Accounting for Partnership: Fundamentals

A partnership is the relation between persons who have agreed to share the profits of a business carried on by all or any of them acting for all (Indian Partnership Act, 1932). The persons are individually called partners and collectively a firm.

Its essential features: (i) two or more persons; (ii) an agreement; (iii) a lawful business; (iv) sharing of profits; and (v) mutual agency (each partner is both an agent and a principal — the act of one binds all). The maximum number of partners is 50 (Companies Act / Rules).

The partnership deed is the written agreement among the partners. It usually states the name of the firm, the capital of each partner, the profit-sharing ratio, interest on capital and drawings, partners' salary/commission, and how disputes are settled. A deed is not compulsory but is highly desirable, because it prevents disputes.

When there is no deed, or the deed is silent on a point, the provisions of the Partnership Act apply:

These default rules are a favourite exam topic. Note especially that profits are shared equally (not in the capital ratio) and that a partner's loan still earns 6% even when the firm makes a loss.

In a sole proprietorship, net profit simply goes to the owner. In a partnership it must be distributed among the partners after various adjustments. This distribution is shown in a special account called the Profit & Loss Appropriation Account — an extension of the P&L Account, prepared after net profit is found.

The distinction to master: a charge against profit is deducted to find net profit (e.g. rent, interest on a partner's loan); an appropriation of profit is a distribution of net profit (interest on capital, partner's salary, transfer to reserve). Charges go in the P&L Account; appropriations go in the P&L Appropriation Account.

The order is: start with net profit (credit), add interest on drawings (credit), then deduct interest on capital, salary/commission and reserve; the balance left is the divisible profit, shared among partners in their profit-sharing ratio. For example, net profit Rs 1,00,000; interest on capital Rs 12,000; A's salary Rs 18,000; the divisible profit = 1,00,000 − 12,000 − 18,000 = Rs 70,000, shared in the PSR. If the appropriations exceed available profit, they are usually allowed only in the ratio of the amounts due (unless the deed says they are a charge).

Each partner has a capital account. There are two methods of maintaining them.

• Fluctuating Capital Method — one account per partner. All items (capital, interest on capital, salary, share of profit, drawings, interest on drawings) pass through it, so its balance fluctuates every year. This is the default when the deed is silent.
• Fixed Capital Method — two accounts per partner: the Capital Account (which stays fixed, recording only capital introduced or withdrawn) and a Current Account (which records all the other items — interest, salary, profit share, drawings). The capital figure therefore stays constant.

Two key calculations recur:

Interest on Capital = Capital × Rate × Time. It is allowed only if the deed provides, and only out of profit (it is an appropriation). For example, capital Rs 2,00,000 at 6% p.a. = Rs 12,000.

Interest on Drawings = charged when the deed allows, to discourage withdrawals. If drawings are made evenly through the year, the average period is 6 months, so interest = total drawings × rate × 6/12. The product method is used when drawings of different amounts are made on different dates: multiply each drawing by the months it stayed in the business, total the products, and charge interest on the total for one month. For example, drawings of Rs 10,000 on 1 April (12 months) and Rs 10,000 on 1 October (6 months) give products 1,20,000 + 60,000 = 1,80,000; interest at 6% = 1,80,000 × 6% × 1/12 = Rs 900.

Mastering these — the appropriation account and the capital accounts — is the foundation for everything else in partnership: goodwill, admission, retirement and dissolution all build on them.