Partnerships
Advantages:
- More Capital: Partners can contribute more money than a sole trader.
- Shared Responsibility: Work and decision-making are shared.
- Specialization: Different partners can manage different areas (e.g., one handles sales, another accounts).
Disadvantages:
- Unlimited Liability: Each partner is personally liable for all business debts. If the business fails, personal assets can be taken to pay creditors.
- Shared Profits: The profit must be divided among partners.
- Conflict: Disagreements between partners can disrupt business operations.
A written document that sets out the rules for running the partnership. It is crucial because, without it, the Partnership Act applies (which usually means equal profit sharing regardless of capital contribution).
Key contents include:
- Amount of capital each partner invests.
- Whether interest is paid on capital or drawings.
- Salaries for partners.
- How profits are shared (ratio).
- Accruals (Accrued Expenses): Expenses incurred in the current year but not yet paid. You add this amount to the expense in the income statement.
- Prepayments (Deferred Expenses): Expenses paid in advance for a future period. You deduct this amount from the expense in the income statement.
This ensures the profit figure reflects only the costs of the current accounting period.
The Statement of Profit or Loss calculates the net profit for the business. The Appropriation Account then shows how this profit is distributed among the partners.
Order of Distribution:
- Interest on Capital: Paid to partners for their investment in the business.
- Salaries: Paid to partners for their work (treated as an expense, not a profit share).
- Interest on Drawings: Charged to partners for taking money out early.
- Residual Profit: The remaining profit is shared according to the partnership agreement ratio.
Partners often have two accounts:
- Capital Account: Records the initial fixed investment. This balance usually remains constant unless new capital is introduced or withdrawn permanently.
- Current Account: Records the dynamic changes: interest on capital, salaries, share of profit (increases balance), and drawings (decreases balance).
In the Statement of Financial Position:
- If both accounts have credit balances, they are summed and shown under Equity.
- If a Current Account has a debit balance (drawings > profit share), it is shown as a Current Liability.
Partners A and B share profits 60:40.
- Net Profit per Income Statement: 10,000</li> <li>Capital Balances: A =10,000; B = 8,000</li> <li>Interest on Capital: 5% p.a.</li> <li>Partner A Salary:2,000
Step 1: Calculate Interest on Capital
- A: 10,000 \times 5% =500</li> <li>B:8,000 \times 5% = 400
Step 2: Prepare Appropriation Account
| Appropriation Account for the year ended 31 Dec | $ | ||
|---|---|---|---|
| Net Profit per Income Statement | 10,000 | ||
| Add: Interest on Drawings (if any) | 0 | ||
| Less: | |||
| Interest on Capital: | |||
| Partner A | (500) | ||
| Partner B | (400) | ||
| Salaries: | |||
| Partner A | (2,000) | ||
| Residual Profit (10,000 - 500 - 400 - 2,000) | 7,100 | ||
| Share of Residual Profit: | |||
| Partner A (60%) | (4,260) | ||
| Partner B (40%) | (2,840) |
Correction: Interest on Capital is an appropriation of profit, not a business expense. It appears only in the Appropriation Account.
Mistake: Forgetting to add Interest on Drawings back to the Net Profit.
Correction: Interest on Drawings is income for the business (paid by partners). You must add it to the Net Profit before distributing the remaining profit.
Why this matters: Examiners test if you understand the order of distribution. Skipping a step leads to an incorrect residual figure.
Example Usage: 'The residual profit is calculated as 10,000 (Net Profit) +200 (Int on Drawings) - 900 (Int on Capital) -2,000 (Salary) = 7,300. Partner A's share is 60% of7,300.'
Partner A Current Account
- Balance b/d: 5,000</li> <li>Interest on Capital:500
- Salary: 2,000</li> <li>Share of Profit:4,260
- Drawings: (2,000)</li> <li><strong>Balance c/d:9,760
Partner B Current Account
- Balance b/d: 3,000</li> <li>Interest on Capital:400
- Share of Profit: 2,840</li> <li>Drawings: (1,500)
- Balance c/d: $4,740
Key Rule: If a Current Account has a debit balance (negative), it is a liability. Do not net it off against another partner's credit balance unless explicitly instructed.
Example Usage: 'Equity: Partner A Capital 10,000 + Partner A Current9,760; Partner B Capital 8,000 + Partner B Current4,740. Total Equity = $32,500.'
- Amount of capital to be invested by each partner.
- Interest rate on partners' capital.
- Salaries payable to partners.