Fundamentals of Partnership | ISC Class 12 Accounts Notes

This note covers the fundamentals of partnership accounts: the definition, meaning and features of a partnership, the provisions of the Indian Partnership Act, 1932 that apply to books of accounts, the rules that operate when there is no partnership deed, the Profit and Loss Appropriation Account, partners' capital accounts under the fixed and fluctuating methods, partners' current accounts, interest on capital, interest on drawings, salary and commission to partners and managers, transfer to reserves, division of profit, guarantee of profits and past adjustments.

What is a partnership and what are its features?

A partnership comes into existence when two or more persons join hands to set up a business and share its profits and losses.

As a business expands it needs more capital and more people to manage it and share its risks, and people then usually adopt the partnership form of organisation.

Definition: partnership. Section 4 of the Indian Partnership Act, 1932 defines partnership as 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".

Persons who have entered into partnership with one another are individually called partners and collectively called the firm. The name under which the business is carried on is the firm's name. A partnership firm has no separate legal entity apart from the partners constituting it.

The six essential features

The essential features of partnership are:

1. Two or more persons. At least two persons must come together for a common goal, so the minimum number of partners is two. By virtue of Section 464 of the Companies Act, 2013 the Central Government is empowered to prescribe the maximum number, but the number of partners cannot be more than 100; the Central Government has prescribed the maximum as 50 under the Companies (Miscellaneous) Rules, 2014.
2. Agreement. Partnership is the result of an agreement between two or more persons to do business and share its profits and losses. The agreement need not be in writing; an oral agreement is equally valid, but a written agreement is preferred to avoid disputes.
3. Business. The agreement must be to carry on some business. Mere co-ownership of property does not amount to partnership: if Rohit and Sachin jointly purchase a plot of land they are joint owners, not partners, but if they are in the business of purchase and sale of land for profit they are partners.
4. Mutual agency. The business may be carried on by all the partners or any of them acting for all. Every partner is entitled to take part in the conduct of the business, and each partner is the principal as well as the agent of the others. He can bind the other partners by his acts and is bound by their acts. There would be no partnership if mutual agency were absent.
5. Sharing of profit. The agreement must be to share profits and losses of the business. The Act speaks of sharing profits, but sharing of loss is implied. Persons who join hands for a charitable activity are not partners.
6. Liability of partners. Each partner is liable jointly with all the other partners and also severally to third parties for all acts of the firm done while he is a partner. His liability is unlimited, so his private assets can also be used to pay the firm's debts.

Note: no separate legal entity. Because the firm has no legal personality apart from its partners, the private assets of a partner stand behind the firm's debts. This is what makes the unlimited liability of partners a real risk and not a formality.

Why mutual agency matters

Mutual agency is the feature that separates a partnership from mere joint ownership or a charitable association. A partner who signs a contract for the firm binds every other partner, and he is in turn bound by what they sign.

This double role of principal and agent is why the Act says the business may be carried on "by all or any of them acting for all".

What is a partnership deed and what does it contain?

The agreement among partners may be oral or written. The Partnership Act does not require it to be in writing, but wherever it is in writing the document containing the terms of the agreement is called the partnership deed.

Definition: partnership deed. A partnership deed is the written document that contains the terms of the agreement among the partners, covering all aspects that affect the relationship between them.

The deed generally contains details about the objective of business, the contribution of capital by each partner, the ratio in which profits and losses will be shared, and the entitlement of partners to interest on capital, interest on loan and similar matters.

Its clauses can be altered with the consent of all the partners. The deed should be properly drafted and prepared as per the provisions of the Stamp Act and preferably registered with the Registrar of Firms.

Usual contents of the deed

The usual contents of a partnership deed are:

1. Names and addresses of the firm and its main business.
2. Names and addresses of all partners.
3. Amount of capital to be contributed by each partner.
4. The accounting period of the firm and the date of commencement of partnership.
5. Rules regarding operation of bank accounts.
6. Profit and loss sharing ratio.
7. Rate of interest on capital, loan, drawings and so on.
8. Mode of auditor's appointment, if any.
9. Salaries, commission and similar payments payable to any partner.
10. The rights, duties and liabilities of each partner.
11. Treatment of loss arising out of insolvency of one or more partners.
12. Settlement of accounts on dissolution of the firm.
13. Method of settlement of disputes among the partners.
14. Rules to be followed in case of admission, retirement or death of a partner.
15. Any other matter relating to the conduct of business.

Normally the deed covers all matters affecting the relationship of partners among themselves. If there is no express agreement on certain matters, the provisions of the Indian Partnership Act, 1932 apply.

Why a written deed is preferred

An oral agreement is valid, but it is hard to prove when partners fall out. A written deed records the capital, the sharing ratio and the claims of each partner, so disputes are settled by the document rather than by memory.

Registration of the firm with the Registrar of Firms is not compulsory, but under Section 69 of the Act an unregistered firm, or a partner on its behalf, cannot file a suit against a third party to enforce a right arising from a contract.

What are the provisions of the Indian Partnership Act, 1932 for books of accounts?

The Act supplies the rules that fill the gaps in a partnership deed. These rules matter for accounting because they decide how profit is divided and what each partner may claim.

Apart from these, the Act provides that, subject to contract between the partners, if a partner derives any profit for himself from any transaction of the firm or from the use of the property, business connection or name of the firm, he shall account for that profit and pay it to the firm.

If a partner carries on any business of the same nature as and competing with that of the firm, he shall account for and pay to the firm all profit made by him in that business.

Interest on a partner's loan as a charge

Note: interest on a partner's loan is a charge. Interest on a loan given by a partner to the firm is a charge against profits. It is debited to the Profit and Loss Account and credited to his loan account, not to his capital account.

Because it is a charge, this interest is payable whether the firm earns a profit or suffers a loss, unlike interest on capital, which is an appropriation of profit and is allowed only out of profit.

How are partners' capital accounts maintained under the two methods?

All transactions relating to partners are recorded in the books of the firm through their capital accounts.

This includes money brought in as capital, withdrawal of capital, share of profit, interest on capital, interest on drawings, partner's salary and commission to partners.

There are two methods of maintaining these accounts: the fixed capital method and the fluctuating capital method. The difference lies in whether transactions other than addition or withdrawal of capital are recorded in the capital accounts.

Fixed capital method

Under the fixed capital method the capitals of the partners remain fixed unless additional capital is introduced or a part of the capital is withdrawn as per the agreement.

All items such as share of profit or loss, interest on capital, drawings and interest on drawings are recorded in a separate account called the partner's current account.

The capital accounts always show a credit balance, which remains the same year after year unless there is an addition or withdrawal of capital. The current account may show a debit or a credit balance.

Two accounts are therefore kept for each partner. The capital accounts always appear on the liabilities side of the balance sheet. The current account balance appears on the liabilities side if it is a credit balance and on the assets side if it is a debit balance.

Draw two T-accounts.

In the capital account, debit side: bank (permanent withdrawal of capital) and balance c/d; credit side: balance b/d (opening balance) and bank (fresh capital introduced).

In the current account, debit side: balance b/d (debit opening balance), drawings, interest on drawings, Profit and Loss Appropriation (share of loss) and balance c/d (credit closing balance); credit side: balance b/d (credit opening balance), salary, commission, interest on capital, Profit and Loss Appropriation (share of profit) and balance c/d (debit closing balance).

Interest on current account balances

When capitals are fixed, the deed may also provide for interest on current accounts. Interest on a credit balance is allowed to the partner in the same way as interest on capital: the Profit and Loss Appropriation Account is debited and the partner's current account is credited.

Interest on a debit balance is charged to the partner in the same way as interest on drawings: the partner's current account is debited and the Profit and Loss Appropriation Account is credited. Unless the question says otherwise, the interest is calculated on the opening balance of the current account for the year.

For example, if X's current account opens with a credit balance of Rs. 20,000 and Y's with a debit balance of Rs. 5,000, and the deed provides for interest at 10 per cent per annum on current account balances, X is credited with Rs. 2,000 and Y is debited with Rs. 500 through the appropriation account.

Fluctuating capital method

Under the fluctuating capital method only one account, the capital account, is maintained for each partner.

All adjustments such as share of profit and loss, interest on capital, drawings, interest on drawings and salary or commission to partners are recorded directly in the capital account.

This makes the balance fluctuate from time to time, which is why the method is so called. In the absence of any instruction, the capital account should be prepared by this method.

Draw one T-account. Debit side: balance b/d (debit opening balance), drawings, interest on drawings, Profit and Loss Appropriation (share of loss) and balance c/d (credit closing balance).

Credit side: balance b/d (credit opening balance), bank (fresh capital introduced), salary, interest on capital, Profit and Loss Appropriation (share of profit) and balance c/d (debit closing balance).

Advantages and limitations of the two methods

The fixed capital method keeps the capital figure steady, so the original investment of each partner is always visible and the record of drawings and appropriations sits in a separate current account.

Its limitation is that two accounts must be kept for every partner, which doubles the writing and the chance of posting errors.

The fluctuating capital method has the merit of simplicity: one account per partner shows everything, and the closing balance is the partner's net interest in the firm.

Its limitation is that the original capital is no longer visible, because drawings, interest and share of profit are mixed into the same account, and the capital account may even show a debit balance.

Why is a Profit and Loss Appropriation Account prepared?

The profits and losses of the firm are distributed among the partners in an agreed ratio, and if the deed is silent they are shared equally.

In a sole proprietorship the profit or loss as ascertained by the profit and loss account is simply transferred to the proprietor's capital account.

In a partnership, certain adjustments such as interest on drawings, interest on capital, salary to partners and commission to partners must be made first.

For this purpose a Profit and Loss Appropriation Account is prepared to ascertain the final figure of profit or loss to be distributed among the partners in their profit sharing ratio.

Definition: Profit and Loss Appropriation Account. It is merely an extension of the Profit and Loss Account of the firm, showing how the profits are appropriated or distributed among the partners.

How the account is written

All adjustments in respect of partner's salary, partner's commission, interest on capital and interest on drawings are made through this account. It starts with the net profit or net loss as per the Profit and Loss Account.

The account is usually debited with interest on capital and salary or commission allowed to partners, and credited with net profit as per the Profit and Loss Account and with interest on drawings.

The balance, being profit or loss, is distributed among the partners in the profit sharing ratio and transferred to their capital accounts.

The journal entries used are:

1. Transfer of a credit balance of the Profit and Loss Account: debit Profit and Loss A/c, credit Profit and Loss Appropriation A/c. For a debit balance the entry is reversed.
2. Interest on capital: debit Interest on Capital A/c, credit the partners' capital or current accounts individually; then debit Profit and Loss Appropriation A/c, credit Interest on Capital A/c.
3. Interest on drawings: debit the partners' capital or current accounts individually, credit Interest on Drawings A/c; then debit Interest on Drawings A/c, credit Profit and Loss Appropriation A/c.
4. Partner's salary: debit Salary to Partner A/c, credit the partner's capital or current account; then debit Profit and Loss Appropriation A/c, credit Salary to Partner A/c.
5. Partner's commission: debit Commission to Partner A/c, credit the partner's capital or current account; then debit Profit and Loss Appropriation A/c, credit Commission to Partner A/c.
6. Transfer to reserve: debit Profit and Loss Appropriation A/c, credit General Reserve A/c.
7. Share of profit: debit Profit and Loss Appropriation A/c, credit the partners' capital or current accounts individually. For a loss the entry is reversed.

Note: loss and appropriations. In case the firm suffers a loss, no interest on capital, salary or remuneration is to be allowed to partners.

Debit side: Profit and Loss (if there is loss), interest on capital, interest on current account (credit balance), salary to partner, commission to partner, transfer to general reserve, and partners' capital or current accounts (distribution of profit).

Credit side: Profit and Loss (if there is profit), interest on drawings, interest on current account (debit balance), and partners' capital or current accounts (distribution of loss).

Transfer to reserve

The deed may require a part of the profit to be kept back in the business as a reserve. The transfer is an appropriation of profit, so it appears on the debit side of the appropriation account before the remaining profit is divided among the partners.

When the transfer is a percentage of profit, it is calculated on the correct trading profit, that is the net profit after all charges, and not on the divisible profit left after the other appropriations.

Commission to a partner, and a full appropriation account

Commission to a partner may be a fixed amount or a percentage of profit. Where it is a percentage, the percentage of a partner's commission or of a general reserve is calculated only on the correct trading profit and not on the divisible profit.

Worked example 1. Amit, Babu and Charu set up a partnership firm on April 1, 2019 with capitals of Rs. 50,000, Rs. 40,000 and Rs. 30,000, sharing profits and losses in the ratio 3:2:1.

Amit is to be paid a salary of Rs. 1,000 per month and Babu a commission of Rs. 5,000. Interest on capital is allowed at 6 per cent per annum.

Drawings were Amit Rs. 6,000, Babu Rs. 4,000 and Charu Rs. 2,000, and interest on drawings was Rs. 270, Rs. 180 and Rs. 90 respectively.

The net profit as per the Profit and Loss Account for the year ending March 31, 2020 was Rs. 35,660. Prepare the Profit and Loss Appropriation Account.

Answer: Debit side: Amit's salary Rs. 12,000; Babu's commission Rs. 5,000; interest on capitals Amit Rs. 3,000, Babu Rs. 2,400, Charu Rs. 1,800, total Rs. 7,200; share of profit transferred to capital accounts Amit Rs. 6,000, Babu Rs. 4,000, Charu Rs. 2,000, total Rs. 12,000.

Total Rs. 36,200. Credit side: Profit and Loss A/c (net profit) Rs. 35,660 plus interest on drawings Amit Rs. 270, Babu Rs. 180, Charu Rs. 90, total Rs. 540, giving Rs. 36,200.

The divisible profit is Rs. 35,660 + Rs. 540 - Rs. 12,000 - Rs. 5,000 - Rs. 7,200 = Rs. 12,000, shared 3:2:1.

How is interest on capital calculated?

No interest is allowed on partners' capitals unless it is expressly agreed among the partners.

When the deed specifically provides for it, interest on capital is credited to the partners at the agreed rate with reference to the time period for which the capital remained in business during the financial year.

It is generally provided for in two situations: where the partners contribute unequal amounts of capital but share profits equally, and where the capital contribution is the same but profit sharing is unequal.

Additions and withdrawals of capital

Interest on capital is calculated with due allowance for any addition or withdrawal of capital during the accounting period. The rules are:

1. On the opening balance of the capital accounts, interest is calculated for the whole year.
2. On additional capital brought in during the year, interest is calculated from the date of introduction to the last day of the financial year.
3. In case of withdrawal of capital, interest is calculated on the opening capital from the beginning of the year to the date of withdrawal, and then on the reduced capital for the remaining period. Alternatively, it can be calculated on the amount that remained in business for the relevant period.

Interest on capital = capital × rate ÷ 100 × period in months ÷ 12

Worked example 2. Mansoor and Reshma had capitals of Rs. 2,00,000 and Rs. 1,50,000 on April 1, 2019.

Mansoor introduced additional capital of Rs. 1,00,000 on August 1, 2019 and Reshma brought in further capital of Rs. 1,50,000 on October 1, 2019. Interest is allowed at 6 per cent per annum. Calculate the interest on capital.

Answer: Mansoor: 6 per cent on Rs. 2,00,000 for 12 months = Rs. 12,000, plus 6 per cent on Rs. 1,00,000 for 8 months (August 1 to March 31) = Rs. 4,000. Total Rs. 16,000.

Reshma: 6 per cent on Rs. 1,50,000 for 12 months = Rs. 9,000, plus 6 per cent on Rs. 1,50,000 for 6 months (October 1 to March 31) = Rs. 4,500. Total Rs. 13,500.

Worked example 3. Saloni and Srishti had capitals of Rs. 2,00,000 and Rs. 3,00,000 on April 1, 2019. On July 1, 2019 Saloni introduced Rs. 50,000 and Srishti Rs. 60,000.

On October 1 Saloni withdrew Rs. 30,000 and on January 1, 2020 Srishti withdrew Rs. 15,000. Interest is allowed at 8 per cent per annum. Calculate the interest on capital for 2019-20.

Answer: Saloni: 8 per cent on Rs. 2,00,000 for 3 months = Rs. 4,000; on Rs. 2,50,000 for 3 months = Rs. 5,000; on Rs. 2,20,000 for 6 months = Rs. 8,800. Total Rs. 17,800.

Srishti: 8 per cent on Rs. 3,00,000 for 3 months = Rs. 6,000; on Rs. 3,60,000 for 6 months = Rs. 14,400; on Rs. 3,45,000 for 3 months = Rs. 6,900. Total Rs. 27,300.

Finding the opening capital

Sometimes the opening capitals are not given. In that case the opening capitals must be worked out from the closing capitals by adding back drawings, deducting any additional capital introduced during the year, and deducting the share of profit already credited (or adding back the share of loss already debited).

Worked example 4. Josh and Krish share profits and losses in the ratio 3:1. Their capitals at the end of 2015-16 were Rs. 1,50,000 and Rs. 75,000.

Josh's drawings were Rs. 20,000 and Krish's Rs. 5,000, already debited to the capital accounts. Profit before charging interest on capital was Rs. 16,000, already credited to the capital accounts in the profit sharing ratio.

Krish brought additional capital of Rs. 16,000 on October 1, 2015. Calculate interest on capital at 12 per cent per annum.

Answer: Josh: closing capital Rs. 1,50,000 + drawings Rs. 20,000 = Rs. 1,70,000, less share of profit Rs. 12,000 = opening capital Rs. 1,58,000. Interest = 12 per cent of Rs. 1,58,000 = Rs. 18,960.

Krish: closing capital Rs. 75,000 + drawings Rs. 5,000 = Rs. 80,000, less share of profit Rs. 4,000 = Rs. 76,000, less additional capital Rs. 16,000 = opening capital Rs. 60,000.

Interest = 12 per cent of Rs. 60,000 for 12 months = Rs. 7,200, plus 12 per cent of Rs. 16,000 for 6 months = Rs. 960, total Rs. 8,160.

Interest out of insufficient profits

Interest on capital is allowed only when the firm has earned profit during the accounting year. No interest is allowed in a year in which the firm has incurred a net loss.

If the profit of the firm is less than the amount due to the partners as interest on capital, the payment of interest is restricted to the amount of profit, and the profit is then effectively distributed in the ratio of interest on capital of each partner.

Worked example 5. Anupam and Abhishek share profits and losses in the ratio 3:2 and had capitals of Rs. 1,50,000 and Rs. 2,00,000 on April 1, 2019.

Show the interest on capital for the year ending March 31, 2020 if (a) the deed is silent and profit is Rs. 50,000;

(b) the deed allows 8 per cent interest on capital and the firm incurred a loss of Rs. 10,000; (c) the deed allows 8 per cent and the profit is Rs. 50,000;

(d) the deed allows 8 per cent and the profit is Rs. 14,000.

Answer: (a) No interest is paid; the whole profit of Rs. 50,000 is shared 3:2. (b) No interest is allowed; the loss of Rs. 10,000 is shared 3:2.

(c) Interest due is Rs. 12,000 to Anupam and Rs. 16,000 to Abhishek, total Rs. 28,000. The profit is sufficient, so the full interest is allowed and the remaining Rs. 22,000 (Rs. 50,000 - Rs. 28,000) is shared 3:2.

(d) Interest due is Rs. 28,000 but the profit is only Rs. 14,000, so interest is paid to the extent of the available profit: Anupam Rs. 6,000 and Abhishek Rs. 8,000, which amounts to sharing the profit in the ratio of interest, 3:4.

How is interest on drawings calculated?

The partnership agreement may provide for charging interest on money withdrawn out of the firm by the partners for personal use. No interest is charged if there is no express agreement.

Where the deed provides for it, interest is charged at the agreed rate for the period for which the drawings remained outstanding from the partners during the accounting year. Charging interest on drawings discourages excessive drawings by partners.

Interest on drawings = total drawings × rate ÷ 100 × average period ÷ 12

Fixed amounts withdrawn at regular intervals

Where a fixed amount is withdrawn every month, the average period depends on the date of withdrawal.

If the amount is withdrawn on the first day of every month, interest is calculated for 6½ months; if at the end of every month, for 5½ months; and if during the middle of the month, for 6 months.

Average period = (months of first drawing + months of last drawing) ÷ 2

Worked example 6. Aashish withdrew Rs. 10,000 per month during the year ending March 31, 2017.

Calculate interest on drawings at 8 per cent per annum if the amount is withdrawn (a) at the beginning of each month, (b) at the end of each month, (c) in the middle of each month.

Answer: Total drawings Rs. 1,20,000. (a) Average period = (12 + 1) ÷ 2 = 6½ months, so interest = Rs. 1,20,000 × 8 ÷ 100 × 6.5 ÷ 12 = Rs. 5,200.

(b) Average period = (11 + 0) ÷ 2 = 5½ months, so interest = Rs. 1,20,000 × 8 ÷ 100 × 5.5 ÷ 12 = Rs. 4,400.

(c) Average period = (11.5 + 0.5) ÷ 2 = 6 months, so interest = Rs. 1,20,000 × 8 ÷ 100 × 6 ÷ 12 = Rs. 4,800.

Where a fixed amount is withdrawn quarterly, the interest is calculated on the total amount withdrawn during the year for 7½ months if the withdrawal is at the beginning of each quarter, and for 4½ months if at the end of each quarter.

Worked example 7. Satish and Tilak share profits equally. During 2016-17 Satish withdrew Rs. 30,000 quarterly and interest is charged at 8 per cent per annum. Calculate the interest on drawings if the amount is withdrawn (a) at the beginning of each quarter, (b) at the end of each quarter.

Answer: Total drawings Rs. 1,20,000. (a) Beginning of each quarter: April 1 for 12 months Rs. 2,400; July 1 for 9 months Rs. 1,800; October 1 for 6 months Rs. 1,200; January 1 for 3 months Rs. 600.

Total Rs. 6,000, which equals Rs. 1,20,000 × 8 ÷ 100 × 7.5 ÷ 12. (b) End of each quarter: June 30 for 9 months Rs. 1,800; September 30 for 6 months Rs. 1,200;

December 31 for 3 months Rs. 600; March 31 for 0 months nil. Total Rs. 3,600, which equals Rs. 1,20,000 × 8 ÷ 100 × 4.5 ÷ 12.

Varying amounts and the product method

When varying amounts are withdrawn at different intervals, interest is calculated by the product method.

For each withdrawal the amount is multiplied by the period, usually in months, for which it remained withdrawn during the financial year, the period being counted from the date of withdrawal to the last day of the accounting year. The products are totalled and interest is calculated on the total.

Interest on drawings = total of products × rate ÷ 100 × 1 ÷ 12

Worked example 8. Shahnaz withdrew Rs. 16,000 on April 1, 2019, Rs. 15,000 on June 30, 2019, Rs. 10,000 on October 31, 2019, Rs. 14,000 on December 31, 2019 and Rs. 11,000 on March 1, 2020.

Interest is charged at 7 per cent per annum and the books close on March 31, 2020. Calculate interest on drawings by the product method.

Answer: Products: Rs. 16,000 × 12 = Rs. 1,92,000; Rs. 15,000 × 9 = Rs. 1,35,000; Rs. 10,000 × 5 = Rs. 50,000; Rs. 14,000 × 3 = Rs. 42,000; Rs. 11,000 × 1 = Rs. 11,000.

Total of products Rs. 4,30,000. Interest = Rs. 4,30,000 × 7 ÷ 100 × 1 ÷ 12 = Rs. 30,100 ÷ 12 = Rs. 2,508.33.

When the total amount withdrawn is given but the dates are not specified, it is assumed that the amount was withdrawn evenly throughout the year and the period taken is six months.

For example, if Shakila withdrew Rs. 60,000 during the year ending March 31, 2020 and interest is charged at 8 per cent per annum, the interest is Rs. 60,000 × 8 ÷ 100 × 6 ÷ 12 = Rs. 2,400.

How is a guarantee of profit to a partner treated?

Sometimes a partner is admitted into the firm with a guarantee of a certain minimum amount by way of his share of profits.

Such an assurance may be given by all the old partners in a certain ratio, or by any of the old partners individually.

The minimum guaranteed amount is paid to the partner when his share of profit as per the profit sharing ratio is less than the guaranteed amount.

Definition: guarantee of profit. It is an assurance that a partner will receive at least a stated minimum amount as his share of profit, any deficiency being made good by the guaranteeing partner or partners.

Deficiency borne by all or by one

For example, Madhulika and Rakshita admit Kanishka, giving her a guarantee of a minimum of Rs. 25,000 as her share in the firm's profits. The firm earned Rs. 1,20,000 and the agreed ratio is 2:3:1.

Madhulika's share is Rs. 40,000, Rakshita's Rs. 60,000 and Kanishka's Rs. 20,000, so Kanishka is Rs. 5,000 short.

The deficiency is borne by the guaranteeing partners in their profit sharing ratio of 2:3, that is Madhulika Rs. 2,000 and Rakshita Rs. 3,000. The final distribution is Madhulika Rs. 38,000, Rakshita Rs. 57,000 and Kanishka Rs. 25,000.

If only Rakshita gives the guarantee, the whole deficiency of Rs. 5,000 is borne by her, and the distribution is Madhulika Rs. 40,000, Rakshita Rs. 55,000 and Kanishka Rs. 25,000.

Worked example 9. Mohit and Rohan share profits and losses in the ratio 2:1. They admit Rahul as partner with 1/4 share in profits with a guarantee that his share shall be at least Rs. 50,000.

The net profit of the firm for the year ending March 31, 2015 was Rs. 1,60,000. Prepare the Profit and Loss Appropriation Account.

Answer: The new ratio is 2:1:1, so Mohit gets Rs. 80,000, Rohan Rs. 40,000 and Rahul Rs. 40,000.

Rahul's deficiency is Rs. 10,000, borne by Mohit and Rohan in their mutual ratio of 2:1: Mohit 2/3 × Rs. 10,000 = Rs. 6,667 and Rohan 1/3 × Rs. 10,000 = Rs. 3,333.

Final shares: Mohit Rs. 80,000 - Rs. 6,667 = Rs. 73,333; Rohan Rs. 40,000 - Rs. 3,333 = Rs. 36,667; Rahul Rs. 40,000 + Rs. 6,667 + Rs. 3,333 = Rs. 50,000. Total Rs. 1,60,000.

Worked example 10. John and Mathew share profits and losses in the ratio 3:2. They admit Mohanty to 1/6 share.

John personally guarantees that Mohanty's share of profit, after charging interest on capital at 10 per cent per annum, will not be less than Rs. 30,000. Capitals are John Rs. 2,50,000, Mathew Rs. 2,00,000 and Mohanty Rs. 1,50,000.

The profit for the year ending March 31, 2015 was Rs. 1,50,000 before providing interest on capital. Show the appropriation.

Answer: Interest on capital is John Rs. 25,000, Mathew Rs. 20,000 and Mohanty Rs. 15,000, total Rs. 60,000. Profit after interest is Rs. 90,000, shared 3:2:1: John Rs. 45,000, Mathew Rs. 30,000, Mohanty Rs. 15,000.

Mohanty is Rs. 15,000 short of Rs. 30,000, and John alone bears it. Final shares: John Rs. 45,000 - Rs. 15,000 = Rs. 30,000; Mathew Rs. 30,000; Mohanty Rs. 15,000 + Rs. 15,000 = Rs. 30,000.

How are past adjustments made?

Sometimes omissions or errors in recording transactions or in preparing summary statements are found after the final accounts have been prepared and the profits distributed among the partners.

The omission may relate to interest on capital, interest on drawings, interest on a partner's loan, partner's salary, partner's commission or outstanding expenses.

There may also be changes in the provisions of the deed or the system of accounting with retrospective effect.

Instead of altering old accounts, the necessary adjustments can be made either through a Profit and Loss Adjustment Account or directly in the capital accounts of the concerned partners.

Definition: past adjustments. These are corrections made after the accounts are closed for omissions or errors in earlier appropriations, so that each partner's account bears the effect it should have borne.

The single adjusting entry

The steps for a single adjusting entry are:

1. Work out the amount that should have been credited or debited to each partner under the correct treatment.
2. Work out the amount actually credited or debited to each partner.
3. Find the difference for each partner; a short credit means the partner must be credited and an excess credit means he must be debited.
4. Pass one journal entry debiting the partners with excess credit and crediting the partners with short credit, the two sides being equal.

Worked example 11. Rameez and Zaheer are equal partners with capitals of Rs. 50,000 and Rs. 1,00,000 on April 1, 2015.

After the accounts for the year ending March 31, 2016 were prepared, it was discovered that interest on capital at 6 per cent per annum, as provided in the deed, had not been credited before distribution of profit. Record the adjustment.

Answer: Interest on capital should be Rameez Rs. 3,000 and Zaheer Rs. 6,000, total Rs. 9,000. The profit actually distributed was Rs. 9,000 higher than it should have been, so each partner received Rs. 4,500 too much.

Net effect: Rameez has an excess credit of Rs. 4,500 - Rs. 3,000 = Rs. 1,500 and Zaheer a short credit of Rs. 6,000 - Rs. 4,500 = Rs. 1,500. Entry: Rameez's Capital A/c Dr. Rs. 1,500; To Zaheer's Capital A/c Rs. 1,500.

Worked example 12. Nusrat, Sonu and Himesh share profits and losses in the ratio 5:3:2. The deed provides for interest on drawings at 10 per cent per annum. Drawings, all made on the first day of the accounting year, were Nusrat Rs. 20,000, Sonu Rs. 15,000 and Himesh Rs. 10,000.

After the final accounts were prepared it was found that interest on drawings had not been charged. Give the adjusting entry.

Answer: Interest on drawings should be Nusrat Rs. 2,000, Sonu Rs. 1,500 and Himesh Rs. 1,000, total Rs. 4,500.

That amount was distributed as profit in the ratio 5:3:2, so Nusrat received Rs. 2,250, Sonu Rs. 1,350 and Himesh Rs. 900.

Net effect: Nusrat is short by Rs. 2,250 - Rs. 2,000 = Rs. 250, Sonu has excess of Rs. 1,500 - Rs. 1,350 = Rs. 150 and Himesh excess of Rs. 1,000 - Rs. 900 = Rs. 100.

Entry: Sonu's Capital A/c Dr. Rs. 150; Himesh's Capital A/c Dr. Rs. 100; To Nusrat's Capital A/c Rs. 250.

Adjustments for salary and the profit sharing ratio

The same method corrects an omitted salary or profits shared in a wrong ratio. Work out what each partner should have received in total, compare it with what was actually credited, and pass one entry for the differences.

Worked example 13. Asha and Bina share profits in the ratio 3:2. For the year ending March 31, 2025 the profit of Rs. 60,000 was wrongly shared equally, and Asha's salary of Rs. 6,000 provided in the deed was also omitted. Pass a single adjusting entry.

Answer: Correct position: Asha's salary Rs. 6,000; remaining profit Rs. 60,000 - Rs. 6,000 = Rs. 54,000, shared 3:2 as Asha Rs. 32,400 and Bina Rs. 21,600. Asha should have received Rs. 6,000 + Rs. 32,400 = Rs. 38,400 and Bina Rs. 21,600.

Actually credited: Asha Rs. 30,000 and Bina Rs. 30,000. Net effect: Asha is short by Rs. 8,400 and Bina has an excess of Rs. 8,400. Entry: Bina's Capital A/c Dr. Rs. 8,400; To Asha's Capital A/c Rs. 8,400.

Where the correction is large or relates to several items, a Profit and Loss Adjustment Account may be opened.

The items omitted are first recorded through this account and its balance is then transferred to the partners' capital accounts in the profit sharing ratio. Partners' adjusted capital or current accounts are then prepared to show the corrected balances.

What are the special points about interest on loan, rent and commission?

Several items are charges against profit rather than appropriations of profit, and the distinction changes where they are recorded.

Because these items are charges, they are dealt with before the Profit and Loss Appropriation Account begins. The net profit shown in the appropriation account is therefore the profit after these charges.

For example, if a partner has given a loan of Rs. 50,000 to the firm on April 1 without any agreement, interest at 6 per cent per annum, that is Rs. 3,000, is charged to the Profit and Loss Account before the profit is appropriated.

Worked example 14. Amitabh and Babul share profits in the ratio 3:2 with capitals of Rs. 50,000 and Rs. 30,000. Interest on capital is agreed at 6 per cent per annum.

Babul is allowed an annual salary of Rs. 2,500 and the manager is allowed a commission of Rs. 5,000. Amitabh gave a loan of Rs. 50,000 to the firm on April 1, 2019 without any agreement.

The profit earned during 2019-20 is Rs. 22,250. Prepare the appropriation account and the capital accounts.

Answer: The Profit and Loss Account is debited with the manager's commission Rs. 5,000 and interest on Amitabh's loan at 6 per cent, Rs. 3,000, leaving Rs. 14,250 for appropriation.

Appropriation: Babul's salary Rs. 2,500; interest on capital Amitabh Rs. 3,000 and Babul Rs. 1,800, total Rs. 4,800; divisible profit Rs. 14,250 - Rs. 2,500 - Rs. 4,800 = Rs. 6,950, shared 3:2 as Amitabh Rs. 4,170 and Babul Rs. 2,780.

Amitabh's capital becomes Rs. 50,000 + Rs. 3,000 + Rs. 4,170 = Rs. 57,170 and Babul's Rs. 30,000 + Rs. 2,500 + Rs. 1,800 + Rs. 2,780 = Rs. 37,080.

Commission to a manager

A manager who is not a partner is an employee, so the manager's commission is a charge against profit and is debited to the Profit and Loss Account, not to the appropriation account. When the commission is a percentage of net profit, read the wording carefully.

If it is a percentage of net profit before charging the commission, it is profit × rate ÷ 100. If it is a percentage of net profit after charging such commission, it is profit before commission × rate ÷ (100 + rate).

Worked example 15. The net profit of a firm before charging the manager's commission is Rs. 1,32,000. The manager is entitled to a commission of 10 per cent of the net profit after charging such commission. Calculate the commission and the profit available for appropriation.

Answer: Commission = Rs. 1,32,000 × 10 ÷ 110 = Rs. 12,000. Check: 10 per cent of (Rs. 1,32,000 - Rs. 12,000) = 10 per cent of Rs. 1,20,000 = Rs. 12,000.

The profit available for appropriation is Rs. 1,32,000 - Rs. 12,000 = Rs. 1,20,000. Had the commission been 10 per cent of the profit before charging it, it would have been Rs. 13,200.

Glossary

• Partnership: 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.
• Partners: the persons who have entered into partnership with one another.
• Firm: the collective name for the partners taken together as a business unit.
• Mutual agency: the relationship in which each partner acts as principal and as agent for all the others.
• Partnership deed: the written document containing the terms of the agreement among the partners.
• Fixed capital method: a method in which capital stays fixed and other items are recorded in a separate current account.
• Fluctuating capital method: a method in which all adjustments are recorded directly in the single capital account of each partner.
• Current account: the account that records drawings, interest, salary, commission and share of profit under the fixed capital method.
• Profit and Loss Appropriation Account: an extension of the Profit and Loss Account that shows how profit is distributed among partners.
• Interest on capital: interest credited to a partner on his capital at the agreed rate, allowed only when the deed provides for it.
• Interest on drawings: interest charged to a partner on amounts withdrawn for personal use, when the deed so provides.
• Average period: the assumed period for which a series of equal drawings is taken to remain outstanding.
• Product method: a method of computing interest on drawings by multiplying each withdrawal by its outstanding period.
• Guarantee of profit: an assurance of a minimum share of profit to a partner, any deficiency being borne by the guarantor.
• Past adjustments: corrections of earlier omissions or errors made after the accounts have been closed.

Common errors and misconceptions

• Misconception: Interest on capital is a matter of right for every partner. Correct: No partner can claim interest on capital as a matter of right; it is allowed only when the deed expressly provides for it.
• Misconception: If the deed is silent, interest on a partner's loan is also refused. Correct: Interest on a partner's loan is allowed at 6 per cent per annum even when the deed is silent.
• Misconception: Profits are shared in the ratio of capital when there is no deed. Correct: Profits and losses are shared equally, irrespective of capital contribution.
• Misconception: Interest on capital is allowed even when the firm makes a loss. Correct: No interest on capital, salary or remuneration is allowed when the firm suffers a loss.
• Misconception: Interest on a partner's loan is debited to the appropriation account. Correct: It is a charge against profits, debited to the Profit and Loss Account and credited to the loan account.
• Misconception: A partner's commission as a percentage is calculated on the divisible profit. Correct: It is calculated on the correct trading profit, not on the divisible profit.
• Misconception: Under the fixed capital method the capital account changes every year. Correct: It changes only when capital is added or withdrawn; other items go to the current account.
• Misconception: A partnership must be created by a written agreement. Correct: An oral agreement is equally valid, though a written deed is preferred to avoid disputes.

Exam-style questions with model answers

Q1. State the rule for interest on a partner's loan when the partnership deed is silent, and say where this interest is recorded. [2 marks]

1. When the deed is silent, a partner who has advanced a loan to the firm is entitled to interest at 6 per cent per annum.
2. The interest is a charge against profits: it is debited to the Profit and Loss Account and credited to the partner's loan account, not to his capital account.

Q2. A firm has partners with capitals of Rs. 4,00,000 and Rs. 1,00,000 and no partnership deed. The profit for the year is Rs. 60,000. How is the profit shared and why? [2 marks]

1. The profit is shared equally, Rs. 30,000 to each partner.
2. When the deed is silent on the profit sharing ratio, the Indian Partnership Act, 1932 requires profits and losses to be shared equally, irrespective of the capital contributed.

Q3. Distinguish between the fixed capital method and the fluctuating capital method on any three bases. [3 marks]

1. Number of accounts: under the fixed method two accounts are kept for each partner, the capital account and the current account; under the fluctuating method only one capital account is kept.
2. Items posted: under the fixed method drawings, salary and interest on capital are posted in the current account; under the fluctuating method all such adjustments are posted in the capital account.
3. Balance: under the fixed method the capital account always shows a credit balance and remains unchanged unless capital is added or withdrawn; under the fluctuating method the balance fluctuates from year to year and may sometimes show a debit balance.

Q4. A partner withdrew Rs. 2,000 at the beginning of every month for twelve months. Interest on drawings is charged at 9 per cent per annum. Calculate the interest on drawings. [3 marks]

1. Total drawings = Rs. 2,000 × 12 = Rs. 24,000.
2. Average period for withdrawals at the beginning of each month = (12 + 1) ÷ 2 = 6½ months.
3. Interest = Rs. 24,000 × 9 ÷ 100 × 6.5 ÷ 12 = Rs. 1,170.

Q5. Explain the meaning and importance of a partnership deed and list any four of its usual contents. [4 marks]

1. A partnership deed is the written document that contains the terms of the agreement among the partners; the Act does not require writing, but a written deed is preferred to avoid disputes.
2. It is important because it settles the capital to be contributed, the profit sharing ratio, interest on capital and loan, salaries and commission, and the method of settling disputes, so that the Act's default rules need not be applied.
3. Its clauses can be altered with the consent of all partners, and it should be drafted as per the Stamp Act and preferably registered with the Registrar of Firms.
4. Usual contents include the names and addresses of the firm and partners, the capital to be contributed by each partner, the profit and loss sharing ratio, and the rate of interest on capital, loan and drawings.

Q6. Anupam and Abhishek share profits in the ratio 3:2 with capitals of Rs. 1,50,000 and Rs. 2,00,000. The deed allows interest on capital at 8 per cent per annum. The profit for the year is Rs. 14,000. Show how interest on capital is allowed. [4 marks]

1. Interest due: Anupam 8 per cent of Rs. 1,50,000 = Rs. 12,000; Abhishek 8 per cent of Rs. 2,00,000 = Rs. 16,000; total Rs. 28,000.
2. The profit of Rs. 14,000 is less than the interest due, so interest is paid only to the extent of the available profit.
3. Anupam is credited with Rs. 14,000 × 12,000 ÷ 28,000 = Rs. 6,000 and Abhishek with Rs. 14,000 × 16,000 ÷ 28,000 = Rs. 8,000.
4. Effectively the profit is shared in the ratio of interest on capital, that is 3:4.

Q7. Mohit and Rohan share profits in the ratio 2:1. They admit Rahul for 1/4 share with a guarantee of at least Rs. 50,000. The profit for the year is Rs. 1,60,000. Show the distribution of profit. [5 marks]

1. The new ratio is 2:1:1, so on Rs. 1,60,000 Mohit gets Rs. 80,000, Rohan Rs. 40,000 and Rahul Rs. 40,000.
2. Rahul's share falls short of the guarantee by Rs. 50,000 - Rs. 40,000 = Rs. 10,000.
3. The deficiency is borne by Mohit and Rohan in their mutual ratio of 2:1: Mohit 2/3 × Rs. 10,000 = Rs. 6,667 and Rohan 1/3 × Rs. 10,000 = Rs. 3,333.
4. Final shares: Mohit Rs. 80,000 - Rs. 6,667 = Rs. 73,333; Rohan Rs. 40,000 - Rs. 3,333 = Rs. 36,667; Rahul Rs. 40,000 + Rs. 10,000 = Rs. 50,000.
5. The total distributed is Rs. 73,333 + Rs. 36,667 + Rs. 50,000 = Rs. 1,60,000, which agrees with the profit.

Q8. Rameez and Zaheer are equal partners with capitals of Rs. 50,000 and Rs. 1,00,000. Interest on capital at 6 per cent per annum was omitted before the profit was shared. Pass the adjusting entry and explain it. [5 marks]

1. Interest on capital should have been Rameez Rs. 3,000 and Zaheer Rs. 6,000, total Rs. 9,000.
2. Because this was omitted, the profit distributed was Rs. 9,000 higher than it should have been, and each partner received Rs. 4,500 too much.
3. Net effect: Rameez has an excess credit of Rs. 4,500 - Rs. 3,000 = Rs. 1,500; Zaheer has a short credit of Rs. 6,000 - Rs. 4,500 = Rs. 1,500.
4. Adjusting entry: Rameez's Capital A/c Dr. Rs. 1,500; To Zaheer's Capital A/c Rs. 1,500.
5. After the entry Rameez's capital account is Rs. 1,500 lower and Zaheer's is Rs. 1,500 higher than before, so each has borne the correct effect of the omission without reopening the closed accounts.

Q9. Amitabh and Babul share profits in the ratio 3:2 with capitals of Rs. 50,000 and Rs. 30,000. Interest on capital is 6 per cent per annum, Babul is allowed a salary of Rs. 2,500, the manager is allowed a commission of Rs. 5,000, and Amitabh gave the firm a loan of Rs. 50,000 on April 1 without any agreement. The profit for the year is Rs. 22,250. Prepare the appropriation account. [6 marks]

1. Charges against profit: manager's commission Rs. 5,000 and interest on Amitabh's loan at 6 per cent of Rs. 50,000 = Rs. 3,000, total Rs. 8,000, leaving Rs. 22,250 - Rs. 8,000 = Rs. 14,250 for appropriation.
2. Debit side of the appropriation account: Babul's salary Rs. 2,500; interest on capital Amitabh Rs. 3,000 and Babul Rs. 1,800, total Rs. 4,800; share of profit Amitabh Rs. 4,170 and Babul Rs. 2,780, total Rs. 6,950. Total Rs. 14,250.
3. Credit side: Profit and Loss A/c (net profit after the manager's commission and the interest on the loan) Rs. 14,250.
4. The divisible profit is Rs. 14,250 - Rs. 2,500 - Rs. 4,800 = Rs. 6,950, shared 3:2.
5. Amitabh's capital becomes Rs. 50,000 + Rs. 3,000 + Rs. 4,170 = Rs. 57,170.
6. Babul's capital becomes Rs. 30,000 + Rs. 2,500 + Rs. 1,800 + Rs. 2,780 = Rs. 37,080.

Key takeaways

• Partnership is the relation between persons who agree to share the profits of a business carried on by all or any of them acting for all.
• Mutual agency is essential: each partner is both principal and agent, and the liability of partners is unlimited.
• When the deed is silent, profits are shared equally, no interest on capital or drawings is allowed, and no salary is payable.
• Interest on a partner's loan is allowed at 6 per cent per annum even without a deed, and is a charge against profits.
• Under the fixed capital method a separate current account records drawings, interest, salary and share of profit.
• In the absence of instructions, capital accounts are prepared by the fluctuating capital method.
• Interest on capital is allowed only out of profits, and is restricted to the profit available if profits fall short.
• Interest on drawings uses an average period of 6½, 5½ or 6 months for monthly drawings, and the product method for varying amounts.
• A guaranteed minimum profit is made up by the guaranteeing partners in their agreed ratio, usually the profit sharing ratio.
• Past omissions are corrected by a single adjusting entry or through a Profit and Loss Adjustment Account.

Test yourself

What is the maximum number of partners a firm may have?

The number cannot be more than 100 under Section 464 of the Companies Act, 2013, and the Central Government has prescribed the maximum as 50 under the Companies (Miscellaneous) Rules, 2014.

Is an oral partnership agreement valid?

Yes. The Act does not require the agreement to be in writing, and an oral agreement is equally valid, though a written deed is preferred to avoid disputes.

What is the rate of interest on a partner's loan when the deed is silent?

Six per cent per annum. The interest is debited to the Profit and Loss Account and credited to the partner's loan account.

Which method of maintaining capital accounts is used when there is no instruction?

The fluctuating capital method, in which all adjustments are recorded directly in the single capital account of each partner.

For what average period is interest calculated on drawings made at the end of every month?

Five and a half months, because the average period is (11 + 0) ÷ 2 = 5½ months.

What average period is used when the total drawings are given but the dates are not?

Six months, assuming the amount was withdrawn evenly throughout the year.

Who bears the deficiency when one partner alone guarantees a minimum profit to another?

The partner who gave the guarantee bears the whole deficiency, and the other partners' shares are not reduced.

On what amount is a partner's commission as a percentage calculated?

On the correct trading profit, not on the divisible profit that remains after appropriations.