According to Section 4 of the Indian Partnership Act, 1932, a partnership is the relationship between persons who have agreed to share the profits of a business carried on by all or any one of them acting for all. A partnership is a voluntary association of two or more individuals who agree to carry on a lawful business for mutual benefit. The agreement between the partners may be oral or written. When written, it is referred to as a partnership deed. This agreement sets out the terms and conditions governing the partnership, including profit-sharing ratios, capital contributions, responsibilities, and other matters related to the firm.
Features or Characteristics of Partnership
A partnership must have a minimum of two partners. The maximum number is guided by Section 464 of the Indian Companies Act, 2013. According to the Companies (Miscellaneous) Rules, 2014, the number of partners in any association cannot exceed 50. If this limit is exceeded, it becomes an illegal association. An agreement is the foundation of a partnership. This agreement may be oral or written and must specify the roles and responsibilities of each partner. The agreement should be formed to carry on a business. Partnerships are not formed for charitable or religious purposes. Profit-sharing is essential. The partners must share the profits and losses of the business in a specified ratio. If no ratio is mentioned, profits and losses are shared equally. Every partner acts as both an agent and a principal. A partner can bind the firm through their actions and can also be bound by the acts of other partners. All partners are jointly and severally liable for the debts of the firm. This means that even the personal assets of the partners can be used to settle the firm’s obligations.
Nature of Partnership Firm
From a legal standpoint, a partnership firm has no existence separate from the partners who constitute it. This means it cannot own property or sue or be sued in its name. However, from an accounting perspective, the partnership firm is treated as a separate business entity. Under 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 agreement are individually known as partners. Collectively, they are referred to as a firm. The name under which they conduct business is known as the firm name. A firm is not a separate legal entity but is simply a collective name for the partners.
Accounting Procedure of a Partnership Firm
The final accounts of a partnership firm are prepared in the same manner as those of a sole proprietorship. However, since more than one person is involved, the net profit is distributed among the partners in the agreed profit-sharing ratio. The account that reflects this distribution is called the profit and loss appropriation account. It is an extension of the profit and loss account and is prepared after calculating the net profit.
Additional Accounting Elements of a Partnership Firm
Some important components of partnership accounting include 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’ loan, and adjustments after closing the partnership accounts.
Partnership Deed
A partnership deed is a document that contains the terms and conditions of the partnership as agreed upon by the partners. Although it is not compulsory, it is highly recommended. A partnership deed can be oral or written. When written, it should be prepared according to the provisions of the Stamp Act and preferably registered with the Registrar of Firms. A well-drafted partnership deed helps prevent misunderstandings and disputes among the partners. The deed generally contains details such as the name of the firm, names and addresses of partners, nature of business, principal place of business, amount of capital contributed by each partner, profit-sharing ratio, rules regarding drawings, interest on capital, interest on drawings, loans and advances, salaries or commissions, duration of the firm, rights and duties of partners, procedures for admitting new partners, retirement, death or insolvency of a partner, settlement of accounts, method of valuation of goodwill, and arbitration clauses in case of disputes.
Provisions in Absence of Partnership Deed
If there is no partnership deed or if the deed does not address a specific issue, the provisions of the Indian Partnership Act, 1932, apply. These default provisions include equal sharing of profits and losses under Section 13(b), no interest on capital under Section 13(c), interest on loans and advances at 6 percent per annum under Section 13(d), no interest on drawings, and no remuneration to any partner for participation in the conduct of business as per Section 13(a).
Profit and Loss Appropriation Account
The profit and loss appropriation account is an extension of the profit and loss account. It is prepared to show the distribution of net profit or loss among the partners. The appropriation account is debited with items such as interest on capital, salaries, and commissions to partners. It is credited with the net profit transferred from the profit and loss account and with interest on drawings. The balance of the appropriation account is transferred to the partners’ capital or current accounts in the agreed profit-sharing ratio. If partners are allowed commission based on profit, it is recorded in the appropriation account. However, if commission is based on turnover or purchases, it is recorded in the profit and loss account. Interest on partners’ loans, rent paid to a partner, and manager’s commission are also recorded in the profit and loss account, as they are charges against profit.
Partners’ Capital Accounts
The capital accounts of partners can be maintained using either the fluctuating capital method or the fixed capital method. In the fluctuating method, all transactions related to the partners, such as drawings, interest, salaries, commissions, and share of profit or loss, are recorded in a single account. The balance in the capital account may vary over time. In the fixed capital method, two accounts are maintained for each partner. The capital account records only the capital introduced or withdrawn, while all other transactions are recorded in a separate current account. The balance in the capital account remains unchanged unless there is additional capital introduced or capital withdrawn. In contrast, the current account may show either a debit or credit balance, depending on the transactions.
Interest on Capital
Interest on capital is allowed only if the partnership deed specifies it. If allowed, interest is calculated on the opening balance of the capital. If additional capital is introduced during the year, interest is calculated proportionately. When the closing capital is given and the capital is fluctuating, the opening capital must be calculated to determine the interest. In the fixed capital method, only changes in capital due to introduction or withdrawal are considered for interest calculation. In the fluctuating capital method, adjustments must be made for drawings, interest on drawings, share of profits, and other items to determine the opening capital. Interest on capital is not allowed if the partnership agreement is silent on the matter. If the agreement states that interest on capital is a charge, it is allowed even if there is a loss. If the agreement simply mentions interest on capital without specifying whether it is a charge or appropriation, it is allowed only if there is sufficient profit.
Interest on Drawings
Interest on drawings is charged to partners if the partnership deed provides for it. If the deed is silent, no interest is charged. Interest on drawings is an income for the firm and is credited to the profit and loss appropriation account. It is a loss for the partner and is debited to their capital or current account. There are two methods to calculate interest on drawings. The product method calculates interest by multiplying the amount of each drawing by the period it was used during the year. The average period method is a shortcut used when the amount and interval of drawings are uniform. Under this method, the average period is determined by taking the average time between the first and last drawings. The average periods for common types of drawings are 6.5 months for drawings at the beginning of each month, 6 months for drawings in the middle of each month, and 5.5 months for drawings at the end of each month. For quarterly drawings throughout the year, the average periods are 7.5, 6, and 4.5 months, respectively, depending on the timing.
Interest on Partners’ Loan
When a partner gives a loan to the firm, they are entitled to receive interest at the agreed rate. If the rate is not specified, interest is payable at 6 percent per annum as per Section 13(d) of the Indian Partnership Act. Interest on a partner’s loan is a charge against profit. This means it is to be paid even if the firm makes a loss. The interest is debited to the profit and loss account and not the profit and loss appropriation account. This treatment differs from interest on capital, which is an appropriation and not a charge.
Salary or Commission to Partners
Salary or commission is paid to partners only if it is provided for in the partnership agreement. These payments are appropriations of profit and are therefore allowed only if there are sufficient profits. They are not charges against profit. The salary or commission is debited to the profit and loss appropriation account. Commission can be calculated as a percentage of net profit, either before or after charging the commission. If the commission is on net profit before charging the commission, it is calculated by multiplying the net profit by the commission rate divided by 100. If it is after charging the commission, the formula is net profit multiplied by the rate of commission divided by 100 plus the rate of commission.
Legal and Practical Notes
The Indian Partnership Act, 1932, governs all aspects of partnerships in India. A minor cannot form a partnership but may be admitted to the benefits of an existing firm with the consent of all partners. Partnerships cannot be formed for charitable activities. A firm is not a legal entity apart from its partners. Registration of a firm is optional, but an unregistered firm cannot claim a set-off in a legal dispute exceeding one hundred rupees. The capital account in the fixed method always shows a credit balance, but under the fluctuating method, it can show either a credit or a debit balance. Interest on capital is payable only from current profits unless the deed provides otherwise. A firm can be registered any time after formation. The partnership deed must be signed by all partners. The firm name is simply the name under which the business is conducted. In case of dissolution or reconstitution, the goodwill must be valued as per the terms in the deed. Rent paid to a partner and interest on a loan from a partner are considered charges against profit and are debited to the profit and loss account. Profit and loss appropriation accounts are not prepared for sole proprietorships. Drawings by partners are transferred to the credit side of their capital or current account when closed. All partners are jointly and severally liable for the debts of the firm. If the deed is silent on any matter, the provisions of the Indian Partnership Act, 1932, apply. In case of guaranteed profit, the guaranteeing partners must ensure that the guaranteed partner receives the minimum amount, even if the firm incurs losses. Unless otherwise stated, all existing partners are considered to have given the guarantee in their profit-sharing ratio.
Methods of Maintaining Partners’ Capital Accounts
There are two methods for maintaining capital accounts in a partnership firm: the fluctuating capital method and the fixed capital method. These methods determine how partner-related transactions are recorded and reflected in the accounting system.
Fluctuating Capital Method
In the fluctuating capital method, only one capital account is maintained for each partner. All transactions such as capital contributions, drawings, interest on capital, interest on drawings, partner salaries or commissions, and share of profit or loss are recorded in this account. As these entries vary over time, the balance in the capital account changes or fluctuates. The fluctuating method is commonly used unless otherwise agreed by the partners. This method reflects the true changes in the capital of each partner as a result of multiple business activities.
Features of the Fluctuating Capital Method
In the fluctuating capital method, the balance of the partner’s capital account changes frequently. It reflects the net changes resulting from drawings, interest on drawings, interest on capital, salaries, commissions, and profit or loss sharing. There is no need to maintain a separate current account for the partners. The closing balance in the capital account may be on either the credit or debit side, depending on the net effect of all entries. If a partner has withdrawn more than what was added, it may result in a debit balance.
Fixed Capital Method
In the fixed capital method, two accounts are maintained for each partner: a capital account and a current account. The capital account records only the initial and additional capital introduced or withdrawn. No other transactions are recorded in this account. It generally remains fixed unless there is an introduction or withdrawal of capital. The current account records all other partner-related transactions such as interest on capital, drawings, interest on drawings, salary or commission, and share of profits or losses. The current account may show either a debit or credit balance depending on the transactions during the year. The fixed capital method is more structured and provides a clearer distinction between long-term capital and routine operational adjustments.
Advantages of Fixed Capital Method
The fixed capital method provides a clearer financial picture by separating permanent capital contributions from daily partner-related transactions. It avoids unnecessary fluctuations in the capital account, ensuring that capital balances reflect only the core investment in the business. The method also simplifies the calculation of interest on capital and facilitates better internal control and monitoring of partner transactions.
Interest on Capital
Interest on capital is allowed to partners only if specified in the partnership deed. If the deed is silent, no interest is allowed. Interest on capital is considered an appropriation of profit, not a charge. This means it is allowed only if there are sufficient current profits. It is debited to the profit and loss appropriation account and credited to the partners’ capital or current accounts.
Calculation of Interest on Capital
Interest on capital is usually calculated on the opening balance of the capital account. If additional capital is introduced during the year, interest is calculated proportionately from the date of introduction. In some cases, only the closing capital is given. In such situations, the opening capital must be calculated to determine the interest.
Interest on Capital under Fixed Capital Method
In the fixed capital method, interest is calculated only on the balance in the capital account. Any additional capital introduced during the year is considered separate, and interest is calculated based on the period for which the additional capital was used.
Interest on Capital under Fluctuating Capital Method
In the fluctuating capital method, adjustments must be made to calculate the opening capital if only the closing capital is provided. The calculation includes adding drawings and interest on drawings and subtracting additional capital, interest on capital, and share of profits. This gives the effective opening capital for interest calculation.
Treatment of Interest on Capital in Case of Loss or Insufficient Profit
If the partnership deed treats interest on capital as a charge against profits, it must be paid even if the firm incurs a loss. In such a case, interest is recorded in the profit and loss account. If the deed treats interest on capital as an appropriation and the firm incurs a loss, no interest is allowed. If there are insufficient profits, interest is allowed only to the extent of the available profit and is distributed among the partners in the ratio of their capital contributions.
Accounting Treatment of Interest on Capital
Interest on capital is debited to the profit and loss appropriation account and credited to the partner’s capital or current account. If it is treated as a charge, it is debited to the profit and loss account. However, this is uncommon unless expressly mentioned in the deed.
Interest on Drawings
Interest on drawings is charged to partners if the partnership agreement provides for it. If the deed is silent, no interest is charged. Interest on drawings is credited to the profit and loss appropriation account, as it is income for the firm. It is debited to the capital or current account of the partner concerned. Interest on drawings is usually calculated using either the product method or the average period method.
Product Method of Calculating Interest on Drawings
Under the product method, the amount of each drawing is multiplied by the number of months it remains withdrawn during the accounting year. These products are then summed. Interest is calculated on the total of these products by applying the annual interest rate divided by 12 to convert it to a monthly basis.
Average Period Method of Calculating Interest on Drawings
The average period method is a simplified approach used when drawings are made uniformly at regular intervals and in equal amounts. The average period is calculated by taking the average of the time left after the first and last drawing. For example, if equal monthly drawings are made at the beginning of each month for a year, the average period is 6.5 months. If the drawings are made in the middle of the month, the average period is 6 months. If the drawings are made at the end of the month, the average period is 5.5 months.
Accounting Treatment of Interest on Drawings
Interest on drawings is income for the firm and is credited to the profit and loss appropriation account. It is debited to the capital or current account of the partner. This entry reduces the partner’s closing balance in the respective account.
Interest on Partner’s Loan
When a partner lends money to the firm, he is entitled to receive interest on the loan. If the partnership deed specifies a rate, interest is paid at that rate. If the deed is silent, interest is paid at 6 percent per annum as per Section 13(d) of the Indian Partnership Act. Interest on a partner’s loan is a charge against profit and is paid even if the firm incurs a loss. It is recorded in the profit and loss account and not in the profit and loss appropriation account.
Accounting Treatment of Interest on Partner’s Loan
Interest on a partner’s loan is debited to the profit and loss account and credited to the partner’s loan account. It is treated as a liability of the firm and paid irrespective of profits. This treatment differentiates it from interest on capital, which is allowed only when there are profits and is recorded in the appropriation account.
Salary or Commission to Partners
Salary or commission to a partner is allowed only if the partnership agreement provides for it. It is not treated as a charge against profits but as an appropriation of profit. Therefore, salary or commission is paid only when the firm earns a profit.
Nature of Salary or Commission
Salary or commission paid to a partner is not a business expense. It is considered a distribution of profit and hence is debited to the profit and loss appropriation account. If the firm does not earn a profit, the partner is not entitled to a salary or commission, unless the deed specifies it as a charge.
Calculation of Commission
Commission to a partner can be calculated on net profit,, either before charging the commission or after charging the commission. When the commission is a percentage of net profit before charging the commission, it is calculated as net profit multiplied by the commission rate divided by 100. When the commission is calculated after charging the commission itself, the formula used is net profit multiplied by the rate of commission divided by 100 plus the rate of commission.
Accounting Treatment of Salary or Commission
Salary or commission to a partner is debited to the profit and loss appropriation account and credited to the partner’s capital or current account. It is allowed only when there is sufficient profit. If profits are insufficient or the firm incurs a loss, no salary or commission is allowed unless specified otherwise in the agreement.
Legal Status of Partnership Firm
Under Indian law, a partnership firm has no separate legal identity from its partners. It cannot own property, sue, or be sued in its name. However, for accounting purposes, a firm is treated as a separate entity. This helps in maintaining accurate financial records and computing taxable income. Under Section 2(3) of the Income-tax Act, 1961, a partnership firm is treated as a separate person for taxation purposes. This allows the firm to be assessed independently of its partners.
Minor as a Partner
A minor cannot become a full partner in a firm. However, a minor can be admitted to the benefits of an existing partnership with the consent of all partners. The minor is entitled to a share in the profits but is not liable for losses. Upon attaining majority, the minor must choose whether to become a full partner. If the minor chooses not to become a partner, they must give public notice of this decision. Otherwise, they will be considered a full partner by default and will become liable for losses from the date of attaining majority.
Sharing of Profits and Losses
Unless otherwise agreed, profits and losses are shared equally among partners. This is the default provision under Section 13(b) of the Indian Partnership Act. Even if partners contribute different amounts of capital, profits and losses must be shared equally unless the partnership deed states otherwise. An agreement to share profits does not necessarily mean an agreement to share losses. However, in the absence of specific provisions, it is assumed that losses are also shared in the same ratio as profits.
Registration of Partnership Firm
Registration of a partnership firm is not compulsory under the Indian Partnership Act. However, an unregistered firm suffers certain disabilities. For instance, an unregistered firm cannot file a suit against third parties to enforce its contractual rights. Also, the firm cannot claim a set-off in a legal dispute exceeding one hundred rupees. To avoid these consequences, firms are encouraged to register with the Registrar of Firms. The registration process involves applying along with the prescribed fees and a copy of the partnership deed.
Advantages of Registering a Partnership Firm
Registration offers several legal advantages. A registered firm can enforce its contractual rights through the courts. It can claim a set-off and counterclaim in legal proceedings. Registration also gives legal recognition to the partnership and helps avoid disputes among partners. It serves as legal evidence of the existence of the firm and its terms.
Adjustments in Partnership Accounts
Partnership firms must deal with various adjustments at the end of each accounting period. These adjustments ensure that the profit or loss is shared accurately and that the financial position of each partner is correctly reflected. Some common adjustments include interest on capital, interest on drawings, salary or commission to partners, and the treatment of past adjustments or errors.
Interest on capital is provided to partners as a reward for investing their funds in the business. It is usually agreed upon in the partnership deed. Interest on drawings, on the other hand, is charged to partners for withdrawing funds for personal use. The amount is generally calculated based on the period and frequency of the drawings. Partner salaries or commissions are provided to compensate them for managing the firm’s affairs, especially in cases where partners are not equally involved in the business operations. If past adjustments or errors are discovered after accounts have been prepared, these need to be rectified in the subsequent period, and the partners’ capital accounts should be adjusted accordingly.
Goodwill in Partnership Accounts
Goodwill refers to the reputation of a business that enables it to earn higher profits than its competitors. In a partnership, goodwill becomes relevant during situations like the admission of a new partner, retirement, or death of an existing partner, or changes in profit-sharing ratios. Goodwill can be valued using several methods, such as the average profit method, the super profit method, and the capitalization method. The average profit method calculates goodwill based on the average of the past few years’ profits. The super profit method considers the excess of actual profit over normal profit, multiplied by a certain number of years. The capitalization method determines goodwill by capitalizing the average profits using the normal rate of return.
When goodwill is brought in by a new partner, it is usually done in cash and is shared by the old partners in their sacrificing ratio. In the case of retirement or death, the continuing partners compensate the outgoing partner for their share of goodwill in the gaining ratio. Proper treatment of goodwill is essential to ensure fairness among partners and to maintain transparency in financial records.
Reconstitution of Partnership
Reconstitution of a partnership refers to any change in the existing agreement among the partners without dissolving the firm. Common events leading to reconstitution include the admission of a new partner, retirement or death of a partner, or a change in the profit-sharing ratio. Reconstitution affects the profit and loss sharing arrangements, capital structure, and sometimes the name of the firm.
When a new partner is admitted, he may bring in capital and goodwill. His share in the profits is agreed upon, and the profit-sharing ratio of existing partners is adjusted accordingly. In the case of retirement, the retiring partner’s dues are settled, which includehis share in profits, goodwill, and revaluation gains or losses. If a partner dies, the firm usually settles the deceased partner’s account with the legal heirs, including his capital, share in profits till the date of death, and goodwill. A change in profit-sharing ratio among existing partners requires revaluation of assets and liabilities and adjustment of reserves and accumulated profits.
Revaluation of Assets and Liabilities
Revaluation of assets and liabilities is carried out at the time of reconstitution to ensure that the new partner or the retiring/deceased partner gets a fair value. This process results in either a profit or a loss, which is transferred to the partners’ capital accounts in their old profit-sharing ratio. A revaluation account is prepared for this purpose. The account is credited with an increase in the value of assets and a decrease in the value of liabilities, and it is debited with a decrease in the value of assets and an increase in the value of liabilities.
The balance in the revaluation account, whether profit or loss, is distributed among all the existing partners before reconstitution. This ensures that any change in the firm’s financial position is fairly accounted for and that no partner is at a loss or undue advantage during the change in the partnership structure.
Distribution of Profits on Reconstitution
After reconstitution, the profit-sharing ratio usually changes. A new profit-sharing ratio is agreed upon, and profits are distributed accordingly. If goodwill has been accounted for during reconstitution, then capital accounts are also adjusted based on the revised ratios. Accumulated profits and reserves appearing in the balance sheet are also distributed among the partners in the old ratio before the reconstitution.
The reconstitution process ensures continuity of the business with a new or modified partnership structure. Proper accounting and documentation of all changes are essential for legal and financial clarity and to avoid disputes among partners.
Retirement and Death of a Partner
When a partner retires or dies, the firm must settle his or her dues. This includes the partner’s share in the capital, share of revaluation profit or loss, share in goodwill, accumulated profits or losses, and any interest due. The share of the retiring partner is transferred to his capital account and then paid out either in cash or through a loan account.
In the case of a deceased partner, the settlement is made with the legal representatives. The deceased partner is entitled to his share of profit up to the date of death, which is often calculated based on time or average profits. A new partnership deed is usually drawn up after retirement or death, specifying the new terms and profit-sharing ratios among the continuing partners.
Admission of a New Partner
Admission of a new partner brings additional capital and sometimes expertise or contacts to the firm. The new partner is admitted with the consent of all existing partners unless otherwise agreed in the deed. The new partner’s share in profits, contribution of capital, and goodwill are all decided beforehand.
On admission, the old partners may sacrifice a part of their share in profits in favor of the new partner. This sacrificed share determines the amount of goodwill that the new partner must bring in. A revaluation of assets and liabilities is often carried out to ensure accurate capital account balances before the new partner joins. A fresh capital ratio is also drawn up based on the contributions and profit-sharing agreements of all partners.
Admission of a New Partner
The admission of a new partner into a partnership firm changes the existing partnership agreement and requires careful accounting adjustments. A new partner may be admitted for various reasons,such as infusion of additional capital, acquiring managerial expertise, or enhancing the goodwill and reputation of the firm. Upon admission, the existing partnership is dissolved and a new one is formed.
The following adjustments are necessary at the time of admission:
- Revaluation of assets and liabilities
- Distribution of goodwill
- Adjustment of capital accounts of existing partners
- Determination of the new profit-sharing ratio
Revaluation is done to bring the book values of assets and liabilities in line with their current market values. Any gain or loss from revaluation is shared by the existing partners in the old ratio. Goodwill is an intangible asset and may be brought in cash by the new partner or adjusted through the capital accounts. If a new partner is admitted without bringing goodwill, his share in the firm’s goodwill is debited to his capital account and credited to the existing partners in their sacrificing ratio.
The capital of the new partner may be in proportion to his share in the profit or based on mutual agreement. All the above adjustments ensure that the interests of the old partners are protected and the new arrangement is equitable to all.
Retirement of a Partner
A partner may retire voluntarily or as per the partnership agreement. Retirement leads to a change in the profit-sharing ratio among the remaining partners. Several adjustments need to be made at the time of retirement:
- Calculation of the amount due to the retiring partner
- Revaluation of assets and liabilities
- Distribution of goodwill
- Adjustment of capital accounts of remaining partners
- Settlement of the retiring partner’s dues
The amount due to the retiring partner includes his share of capital, share in revaluation profit or loss, accumulated profits or losses, and goodwill. The share of goodwill is adjusted through the capital accounts of the continuing partners in their gaining ratio. The settlement of the retiring partner may be done either in cash or in the form of a loan.
If the firm does not have sufficient cash, the amount is transferred to the retiring partner’s loan account, which is later paid with interest as agreed.
Death of a Partner
The death of a partner results in the dissolution of the existing partnership agreement. The surviving partners may choose to continue the business under a new agreement. Several adjustments are required to settle the accounts of the deceased partner:
- Determining the deceased partner’s share of profit up too the date of death
- Revaluation of assets and liabilities
- Distribution of goodwill
- Calculation of accumulated profits or losses
- Settlement with the legal heirs
The profit to date of death is calculated based on the average profit of previous years or based on time and turnover. Goodwill is distributed among the partners, and the deceased partner’s share is credited to his capital account. The total due to the deceased partner is transferred to his executor’s account for payment.
Proper accounting treatment ensures that the legal heirs receive the rightful claim and there are no future disputes.
Dissolution of a Partnership Firm
Dissolution refers to the termination of the partnership business. It can occur due to mutual agreement, expiry of term, insolvency of partners, completion of venture, or court order. On dissolution, the assets of the firm are sold off,, and liabilities are settled.
The following order of settlement is followed:
- Payment of the firm’s liabilities to external parties
- Repayment of partner’s loans to the firm
- Return of partner’s capital
- Distribution of remaining balance as per the profit-sharing ratio
The realisation account is prepared to record the sale of assets and the settlement of liabilities. Any profit or loss on realisation is distributed among partners in their profit-sharing ratio.
If any partner is insolvent and unable to pay his dues, the remaining partners may bear the loss based on the Garner v. Murray rule, where the solvent partners share the loss in their capital ratio.
Proper closure ensures transparency and avoids legal complications.
Accounting Treatment of Goodwill
Goodwill is the reputation of the firm and its ability to earn excess profits. It is an intangible asset and arises when a firm earns supernormal profits compared to the average profits of the industry.
Methods of valuation include:
- Average Profit Method
- Super Profit Method
- Capitalisation Method
In the Average Profit Method, goodwill is calculated by multiplying the average of past profits by the number of years of purchase. In the Super Profit Method, the excess of average profit over normal profit is multiplied by the number of years of purchase. The Capitalisation Method calculates goodwill by deducting the actual capital employed from the capitalised value of average profits.
Goodwill is recorded in the books only when consideration in money or money’s worth is paid. It may be adjusted through capital accounts or brought in by new partners in cash.
Conclusion
Accounting for partnerships involves a unique set of principles tailored to the nature of shared ownership. From the formation of the partnership to the distribution of profits, treatment of capital, and handling of reconstitution or dissolution, each phase requires careful documentation and understanding of the partners’ rights and obligations. The key elements like the partnership deed, capital accounts, profit-sharing ratios, interest on capital and drawings, salaries, and goodwill form the foundation for transparent and equitable accounting practices.
A well-maintained partnership accounting system not only ensures compliance with legal and regulatory requirements but also fosters trust among partners. It allows for the clear representation of each partner’s financial stake and provides a reliable framework for resolving disputes, reallocating interests, and making informed business decisions.