it to be
included in the heading, in which case, you need to do so!)
The profit and loss appropriation account of Taylor and Clarke from the details given
would be:
520