Class XII Accounts Fundamental Concepts
Accounts - Fundamentals
partnership firm is a business jointly owned by two or more persons. Partnership
is defined by Indian Partnership Act of 1932 as “the relation between persons
who have agreed to share profits of a business carried on by all or any one of
them acting for all”. This definition highlights the following features of a
A partnership involves two or more persons.
It is formed on the basis of an agreement.
It is formed for conducting a business.
Profit or loss arising from the business will be shared by the partners.
It may be run by all the partners or any one of the partners representing all of
for partnership involves several special adjustments due to the presence of more
than one owner. It should safeguard the rights of partners and it should
establish liabilities of partners in an impartial manner. Any error in
accounting decision will result in undue advantage to some partners at the
expense of others. This problem does not arise in a sole trading business since
there is only one owner, whose decisions, whether they are right or wrong would
affect only his own interest.
/ Characteristics of Partnership
Two or More Owners
basic feature of a partnership is the presence of more than one owner of the
business. Partnership is formed by two or more persons joining together to
conduct a business within the legal framework of Indian Partnership Act of 1932.
The maximum number of partners in a firm is legally restricted to 10 for banking
business and 20 for non banking business.
stated in the definition a partnership business is based on the agreement
between partners. This agreement should be in conformity with the provisions of
Indian Partnership Act, 1932, which is the governing law for the partnership
firms in India. From the legal point of view, it is not compulsory that the
partnership agreement is made in writing. But it is a matter of common sense
that the agreement is made in writing to avoid unnecessary dispute between
partners in future. The written agreement between partners is known as
object of partnership is to conduct a lawful business. In the absence of such a
business, an agreement between individuals will not become a partnership in the
Sharing of profit
business activity will result in profit or loss. This profit or loss has to be
shared by the partners. Usually the profit sharing ratio will be mentioned in
the partnership agreement. But if it is not mentioned in the agreement, the
Partnership Act specifies that, the partners shall share profit or loss equally.
principal agency relationship is a special feature of a partnership business.
Due to this relationship any act by a partner on behalf of the firm shall be
automatically be binding on other partners also. Similarly any default of a
partner shall be considered a default of all the partners.
Deed – Meaning, Impact
deed is the written agreement between partners. This agreement contains all the
terms and conditions agreed between partners. Rights, duties and liabilities of
all partners are stated in the partnership deed.
effect or impact of partnership deed is that it guides partners’ decisions at
all stages of the business. In the absence of a Partnership Deed or when the
Deed is silent on an issue, the partners are expected to follow the relevant
provisions of the Indian Partnership Act, 1932. The Act gives guidelines on the
general principles of partnership business. If the partners agree on any
specific condition such as interest on capital, salary etc. such agreements are
to be clearly stated in the partnership deed.
of the Partnership Deed
Partnership Deed contains elaborate provisions on almost all aspects of a
partnership business. If the partnership deed does not contain any specific
condition on any issue, it will be decided according to the provisions of the
Partnership Act. Following is the list of major items mentioned in a partnership
address of the partnership business
addresses of partners
loss sharing arrangement
and responsibilities of each partner in conducting the business
accounting, auditing etc.
regarding maintenance of bank account.
regarding interest on capital, interest on drawings etc.
or not salary is allowed to partners, conditions regarding salary.
regarding loans from partners, loans to partners
and presentation of goodwill
for settlement of accounts in the event of retirement or death of a partner.
clause, to settle disagreement if any.
Applied in the Absence of Specific Conditions in the Partnership Deed.
the absence of specific conditions in the partnership deed regarding the
following issues, they will be settled according to the provisions of the
Partnership Act as follows:
A partner is not entitled to any salary for his service rendered to the firm.
Partner is not entitled to interest on capital
No interest is charged on partner’s drawings.
A Partner is entitled to interest at the rate of 6% p.a. on any loan given to
The profit or loss from the business has to be shared equally.
Aspects of Final Accounts of Partnership
Fixed and Fluctuating Capital Accounts
partners of a firm have the option to decide whether their capital accounts may
remain fixed or fluctuating. This aspect is not much relevant in a sole trading
business, where the capital account is usually fluctuating. Stability in capital
balances is important in a firm, because the capital investment is usually one
of the major aspects of partner’s business relationship. When the capital
accounts are said to be ‘fixed’ it implies that the capital accounts will
remain steady for a reasonably long time. In other words the daily items of
credit and debit to partners will not be recorded in the capital accounts. They
will open current accounts in each partner’s name. These current accounts are
regarded as subsidiary capital accounts. Daily transactions related to a partner
are recorded in his current account, instead of capital account. Thus the
current account keeps on changing as the transactions are posted into it, while
the capital balance stays the same. However, if there is any additional capital
investment by a partner or capital withdrawal, other than minor routine
drawings, it will be recorded in the capital account, not in the current
account. In the event of rescheduling of capitals transfers can be made from
current accounts to capital or vice versa to adjust the capital balances.
the capital accounts are fluctuating there will not be a current account in the
name of partner. All transactions related to a partner, such as salary to a
partner, interest on capital, additional capital investment and similar items
are directly credited to the capital accounts of partner. Drawings, interest on
drawings capital withdrawal etc. are debited to the capital accounts. Thus the
balance in the capital account keeps on changing with every transaction posted
Opening and Closing balances in the capital account will remain
Current Accounts will be opened in the name of partners when
capitals are fixed.
Regular transactions related to partners are not entered in the
Fixed capital accounts always have credit balance
and closing balances rarely remain the same.
accounts are not required.
regular transactions related to partners are recorded in their capital
capital accounts can sometimes have debit balance
Division of Profit among Partners
making and profit sharing are the main objectives of partnership business. When
the partners do not have any special conditions regarding the profit
distribution the task of profit sharing is a simple, one-step operation of
dividing the profit in the given ratio. But in actual practice the partners are
compelled to include many conditions such as interest on capital, interest on
drawings, salaries, commission on profit etc. The purpose of these special
conditions is to fairly compensate extra capital, extra effort or similar
additional factors contributing to the profitability of the firm. Thus the
profit distribution becomes little more complex. A profit and loss appropriation
account is prepared with full details of profit distribution. This is prepared
as a supplementary account to the profit and loss account, prior to preparing
the balance sheet.
Omission of Interest on Capital / Interest on Drawings
step is almost like rectification of errors that you studied last year. Let us
first consider omission of interest on capital. Interest on capital is taken out
of the available net profit and distributed to partners. Thereafter the balance
of net profit is distributed in the profit sharing ratio. So, when the interest
on capital is omitted in the first place it means that the entire net profit is
how do we correct it?
take out the total amount required for paying interest on capital from the
capital accounts of partners in the profit sharing ratio, and give it back to
them as interest.
is the use of taking out from partners and give them back the same?
usually do not give back exactly what we take out. The profit sharing ratio
plays a very important role here. See the next illustration. We take out the
total interest divided equally from the three partners, and redistribute them as
interest according to capital balance. The point to notice here is, that there
is no definite relationship between profit sharing ratio and capital balance. In
the illustration the partners are sharing profits and losses equally even though
their capitals are not equal.
Omission of Outstanding Expenses and Incomes
expenses and outstanding incomes have direct effect on the net profit.
Outstanding expense is an expense in the first place and a liability as well.
When it is omitted it means a higher profit is distributed to partners and a
liability is not provided in the books. Outstanding income has the opposite
effect. Rectification of these errors is a simple procedure.
the number of items is less, correct it by passing simple rectification entry,
by debiting outstanding income, crediting outstanding expense and passing the
difference into capital account. This way you are creating asset account in the
books for the outstanding income, creating liability account for the outstanding
expense, and transferring the net loss or gain into capital accounts.
number of items involved is more or when it is specifically asked in the
question, you should open a profit and loss adjustment account.
adjustment account can be safely assumed as a combined capital account of
partners. When you want debit partner’s capital account you can debit P&L
adjustment account instead.
there is an outstanding expense, we usually debit capital accounts and credit
outstanding expense account. Now you debit P&L adjustment account for any
outstanding expense and credit it for the outstanding income.
balance of profit and loss adjustment account is transferred to the capital
accounts of partners in the profit sharing ratio.
Guarantee of Profits
partners agree to guarantee minimum profit to a partner as a special privilege.
There can be many reasons for granting such a privilege. Attracting a reputed
individual, who is unwilling to bear the risk of income fluctuations to become a
partner, is one of such reasons. If the share of profit for such a partner falls
short of the minimum amount guaranteed, the other partners will adjust that
shortage form their share of profit according to the agreed conditions. If the
share of profit of the partner holding guarantee privilege comes equal or more
than the guaranteed sum, that actual share will be given without any
Accounting for Joint Life Policy
partner ceases to be a partner either by retirement or death. At the time of
retirement or death of a partner the firm represented by the continuing
partners, has to settle the amount due to the outgoing partner. Since retirement
is a pre-planned event proper arrangement for the payment of amount due to
retiring partner can be made. Death comes unexpectedly. The firm suffers the
loss of an experienced partner and it has the added burden of settling a huge
amount of capital and other dues to the deceased partner. Unlike retirement,
death of a partner results in a financial emergency, as the amount due cannot be
delayed for long time. Unless adequate precautions are made, this emergency can
turn into deep financial crisis.
refer Chapter 4 – Retirement of Partners for details on Joint Life Policy)
is allowed on partner’s capitals only if there is a specific agreement in the
partnership deed. When interest is allowed on partner’s capital it should be
calculated on the basis of period of capital investment. Suppose a partner makes
additional investment after three months from the starting of a year, interest
on this additional capital is allowed for nine months only, not for the full
is allowed to a partner for his service if all partners agree to such a payment.
Again, in the absence of a specific condition in the partnership deed, a partner
is not entitled to any salary or commission for his service rendered to the
commission is allowed it may be stated as ‘payable on the profit before charging
commission’ or ‘payable on the profit after charging commission’.
If commission is payable on the profit before charging commission, it simply
means that the commission is to be calculated at the given percent on the given
amount of profit. But if it is a certain percentage after charging such
commission, the amount of commission should be exactly the percentage specified
on the balance of profit after deducting such commission, not the total
of Capital Ratio
ratio should be understood as investment ratio. Money is considered an important
working factor in the business. When the capital contribution of a partner is
higher, it also means that his money worked more in making the profit. In
calculating the capital ratio the amount and the period of investment are to be
considered. Suppose A contributes 10,000 in January and B contributes the same
amount on 1st July, A's capital has worked double that of B due to
earlier investment, even though both the amounts are the same at the end of the
year. Therefore, capital ratio should be based on the amount of capital
multiplied by the number of months the investment remained with the firm.
What is meant by partnership?
Mention any three features of partnership.
Distinguish between fixed and fluctuating capital accounts.
State provisions of the Partnership Act, 1932, in the absence of a partnership
agreement regarding the following:
of profit (ii) Interest on capital and (iii) Interest on partner’s drawings
State any three items that should be included in the partnership agreement form
accounting point of view.
Why is profit and loss appropriation account prepared?
Name any six items, which are shown in the profit and loss appropriation
How will you calculate interest on the drawings of equal amounts on the first
day of every month of a calendar year?
How will you calculate interest on the drawings of equal amounts on the last day
of every month of a calendar year?
How will you calculate interest on the drawings of equal amounts on 15th
day of every month of a calendar year?
List any two items appearing on the debit side of the partner’s current
In the absence of partnership deed, how are the interest on capital and interest
on partner’s loan treated?
Give items that may appear on the credit side of partner’s current account.
State at least five important points from accounting point of view which must be
incorporated in the partnership deed.
In the absence of partnership deed, state four important points that you should
note for proper accounting treatment amongst the partners. (hint:
rules regarding salary to partners, interest on capital etc.)