A partnership is formed when two or more people carry on a business together with the intention of making a profit. Partners must agree on how the business is run, including the amount of capital each contributes and how profits and losses are shared, typically laid out in a partnership agreement.
Partnership Act 1890
If the partners do not have an agreement in place, the Partnership Act 1890 governs their rights and duties. These statutory provisions apply unless explicitly varied by the partners.
The key provisions of the Partnership Act 1890 are:
- Partners will share profits and losses equally.
- All partners are entitled to contribute equally to the capital.
- Partners are not entitled to salaries.
- Partners are not entitled to interest on the capital they have contributed.
- Partners are not charged interest on their drawings.
- Partners are entitled to interest at 5% per annum on loans they make to the partnership.
Partner Remuneration and Appropriation
Unlike a sole trader, where all profit belongs to the owner, a partnership requires a method to show how profit or loss is divided.
The Appropriation Account
The division of profit is shown through the appropriation account, which is a continuation of the income statement. It starts with the profit or loss for the year brought down from the income statement.
The following items are treated as appropriations of profit:
- Partners’ salaries.
- Interest on partners’ drawings.
- Interest on partners’ capital.
- Share of the residual profit.
Important Distinctions:
- Partners' Salaries: These are never debited in the income statement as an expense (unlike employee salaries). A salary guarantees a partner income even if the firm makes no profit.
- Interest on Partners’ Loans: Interest on a loan made by a partner to the firm is not an appropriation of profit; it is an expense that must be debited in the income statement before the profit for the year is calculated, just as if the firm had borrowed from a bank.
Partnership Ledger Accounts
Partnerships typically require three specific accounts for each partner:
- Capital Account: Records the capital introduced by the partner and any capital withdrawn. It is only adjusted for these and other items of a special nature, such as goodwill or profit on the revaluation of partnership assets.
- Current Account: Records the partner’s share of profits, losses, interest, and salary. The balance of the partner's drawings account is transferred to the debit side of their current account at year-end.
- Drawings Account: Records money or goods taken from the business by the partner for personal use.
If partners do not maintain current accounts, all double entries for interest, salaries, and profit shares must be completed directly in their capital accounts.
Financial Statements
Income Statement
The income statement is prepared in exactly the same way as for a sole trader, noting that interest on a partner’s loan is included as an expense. The resultant profit for the year is then transferred to the appropriation account.
Statement of Financial Position (SFP)
The SFP for a partnership lists the assets and liabilities. The partners' total interest is shown by combining their Capital accounts and Current accounts.
Partnership Changes
A partnership change occurs when partners alter their profit-sharing ratio, admit a new partner, or when an existing partner retires or dies.
Revaluation of Assets
When a change occurs, partners may revalue the assets to reflect their market value. This is often done to reward existing partners for building up the business.
- The resultant profit or loss on revaluation (an unrealised profit or loss) is shared between the partners in their current profit-sharing ratio.
- This profit or loss is transferred to the partners’ capital accounts (not their current accounts).
Accounting for Goodwill
Goodwill is the amount by which the value of the partnership as a going concern exceeds the net value of its assets if they were sold separately. Goodwill must be accounted for whenever there is a change in the partnership.
If the partners decide not to open a goodwill account in their books (often because the value is subjective or to avoid overstating assets):
- Credit the partners' capital accounts with their share of goodwill in their old profit-sharing ratio.
- Debit the partners' capital accounts with their share of goodwill in their new profit-sharing ratio.
This process compensates the partner whose share of future profits (and thus future goodwill) is decreasing.
Apportionment of Profit
If a partnership change occurs mid-year, the profit for the financial year must be apportioned into periods before and after the change.
- It is normally assumed that revenue has been earned evenly throughout the year, so profit is divided on a time basis.
- The actual profits and losses (realised) incurred before the change are shared using the old ratio.
- Subsequent profits/losses are shared using the new ratio.
Advantages and Disadvantages
|
Aspect |
Partnership |
|
Advantages |
Can raise more capital than a sole trader, provides a greater fund of knowledge and expertise, can offer a wider range of services, and losses are shared. |
|
Disadvantages |
Partners have less freedom to act independently, profits must be shared, and partners may be legally liable for the acts of other partners (unlimited liability for the firm's debts, unlike limited companies). |
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