According to Section 4 of the Indian Partnership Act, 1932, a partnership is the relation between persons who have agreed to share the profits of a business carried on by all or any one of them acting for all. This means that a partnership arises from a contract between two or more persons who intend to conduct a lawful business together and share its profits. The business may be carried on by all the partners together or by one or more of them acting on behalf of the others.
Features or Characteristics of Partnership
Partnership has certain essential features that distinguish it from other forms of business organizations.
An association of two or more persons is required for a partnership. The minimum number of partners is two. The maximum number is guided by the Companies Act. As per Section 464 of the Indian Companies Act, 2013, the number of partners in any association shall not exceed 100. However, the Companies (Miscellaneous) Rules, 2014 presently restrict this number to 50. If this limit is exceeded, the association becomes illegal.
There must be an agreement between all partners involved in the business. This agreement forms the basis of the partnership and defines the mutual rights and obligations of partners.
The agreement must be for carrying on a business. A partnership can be formed only for lawful business purposes. Non-commercial or charitable purposes do not qualify.
The sharing of profits and losses is an essential aspect of a partnership. Partners must agree to share the profits and bear the losses of the business in the agreed ratio.
The partnership is based on a mutual agency relationship. Each partner is both an agent and a principal. A partner can bind the firm by their acts, and they can also be bound by the acts of the other partners.
The liability of partners is unlimited. Each partner is jointly and severally liable for the acts of the firm. This means that their assets may be used to pay off the firm’s debts incurred during their tenure as a partner.
Nature of a Partnership Firm
Legally, a partnership firm has no separate legal existence from the partners who constitute it. However, from an accounting perspective, the firm is treated as a separate entity. As per Section 2(3) of the Income-tax Act, 1961, a partnership firm is recognized as a separate person for tax purposes.
Partners, Firm, and Firm Name
The individuals who enter into a partnership are called partners. Together, they are collectively referred to as a firm. The name under which they conduct their business is known as the firm name.
Accounting Procedure of a Partnership Firm
The final accounts of a partnership firm are prepared similarly to those of a sole proprietorship. However, since there are two or more partners, the net profit is distributed among them in the agreed ratio. The account that shows the distribution of profit or loss among the partners is called the Profit and Loss Appropriation Account. This is an extension of the Profit and Loss Account and records items such as interest on capital, salaries, commissions, and the final distribution of profits or losses.
Important Components in Partnership Accounting
Partnership accounting includes several components. These are the partnership deed, profit and loss appropriation account, partners’ capital accounts, interest on partners’ drawings, interest on partners’ capital, salary or commission to partners, interest on partners’ loans, and adjustments after closing the accounts.
Partnership Deed
A partnership deed is a voluntary document that outlines the terms and conditions agreed upon by the partners. While it is not compulsory, a written deed is highly recommended. The partnership agreement may be either oral or written, but when written, it is referred to as the partnership deed. It should be properly drafted and stamped under the Stamp Act and preferably registered with the Registrar of Firms.
Contents of the Partnership Deed
The partnership deed typically includes the name of the firm and the partners, the date of commencement and duration of the business, the capital contributed by each partner, the amount and timing of drawings permitted, the rate of interest on capital, loans, and drawings, the profit-sharing ratio, details about salaries or commissions, mutual rights and duties, method of goodwill valuation, procedures for retirement and settlement of accounts, treatment of insolvency, and dispute resolution methods. It also includes provisions for the preparation and audit of accounts.
Applicability of the Indian Partnership Act, 1932
In the absence of a partnership deed, or if the deed is silent on any specific issue, the relevant provisions of the Indian Partnership Act, 1932, apply.
As per Section 13(b), profits and losses are to be shared equally among the partners.
As per Section 13(c), no interest is allowed on capital unless agreed otherwise.
According to Section 13(d), interest at 6 percent per annum is allowed on advances and loans by a partner.
No interest is charged on drawings unless provided in the deed.
According to Section 13(a), no partner is entitled to a salary for taking part in the conduct of business unless agreed upon.
Profit and Loss Appropriation Account
This account is an extension of the Profit and Loss Account and is prepared to distribute profits or losses among the partners. It shows how the net profit is appropriated among various accounts like interest on capital, salaries, commissions, reserve fund, and the remaining balance transferred to partners’ capital accounts in the agreed ratio.
The format of the Profit and Loss Appropriation Account includes debits such as interest on capital, partner salaries, partner commissions, transfer to reserve fund, and profit transferred to partners’ capital accounts. Credits include the net profit from the Profit and Loss Account and interest on drawings.
Commission paid to partners on sales or purchases is recorded in the Profit and Loss Account. However, if it is paid on profits, it is shown in the Profit and Loss Appropriation Account.
Items such as interest on partners’ loans, manager’s commission, and rent paid to a partner are recorded in the Profit and Loss Account as they are charges against the profit.
Profit and Loss Account
The Profit and Loss Account includes debits such as interest on partners’ loans and advances, manager’s salary and commission, and rent paid to partners. The credit side includes the profit figure, which is transferred to the Profit and Loss Appropriation Account for further allocation.
Partners’ Capital Account and Interest on Capitals
The capital accounts of partners may be maintained using either the fluctuating or fixed capital method. In the absence of instructions, the fluctuating capital method is used by default.
Fluctuating Capital Method
Under this method, a single capital account is maintained for each partner. It records all entries such as interest on capital, drawings, interest on drawings, salary, commission, share of profit or loss, and additional capital introduced. The balance fluctuates based on these transactions.
Interest on loans and advances to partners is not recorded in this account. Instead, such interest may be shown separately in an accrued interest account.
Fixed Capital Method
Under the fixed capital method, two accounts are maintained for each partner: the capital account and the current account. The capital account records only the initial and additional capital introduced or withdrawn. The current account records transactions like interest on capital, drawings, interest on drawings, salaries, commissions, and share of profit or loss.
The balance in a partner’s current account may be either a debit or a credit. However, the capital account under this method typically maintains a credit balance.
Interest on Capital
Interest on capital is calculated at a pre-defined rate and for the period during which the capital is used in the business. Generally, it is calculated on the opening balance of the capital account. If additional capital is introduced during the year, interest on the new capital is calculated proportionately.
If the closing capital is given, the opening capital can be calculated by making necessary adjustments for drawings and additional capital introduced.
When Capital is Fixed
The opening capital is determined by adjusting the closing balance for drawings and additional capital. This is useful when interest on capital is to be calculated and only the closing capital is known.
When Capital is Fluctuating
To calculate the opening capital under fluctuating capital, adjustments include adding back drawings and interest on drawings and subtracting additional capital, interest on capital, and share of profits.
Accounting Treatment of Interest on Capital
If the partnership agreement is silent, no interest is allowed on capital. If the agreement provides interest on capital as a charge, it is allowed even in the case of loss. If the agreement is silent about the nature of the allowance, it is considered an appropriation and is allowed only when there is sufficient profit.
If there is no profit, no interest on capital is allowed. If profit is insufficient, interest is allowed only up to the amount of available profit and distributed among partners in the ratio of their capitals.
Interest on Drawings
Interest on drawings is charged from the partners if the partnership agreement provides for it. If the deed is silent about charging interest on drawings, no interest is charged. This amount represents income for the firm and an expense for the partner. Therefore, it is credited to the Profit and Loss Appropriation Account and debited to the respective partner’s capital or current account.
Calculation of Interest on Drawings
There are two primary methods used for calculating interest on drawings: the product method and the average period method.
Product Method
Under the product method, the interest is calculated using the actual date of each withdrawal and the time remaining until the end of the financial year. Each amount withdrawn is multiplied by the period it was used in months or days to get the product. The total product is then used to compute interest using the formula:
Interest on Drawings = Sum of Product × Rate of Interest × Time
This method is precise and commonly used when the amounts and timing of drawings are irregular.
Average Period Method
This method is used when the number of drawings is uniform and the time interval between successive drawings is equal. The average period is calculated using the formula:
Average Period = (Time left after first drawing + Time left after last drawing) ÷ 2
Once the average period is calculated, the interest on drawings is computed using the following formula:
Interest on Drawings = Total Drawings × Rate of Interest × Average Period ÷ 12
This method simplifies the process and is useful in cases where the regularity of drawings allows such estimation.
Timing of Drawings and Average Period
The average period varies based on the timing of drawings. If drawings are made at the beginning of each month throughout the year, the average period is 6 and a half months. If drawings are made in the middle of each month, the average period is 6 months. If drawings are made at the end of each month, the average period is 5 and a half months.
When drawings are made each month for only six months, the average period is 3 and a half months if withdrawn at the beginning, 3 months if withdrawn in the middle, and 2 and a half months if withdrawn at the end. For quarterly drawings throughout the year, the average period is 7 and a half months for beginning-of-quarter drawings, 6 months for mid-quarter drawings, and 4 and a half months for end-of-quarter drawings.
Accounting Treatment of Interest on Drawings
From the firm’s perspective, interest on drawings is considered income and credited to the Profit and Loss Appropriation Account. From the partner’s perspective, it is an expense and is debited to the partner’s capital or current account.
Interest on Partner’s Loan
When a partner gives a loan to the firm in addition to their capital contribution, they are entitled to receive interest on that loan. This is distinct from interest on capital and is treated differently in accounting.
Rate of Interest
If the partnership agreement specifies a rate of interest, the firm is obligated to pay that rate. If the agreement is silent, Section 13(d) of the Indian Partnership Act, 1932, provides that interest at the rate of 6 percent per annum should be paid on the partner’s loan.
Nature of Interest on Loan
Interest on a partner’s loan is considered a charge against profits, which means it must be paid regardless of whether the firm makes a profit or incurs a loss. This differentiates it from interest on capital, which is treated as an appropriation and allowed only out of profits.
Accounting Treatment of Interest on Loan
Interest on a partner’s loan is shown on the debit side of the Profit and Loss Account because it is a charge against the profit. It is not recorded in the Profit and Loss Appropriation Account since it is not an appropriation of profit but a compulsory charge.
Salary or Commission to a Partner
Partners may be entitled to salary or commission for their involvement in the daily operations of the business, provided the partnership agreement explicitly states so.
When Salary or Commission Is Allowed
Salary or commission to a partner is allowed only if there is a clause in the partnership agreement. In the absence of such a clause, no partner can claim remuneration for participating in the business.
Nature of Salary or Commission
Salary or commission paid to a partner is considered an appropriation of profit rather than a charge against profit. This means it is provided only when the firm has sufficient profits and is not payable in the case of losses unless the agreement states otherwise.
Calculation of Commission
Commission may be calculated either as a percentage of net profit before charging such commission or after charging such commission. The calculation differs depending on the method agreed upon.
If commission is a percentage of net profit before charging commission, it is calculated as:
Commission = Net Profit before Commission × Rate of Commission ÷ 100
If commission is a percentage of net profit after charging commission, it is calculated as:
Commission = Net Profit before Commission × Rate of Commission ÷ (100 + Rate of Commission)
Accounting Treatment of Salary or Commission
Salary or commission to a partner is recorded in the Profit and Loss Appropriation Account as it is an appropriation of profits. It is shown on the debit side of the appropriation account and credited to the respective partner’s capital or current account.
Additional Legal and Accounting Points in Partnership
The Indian Partnership Act, 1932, governs partnership firms and came into force on the first day of October 1932. A partnership cannot be formed with a minor at the outset, but a minor can be admitted to the benefits of an existing partnership with the consent of all the partners. The number of partners is capped at 50 by the Companies (Miscellaneous) Rules, 2014, although Section 464 of the Companies Act, 2013, allows up to 100. Partnerships can be created for business or professional purposes, but not for charitable objectives.
Mutual agency is a defining feature of a partnership. Sharing of profits is prima facie evidence of partnership, while mutual agency is conclusive evidence. Registration of a partnership firm is optional but recommended for legal benefits. An unregistered firm cannot claim a set-off exceeding 100. In the absence of an agreement, partners are entitled to receive only interest on loans and to share profits and losses equally.
A partnership deed must be signed by all partners. The firm is the name under which the partnership operates, but has no legal identity separate from its members except under Section 2(3) of the Income-tax Act, 1961. Partnership agreements are not required to be registered,but when registered as a partnership deed, it must be stamped under law.
Interest on capital is paid only out of current profits, not out of accumulated or past profits. The balance in a partner’s capital account under the fluctuating method can be debit or credit, whereas under the fixed capital method, it is always a credit balance.
The Profit and Loss Appropriation Account is prepared in partnership firms to distribute the profit or loss among the partners. This is not required in sole proprietorships. Drawings by partners are adjusted through their capital or current accounts, and interest on drawings is credited to the Profit and Loss Appropriation Account if agreed upon. The liability of all partners is joint and several. They are personally liable for the losses of the firm. When a partner is given a guarantee of a minimum profit, they must receive that amount even if the firm’s actual profit is less. In such a case, the shortfall is borne by the other partners in the agreed ratio.
Accounting for Admission of a New Partner
When a new partner is admitted into the firm, it leads to several changes in the financial structure of the business. The existing agreement between the partners is dissolved, and a new one is formed. The incoming partner generally brings in capital and goodwill and gains a share in the future profits of the firm. The accounting treatment of admission involves revaluation of assets and liabilities, adjustment of accumulated reserves, computation of goodwill, and determination of new profit-sharing ratios.
Revaluation of Assets and Liabilities
Before admitting a new partner, it is common practice to revalue the assets and liabilities of the firm. This ensures that any changes in the value of assets or liabilities are accounted for, and the existing partners benefit from the appreciation or bear the loss due to depreciation. A Revaluation Account is prepared for this purpose. Any profit or loss arising from revaluation is transferred to the existing partners’ capital accounts in their old profit-sharing ratio.
Treatment of Goodwill on Admission
Goodwill represents the reputation and brand value built by the firm over the years. When a new partner is admitted, they benefit from this goodwill and are required to compensate the existing partners. Goodwill may be brought in cash or adjusted through capital accounts. The accounting treatment depends on whether goodwill is already appearing in the books or not. If it is not brought in cash, the existing partners are compensated through the capital account by debiting the new partner’s capital account in the sacrificing ratio.
Determination of New Profit-Sharing Ratio
With the admission of a new partner, the profit-sharing ratio among partners changes. The new ratio is determined based on mutual agreement. The existing partners may sacrifice a portion of their share in favor of the new partner. This sacrifice is expressed as the difference between the old share and the new share. The sacrificing ratio is important for adjusting goodwill and other reserves.
Adjustment of Accumulated Profits and Losses
All accumulated profits, reserves, or losses in the firm must be adjusted before admitting the new partner. These may include general reserves, profit and loss account balances, or any other accumulated items. The distribution of these items is done among the old partners in their old profit-sharing ratio before the capital of the new partner is introduced.
Accounting for Retirement of a Partner
Retirement of a partner occurs when a partner voluntarily withdraws from the firm. Similar to admission, retirement results in the reconstitution of the firm. Adjustments must be made for revaluation of assets and liabilities, goodwill, and accumulated reserves. The outgoing partner is paid their due share, which may include capital, share of goodwill, and revaluation profits or losses.
Revaluation and Distribution of Profit or Loss on Revaluation
On retirement, a Revaluation Account is prepared to account for any changes in the value of assets and liabilities. The resulting profit or loss is distributed among all the partners, including the retiring partner, in their old profit-sharing ratio. This ensures that the retiring partner receives their fair share of the firm’s value.
Calculation and Treatment of Goodwill on Retirement
Goodwill is again a crucial element in retirement accounting. The retiring partner is entitled to a share of goodwill, which is usually adjusted through the capital accounts of the remaining partners. The gaining ratio, which is the difference between the new and old share of continuing partners, is used to determine the amount to be transferred to the retiring partner.
Settlement of Retiring Partner’s Dues
Once all adjustments are made, the amount due to the retiring partner is determined. This includes their capital, share of goodwill, share of revaluation profit or loss, and any share in accumulated reserves or losses. The amount may be paid immediately or transferred to a loan account, which is paid off over time as per the agreement.
Death of a Partner
The death of a partner also results in the reconstitution of the firm. Similar to retirement, the deceased partner’s legal heirs are entitled to receive their share in the firm. The firm may continue with the remaining partners or dissolve, depending on the agreement.
Determining Deceased Partner’s Share
The deceased partner’s share in the firm includes capital, goodwill, share in revaluation profits or losses, and share in accumulated reserves. Additionally, the deceased partner is entitled to a share in the current year’s profit up to the date of death, which is calculated on a time or turnover basis. These amounts are calculated and credited to the deceased partner’s capital account.
Payment to Legal Representatives
The final amount payable to the legal heirs is determined after all adjustments. This may be paid in a lump sum or installments, depending on the firm’s agreement and financial position. The payment settles all obligations toward the deceased partner.
Dissolution of Partnership
Dissolution of a partnership implies the termination of the relationship between all the partners. It can happen voluntarily or by operation of law. On dissolution, the firm ceases to exist, and its assets are realized to pay off liabilities. Any surplus is distributed among the partners according to their capital accounts after settling all outside liabilities.
Settlement of Accounts on Dissolution
According to the Indian Partnership Act, the settlement of accounts on dissolution involves payment to creditors first, followed by loans from partners, and finally capital to partners. Any remaining balance is distributed in the profit-sharing ratio. If liabilities exceed assets, the partners contribute to the loss according to their profit-sharing ratio.
Admission of a New Partner
When a new partner is admitted into the partnership, the existing agreement between partners is modified, and a new agreement is formed. The admission of a new partner can occur for various reasons, such as expansion, need for capital, or requirement of expertise. The incoming partner brings capital and sometimes goodwill to the firm. Upon admission, it is necessary to revalue the assets and liabilitiesand adjust the old partners’ capital accounts based on the new profit-sharing ratio. The profit or loss on revaluation is transferred to the existing partners’ capital accounts in the old ratio. Goodwill may be brought in cash or adjusted through the capital accounts, depending on the partnership agreement.
Retirement or Death of a Partner
A partner may retire voluntarily, on mutual agreement, or due to age or health issues. In case of retirement, the continuing partners may agree to purchase the share of the retiring partner. The calculation involves revaluation of assets and liabilities, determination of goodwill, and adjustment of the retiring partner’s capital account. In the event of death, the deceased partner’s account is settled by the partnership deed or legal guidelines. The deceased partner’s legal representatives receive the amount due, including capital, share of profit up to the date of death, interest, and goodwill, if any. Life insurance policies (Joint Life Policy or Individual Policies) are also used to settle such claims.
Dissolution of Partnership Firm
Dissolution implies the termination of the partnership relationship between all partners. It can be voluntary or ordered by the court. The dissolution process involves the realization of assets, payment of liabilities, and settlement of capital accounts. After settling liabilities, any remaining amount is distributed among the partners as per their final capital balances. If the firm’s assets are insufficient, the partners may contribute additional funds based on their profit-sharing ratios or capital balances. Dissolution expenses are also accounted for before the final settlement. Proper accounting entries must be recorded during each stage of the dissolution process.
Piecemeal Distribution
Sometimes, during the dissolution of a partnership firm, assets are realized gradually over time rather than in one go. In such cases, piecemeal distribution is adopted for settling accounts. This method involves the periodic distribution of cash to partners as assets are realized. There are two commonly used methods: the proportionate capital method and the maximum possible loss method. Both methods aim to ensure that the distribution is fair and that no partner is overpaid during the realization process. This avoids future adjustments and ensures equitable treatment among partners.
Amalgamation of Partnership Firms
Amalgamation occurs when two or more partnership firms combine to form a new entity. The amalgamated firm absorbs the assets and liabilities of the merging firms. This process involves the preparation of revaluation accounts, the determination of goodwill, and capital adjustments for the partners of all firms. A new partnership deed is formed, defining the new profit-sharing ratio and terms of the partnership. Proper disclosure and recording are essential to ensure transparency and fairness in the amalgamation process. The goal is to combine resources and enhance business prospects.
Conversion into a Company
A partnership firm may be converted into a joint-stock company for various strategic reasons, such as expansion, better funding opportunities, or limited liability. The process involves the valuation of assets and liabilities, settlement of existing accounts, and issuance of shares in the new company to the partners. The assets and liabilities of the firm are transferred to the company, and the partners receive shares in exchange for their capital. The accounting treatment requires journal entries for transferring balances and closing the books of the partnership firm. Legal formalities under the Companies Act must be followed during the conversion process.
Accounting Standards and Regulatory Requirements
Partnership firms must comply with relevant accounting standards issued by the accounting regulatory bodies. Although not all standards are mandatory for small firms, adherence to key principles ensures transparency and comparability. Important standards relate to revenue recognition, asset valuation, depreciation, and disclosure practices. Regulatory requirements may also include registration with tax authorities, filing of returns, and maintaining proper books of accounts. Compliance with the partnership deed and local laws governing partnership firms is essential to avoid legal disputes and ensure smooth functioning.
Common Errors and Best Practices
Errors in partnership accounting may arise due to incorrect calculation of interest on capital, improper treatment of goodwill, or inaccurate profit distribution. To avoid these, firms should adopt standardized accounting procedures, maintain regular records, and periodically reconcile accounts. Best practices include the use of accounting software, regular audits, maintaining updated partnership agreements, and clear communication among partners. Periodic review of capital accounts and adherence to agreed terms can prevent disputes and enhance financial clarity. A professional approach to partnership accounting ensures long-term sustainability and mutual trust among partners.
Conclusion
Understanding the basic concepts of partnership accounting is vital for effective financial management in a partnership firm. From maintaining capital and current accounts to handling complex situations like admission, retirement, or dissolution, accounting serves as the foundation for equitable and transparent business operations. By adhering to proper accounting practices and regulatory standards, partnership firms can maintain accuracy, resolve disputes, and build a stable financial future.