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(Paper) CBSE Class XII Accounts Fundamental Concepts "Partnership Accounts - Fundamentals"
CBSE Class XII Accounts Fundamental Concepts
Accounts - Fundamentals
A 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 partnership business.
i) A partnership involves two or more persons.
ii) It is formed on the basis of an agreement.
iii) It is formed for conducting a business.
iv) Profit or loss arising from the business will be shared by the partners.
v) It may be run by all the partners or any one of the partners representing all of them.
Accounting 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.
Nature / Characteristics of Partnership
1. Two or More Owners
The 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.
As 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 Partnership Deed.
The 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 legal sense.
4. Sharing of profit
A 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.
5. Mutual Agency
Mutual 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.
Partnership Deed – Meaning, Impact
Partnership 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.
The 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.
Contents of the Partnership Deed
A 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 deed.
i) Name address of the partnership business
ii) Names and addresses of partners
iii) Nature of partnership business
iv) Profit or loss sharing arrangement
v) Duties and responsibilities of each partner in conducting the business
vi) Method of accounting, auditing etc.
vii) Conditions regarding maintenance of bank account.
viii) Conditions regarding drawings
ix) Conditions regarding interest on capital, interest on drawings etc.
x) Whether, or not salary is allowed to partners, conditions regarding salary.
xi) Conditions regarding loans from partners, loans to partners
xii) Valuation and presentation of goodwill
xiii) Procedures for settlement of accounts in the event of retirement or death of a partner.
xiv) Arbitration clause, to settle disagreement if any.
Rules Applied in the Absence of Specific Conditions in the Partnership Deed.
In 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. A partner is not entitled to any salary for his service rendered to the firm.
b. Partner is not entitled to interest on capital
c. No interest is charged on partner’s drawings.
d. A Partner is entitled to interest at the rate of 6% p.a. on any loan given to the firm.
f. The profit or loss from the business has to be shared equally.
Special Aspects of Final Accounts of Partnership
1. Fixed and Fluctuating Capital Accounts
The 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.
When 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 into it.
1. Opening and Closing balances in the capital account will remain the same.
2. Current Accounts will be opened in the name of partners when capitals are fixed.
3. Regular transactions related to partners are not entered in the capital accounts.
4. Fixed capital accounts always have credit balance
Opening and closing balances rarely remain the same.
Current accounts are not required.
All regular transactions related to partners are recorded in their capital accounts.
Fluctuating capital accounts can sometimes have debit balance
2. Division of Profit among Partners
Profit 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.
3. Past Adjustments
3.1. Omission of Interest on Capital / Interest on Drawings
This 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 distributed.
Now how do we correct it?
Simple, 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.
What is the use of taking out from partners and give them back the same?
We 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.
3.3 Omission of Outstanding Expenses and Incomes
Outstanding 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.
i) If 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.
ii) When the number of items involved is more or when it is specifically asked in the question, you should open a profit and loss adjustment account.
iii) P&L 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.
iv) When 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.
v) The net balance of profit and loss adjustment account is transferred to the capital accounts of partners in the profit sharing ratio.
4. Guarantee of Profits
Sometimes 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 adjustments.
5. Accounting for Joint Life Policy
A 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.
(Please refer Chapter 4 – Retirement of Partners for details on Joint Life Policy)
Interest on Capital
Interest 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 year.
Commission to Partners
Commission 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 firm.
When 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 amount.
Calculation of Capital Ratio
Capital 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.
1. What is meant by partnership?
2. Mention any three features of partnership.
3. Distinguish between fixed and fluctuating capital accounts.
4. State provisions of the Partnership Act, 1932, in the absence of a partnership agreement regarding the following:
(i) Division of profit (ii) Interest on capital and (iii) Interest on partner’s drawings
5. State any three items that should be included in the partnership agreement form accounting point of view.
6. Why is profit and loss appropriation account prepared?
7. Name any six items, which are shown in the profit and loss appropriation account.
8. How will you calculate interest on the drawings of equal amounts on the first day of every month of a calendar year?
9. How will you calculate interest on the drawings of equal amounts on the last day of every month of a calendar year?
10. How will you calculate interest on the drawings of equal amounts on 15th day of every month of a calendar year?
11. List any two items appearing on the debit side of the partner’s current account.
12. In the absence of partnership deed, how are the interest on capital and interest on partner’s loan treated?
13. Give items that may appear on the credit side of partner’s current account.
14. State at least five important points from accounting point of view which must be incorporated in the partnership deed.
15. 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.)