Partnership accounts
Features of partnerships
• Partnership accounts are the financial accounts of a
partnership business. Here we are looking at small
partnerships with a small number of partners, rather than at
large partnerships of accountants or lawyers.
• Partnerships are similar to sole trader businesses. The major
difference between a partnership and a sole trader business
is that:
• a partnership has several joint owners, whereas
• a sole trader’s business has just one owner.
• A partnership business should be based on a formal
partnership agreement (contract) that specifies the
terms of the partnership, such as how much capital
each partner should provide to the business, and how
the profits of the business should be shared between
the partners.
• The accounts of the partnership must record the
capital and profits that are attributable to each
individual partner.
Partners' Capital
• Each partner contributes capital to the business, and the capital of
each partner must be identified separately.
• The partnership agreement will usually specify that each partner
must contribute a minimum amount of ‘fixed’ capital. Partners
cannot draw out any of their fixed capital.
• In addition, each partner might retain some of his or her share of
accumulated profits in the business. The partnership agreement
should allow partners to draw out their share of accumulated
profits, if they wish to do so.
• The capital of each partner can therefore be
divided into two parts:
• fixed capital
• ‘current capital’, which is the partner’s share of
accumulated profits that the partner has not yet taken
out as drawings.
Sharing profits (or losses)
• The partnership agreement will specify how the
partners will share the profits of the business
amongst themselves each year. The partners
may share profits equally. However, the
partnership agreement might specify a different
profit-sharing arrangement.
Special features of partnership accounts
• Accounting for partnerships is similar to
accounting for sole traders. The main differences
are:
• the need to account for the capital of each partner, and
• the need to account for the share of total profits
between the partners
• the need to account for partners’ capital when a new
partner joins the partnership.
•
Partners’ capital and current accounts
• The capital of each partner is recorded separately, and each partner
has two types of capital accounts:
• A capital account: this records the fixed capital or long-term capital of
the partner that the partner must retain in the business and cannot take
out in drawings.
• A current account: this records the accumulated profits of the partner,
which may be taken out by the partner as drawings.
• The profits of the business are shared between the partners. The share of each
partner is credited to (added to) his or her current account.
• Each partner may take drawings out of the business. Drawings are a withdrawal of
profit. These are recorded by debiting the current account of the partner (and
crediting the Bank account).
Partner X: current account
Partner’s accumulated profits at the beginning of the year
Partner’s share of profit for the year
Drawings by the partner during the year
Partner’s accumulated profits at the end of the year
$
A
B
(C)
A+B–C
The statement of financial position for a
partnership
• The statement o f financial position for a partnership
is the same as for a sole trader, except that the equity
section of the statement will consist f the capital
accounts and the current accounts of each partner.
• Total equity is the sum of the balances on the
partners’ capital and current accounts
Sharing the profits between the partners
• The profits of the business are shared between
the partners. The rules for how the profits
should be shared are contained in the
partnership agreement.
Profit-sharing ratio
• The partners in a partnership agree to share the profits (or
residual profits, as explained later) in an agreed proportion
or ratio.
• The profit for the financial period is calculated according to
the normal rules (as described already for a sole trader). This
total profit figure is then divided between the partners and
credited to their current account.
• Example
• The WXY Partnership has three partners, W, X
and Y, who share profits in an agreed ratio of
3:5:8. Profits for the year were $192,000.
Notional salaries for partners
• Partners, as owners of their business, cannot be paid a
salary in the same way as employees who are not the
business owners. (This is for tax reasons.)
• However, some partners might do a lot of work for the
partnership, and the partnership agreement might recognise
the work done by partners by awarding one or more of the
partners with a notional salary.
• A notional salary is an agreed amount awarded to the
individual partner from the partnership profits.
• A notional salary is therefore a share of the
partnership profits. The salary is awarded to each
partner from the profits, and the residual profit after
deduction of notional salaries is then divided between
the partners in the agreed profit-sharing ratio.
• Example
• The PQR Partnership has three partners, P, Q and R. The partnership
agreement provides for the residual profit to be shared between
them in the ratio 4:3:2, after allowing a notional salary of $30,000 to
R.
• The profit for the year is $345,000.
Required
Compute for profit share among the partners
• The profit share of each partner is added to the
balance on their individual current accounts.
Example
• A, B and C are in partnership sharing profits and losses in the ratio of 2:2:1. B
is allowed a salary of $10,000 per annum and C is allowed a salary of $15,000
per annum.
• The net profit for year was $100,000.
Required
• Show how profit should be shared between the partners and enter the total
profit in the partners’ current accounts.
Notional interest on long-term capital
• The partnership agreement might also provide for the
partners to obtain notional interest on the long-term capital
they have invested in the business. This is interest on the
balance in their capital account.
• Interest is not given for balances on the current account,
which partners are able to take out in drawings if they wish.
• Notional interest on long-term capital is not real interest,
because the capital in the partners’ capital account is equity,
not a liability of the business.
• The notional interest is treated in similar way to notional
salaries for partners. The interest is a share of the
partnership profits. Like notional salaries, the notional
interest is awarded to each partner in accordance with the
partnership agreement.
• The residual profit shared between the partners in the profitsharing ratio is the profit after notional salaries and notional
interest on capital are deducted.
Example
• Partnership DEF has three partners, D, E and F. Partner D has contributed
$100,000 of fixed capital, Partner E $120,000 and Partner F $60,000.
They have agreed to share profits in the following way.
• Partner D should receive a salary of $4,000 and Partner F a salary of $7,000.
• All three partners should receive interest at 5% on the fixed capital contributed.
• Residual profit should be shared between D, E and F in the ratio 3:5:2.
• The profit of the partnership for the year is $95,000.
Required
• Show how the partnership profits should be shared between the
partners.
• Note: Loans from partners and loan interest
• If a partner makes a loan to the partnership, the loan
is a long-term liability and interest on the loan is an
expense in the income statement.
• Loans from a partner and interest on loans are
therefore different from partners’ capital and notional
interest on capital.
Exercise
• G, H and I are in partnership. Partner G has contributed $50,000 of fixed
capital, Partner H $40,000 and Partner I $30,000. They have agreed to
share profits in the following way.
• Partner H should receive a salary of $5,000 and Partner I a salary of $10,000.
• All three partners should receive interest at 8% on the fixed capital
contributed.
• Residual profit should be shared between G, H and I in the ratio 3 : 2 : 1.
• The profit of the partnership for the year is $114,600.
Required
• Show how the partnership profits should be shared between the
partners and write up their capital accounts and current accounts.
Guaranteed minimum profit share
• Occasionally, a partnership agreement might provide for a guaranteed
minimum profit share for one (or more) of the partners. In these
cases:
• The partnership profits should be shared according to the partnership
agreement, ignoring the minimum profit agreement.
• Having shared the profits, a problem only occurs if the profit share for a
partner with a minimum guaranteed profit is less than this guaranteed
amount.
• In this situation, the partners who do not have a minimum guaranteed profit
must make up the shortfall. They do this out of their profit share, in their
profit- sharing ratio.
Example
• The XYZ Partnership has three partners, X, Y and Z. The partnership
agreement provides for Partner X to receive a notional salary of
$20,000 and residual profits are shared between X, Y and Z in the
ratio 2:4:6. In addition, the agreement guarantees a minimum profit
share of $32,000 to Partner Y.
• The partnership profit for the current year is $80,000.
Required
• Show how the profit for the year should be shared between the
partners.
Interest on drawings
• Another provision that might occasionally be found in a
partnership agreement is an arrangement that partners
should pay notional interest on any drawings they make
before the end of the financial year.
• The purpose of this type of arrangement is to discourage
partners from taking large drawings during the year, and to
wait until the end of the year before they take any money
out of the business.
• When an interest on drawings arrangement exists, the procedure for
sharing profits is as follows:
i.
Calculate the notional interest payable by each partner on drawings during
the year.
ii. Subtract this notional interest for each partner from the current account
balance of the partner. Add the notional interest to the partnership profit
for the year.
iii. Share out the partnership profit for the year, including this notional
interest, according to the rules of the partnership agreement.
Example
• The ST Partnership has two partners S and T who share partnership profits
in the ratio 2:3. The partnership agreement also provides that interest will
be charged at 6% per annum on any drawings taken out by a partner
before the end of the financial year, which is 31 December.
• As at 1 January Year 8, Partner S had a current account balance of $18,000
and Partner T had a current account balance of $26,000.
• In the year to 31 December Year 8 the partnership profit was $54,000.
Partner S took out $12,000 in drawings on 1 March Year 8 and Partner T
took out $20,000 in drawings on 1 September.
Required
• Calculate the profit share of each partner for the year, and the balance on
each partner’s current account at the end of the year.
Profits, drawings and the partners’ current
accounts
• For each partner, the share of the annual profit is
added to the partner’s current account. Any drawings
during the year are deducted.
Example
• There are three partners in the ABC Partnership, A, B and C. The
capital and current accounts of the partners at the beginning of the
year were as follows:
Partner
Capital account
Current account
$
$
A
100,000
6,000
B
C
200,000
160,000
3,000
8,000
• The profit for the year was $103,000. Profits are shared as
follows:
• Partner A is given a salary of $17,000 and Partner C has a salary of
$15,000
• The partners pay themselves interest on capital at 5% per year
• The residual profit is shared between A, B and C in the ratio 1:3:2.
• During the year, drawings by each partner were:
• A $20,000
• B $25,000
• C $40,000
Required
• Show how the profits should be shared between
the partners, and show their capital and current
accounts as at the end of the year
Exercise
• X, Y and Z are in partnership and the balances on their capital and
current accounts are:
• Partner
•
•
X
•
Y
•
Z
Capital account
$
100,000
80,000
60,000
Current account
$
2,000
5,000
1,000
• The profit for the year was $194,400. Profits are shared as follows:
• The partners pay themselves interest on capital at 6% per year
• The residual profit is shared between X, Y and Z in the ratio 4 : 3 : 2.
• During the year, drawings by each partner were:
• X $78,000
• Y $58,000
• Z $35,000
• Required
Show how the profits should be shared between the partners, and
show their capital and current accounts as at the end of the year.
Changes in the partnership agreement on
profit-sharing
• The agreement on how the partners should share the profits of
the business may be changed during a financial year. When this
happens, the total profits for the year should be apportioned, on
a time basis, between:
• profits of the business during the time of the ‘old’ profit-sharing
arrangements, and
• profits of the business during the time of the ‘new’ profit-sharing
arrangements.
•
• The profits for each time period are then shared between the
partners in accordance with the agreement for that period.
Example
• The DEF Partnership has three partners, D, E and F.
• In the first half of year 1, to 30 June Year 1, Partner D and Partner F each
received an annual salary of $30,000. Residual profits were shared
between D, E and F in the ratio 3:5:2. (There is no interest on capital.)
• In the second half of the year, from 1 July to 31 December, Partner D’s
salary was increased to $40,000, and the partners altered the profitsharing ratio to 1:3:1 for D:E:F). The salary of Partner F was unchanged at
$30,000 per year.
• The profit for the year was $220,000.
• Required
• Show how the annual profit should be shared between the partners.
Admission of a new partner
• Sometimes, a new partner is admitted to a
partnership. When this happens, the new partner
obtains a share of all the net assets of the partnership
business. It will therefore be agreed that the new
partner should introduce capital to represent his share
of these assets.
• The valuation of the assets of the partnership
business usually includes an amount for goodwill.
Goodwill
• Goodwill is the amount by which the value of a
business exceeds the value of all its net assets
(its assets less liabilities).
• All successful businesses have goodwill, which
means that buyers will be prepared to pay more
to acquire the business than the value of its net
assets.
• Goodwill is created over time in a variety of ways:
i.
A business might develop strong relationships with its
customers and build up a large number of potential new
customers through a good reputation for quality, reliability or
fair pricing.
ii. A business might build up a skilled and experienced work
force, with technical expertise and knowledge.
iii. A business might be located in a favorable location, so that it
attracts a considerable volume of business because large
numbers of potential customers are in the area.
Accounting for goodwill
• Goodwill is an intangible asset of a business, but
normally it is not recognized as an asset in the
financial statements.
• However it is an asset which is taken into
consideration in a partnership when a new
partner is admitted.
Calculating the value of goodwill
• The value of goodwill is decided by agreement
and negotiation. It is the difference between:
• The total value agreed for the business, and
• The other assets of the business less its liabilities
$
Total valuation of business
100,000
Value of net assets
(80,000)
Goodwill
20,000
•Alternatively, a partnership may
value its goodwill as a multiple of its
average annual profits or a multiple
of its average annual ‘excess’
profits.
Example
• The XYZ Partnership values its goodwill as two times the average of
the annual profits in excess of $60,000 each year for the last three
years.
• Profit for the last three years as been as follows:
• Year 3
• Year 2
• Year 1
$100,000
$90,000
$80,000
Admitting a new partner
• When a new partner is admitted to a partnership the following
steps are required when accounting for this admission:
• Step 1
Account for the capital introduced by the new partner
Debit
Bank account
Credit New partner’s capital account
• Step 2 Determine the value of the goodwill of the partnership.
• The new partner is not only buying a share of the net assets of the
partnership shown in the statement of financial position. He is also
buying a share of the unrecorded asset, goodwill.
• Step 3
Temporarily record the goodwill
Debit
Credit
Goodwill account
Old partners’ capital accounts in their old profit-sharing ratio
• Step 4 Remove the goodwill
Debit
Credit
New partners’ capital accounts in the new profit-sharing ratio
Goodwill account
•In Step 3 and Step 4 above, the ‘old’
partners are the partners in the business
before the new partner joined.
•The ‘new partners’ are all the partners in
the business after the new partner has
joined.
Example
• R and S are in partnership sharing profits equally. R
has contributed $80,000 of capital and S has
contributed $60,000 of capital. They are about to
admit a new partner, T, to the partnership and T has
agreed to pay the partnership $50,000 of capital. After
the admission of T profits will be shared between R, S
and T in the ratio of 2 : 2 : 1. The goodwill of the
partnership at the date of admission is agreed to be
$30,000.
Step 1 Account for capital introduced by T
Capital accounts
R
$
S
$
T
$
R
$
S
$
T
$
Balance b/d 80,000 60,000
50,000
Bank
•Step 2 Determine the value of goodwill:
$30,000
• Step 3 Temporarily record the goodwill
• Debit Goodwill account
• Credit Old partners’ capital accounts in old profit sharing
ratio
Goodwill account
Capital accounts
• Step 4 Remove the goodwill
• Debit New partners’ capital accounts in new profit
sharing ratio
• Credit Goodwill account
Goodwill account
$
Capital accounts
$
30,000 Partner R capital account (2/5) 12,000
Partner R capital account (2/5) 12,000
Partner R capital account (1/5)
6,000
Capital accounts
R
S
T
R
S
T
$
$
$
$
$
$
Balance b/d 80,000 60,000
Bank
Goodwill
Goodwill (2/5) 12,000
Goodwill (1/5)
Balance c/d
50,000
15,000 15,000
12,000
6,000
83,000 63,000 44,000
––––––– ––––––– –––––––
95,000 75,000 50,000
––––––– ––––––– –––––––
––––––– –––––––
95,000 75,000
––––––– –––––––
Balance b/d 83,000 63,000
–––––––
50,000
–––––––
44,000
•The capital balances of R and S have both
increased by $3,000 whereas the capital
balance of T has been reduced to $44,000. T
has effectively purchased $3,000 of goodwill
from each of the existing partner’s as well
as his purchase of his share of the recorded
assets and liabilities.
Example
• P and Q are in partnership sharing profits in the ratio
of 2:1. P has contributed $60,000 of capital and Q has
contributed $50,000 of capital.
• They are about to admit a new partner, M, to the
partnership and M has agreed to pay the partnership
$40,000 of capital. After the admission of M profits
will be shared between P, Q and M in the ratio of
2:2:1. The goodwill of the partnership at the date of
admission is estimated to be $15,000.
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