ACCA F3 (INT) Financial Accounting - 2010 - Study text - Emile Woolf Publishing
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Paper F3 (INT)
Financial Accounting
CHAPTER
13
Partnership accounts
Contents
1 Featuresofpartnerships
2 Sharingtheprofitsbetweenthepartners
3 Admissionofanewpartner
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Features of partnerships
Partners’ capital
Sharing profits (or losses)
Special features of partnership accounts
1 Features of partnerships
Partnership accounts are the financial accounts of a partnership business. Here we
are looking at small partnerships with a small number of partners, rather than at
large partnerships of accountants or lawyers.
Partnerships are similar to sole trader businesses. The major difference between a
partnership and a sole trader business is that:
a partnership has several joint owners, whereas
a sole trader’s business has just one owner.
A partnership business should be based on a formal partnership agreement
(contract) that specifies the terms of the partnership, such as how much capital each
partner should provide to the business, and how the profits of the business should
be shared between the partners.
The accounts of the partnership must record the capital and profits that are
attributable to each individual partner.
1.1 Partners’ capital
Each partner contributes capital to the business, and the capital of each partner must
be identified separately.
The partnership agreement will usually specify that each partner must contribute a
minimum amount of ‘fixed’ capital. Partners cannot draw out any of their fixed
capital.
In addition, each partner might retain some of his or her share of accumulated
profits in the business. The partnership agreement should allow partners to draw
out their share of accumulated profits, if they wish to do so.
The capital of each partner can therefore be divided into two parts:
fixed capital
‘current capital’, which is the partner’s share of accumulated profits that the
partner has not yet taken out as drawings.
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1.2 Sharing profits (or losses)
The partnership agreement will specify how the partners will share the profits of the
business amongst themselves each year. The partners may share profits equally.
However, the partnership agreement might specify a different profit-sharing
arrangement.
1.3 Special features of partnership accounts
Accounting for partnerships is similar to accounting for sole traders. The main
differences are:
the need to account for the capital of each partner, and
the need to account for the share of total profits between the partners
the need to account for partners’ capital when a new partner joins the
partnership.
Partners’ capital and current accounts
The capital of each partner is recorded separately, and each partner has two types of
capital accounts:
A capital account: this records the fixed capital or long-term capital of the
partner that the partner must retain in the business and cannot take out in
drawings.
A current account: this records the accumulated profits of the partner, which
may be taken out by the partner as drawings.
− The profits of the business are shared between the partners. The share of
each partner is credited to (added to) his or her current account.
− Each partner may take drawings out of the business. Drawings are a
withdrawal of profit. These are recorded by debiting the current account
of the partner (and crediting the Bank account).
Partner X: current account
$
Partner’s accumulated profits at the beginning of the year A
Partner’s share of profit for the year B
Drawings by the partner during the year (C)
Partner’s accumulated profits at the end of the year A + B – C
The statement of financial position for a partnership
The statement o f financial position for a partnership is the same as for a sole trader,
except that the equity section of the statement will consist f the capital accounts and
the current accounts of each partner. Total equity is the sum of the balances on the
partners’ capital and current accounts.
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Sharing the profits between the partners
Profit-sharing ratio
Notional salaries for partners
Notional interest on long-term capital
Guaranteed minimum profit share
Interest on drawings
Profits, drawings and the partners’ current accounts
Changes in the partnership agreement on profit-sharing
2 Sharing the profits between the partners
The profits of the business are shared between the partners. The rules for how the
profits should be shared are contained in the partnership agreement.
2.1 Profit-sharing ratio
The partners in a partnership agree to share the profits (or residual profits, as
explained later) in an agreed proportion or ratio.
The profit for the financial period is calculated according to the normal rules (as
described already for a sole trader). This total profit figure is then divided between
the partners and credited to their current account.
Example
The WXY Partnership has three partners, W, X and Y, who share profits in an agreed
ratio of 3:5:8. Profits for the year were $192,000.
The total profits are divided between the partners as follows:
Profit-sharing ratio: 3 + 5 + 8 = 16.
Partner
$
W $192,000×3/16 36,000
X $192,000×5/16 60,000
Y $192,000×8/16 96,000
192,000
2.2 Notional salaries for partners
Partners, as owners of their business, cannot be paid a salary in the same way as
employees who are not the business owners. (This is for tax reasons.)
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However, some partners might do a lot of work for the partnership, and the
partnership agreement might recognise the work done by partners by awarding one
or more of the partners with a notional salary. A notional salary is an agreed
amount awarded to the individual partner from the partnership profits.
A notional salary is therefore a share of the partnership profits. The salary is awarded to
each partner from the profits, and the residual profit after deduction of notional salaries
is then divided between the partners in the agreed profit-sharing ratio.
Example
The PQR Partnership has three partners, P, Q and R. The partnership agreement
provides for the residual profit to be shared between them in the ratio 4:3:2, after
allowing a notional salary of $30,000 to R.
The profit for the year is $345,000.
Residual profits are shared as follows:
Profit-sharing ratio: 4 + 3 + 2 = 9; therefore 4/9 to P, 3/9 to Q and 2/9 to R.
Residual profits = $345,000 – $30,000 = $315,000.
Total P Q R
$ $ $ $
Notionalsalary 30,000 30,000
Residualprofit 315,000
Pshare $315,000×4/9140,000
Qshare $315,000×3/9105,000
Rshare $315,000×2/9 70,000
Profitshare
345,000 140,000 105,000 100,000
The profit share of each partner is added to the balance on their individual current
accounts.
Exercise 1
A, B and C are in partnership sharing profits and losses in the ratio of 2:2:1. B is
allowed a salary of $10,000 per annum and C is allowed a salary of $15,000 per
annum.
The net profit for year was $100,000.
Show how profit should be shared between the partners and enter the total profit in
the partners’ current accounts.
2.3 Notional interest on long-term capital
The partnership agreement might also provide for the partners to obtain notional
interest on the long-term capital they have invested in the business. This is interest
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on the balance in their capital account. Interest is not given for balances on the
current account, which partners are able to take out in drawings if they wish.
Notional interest on long-term capital is not real interest, because the capital in the
partners’ capital account is equity, not a liability of the business.
The notional interest is treated in similar way to notional salaries for partners. The
interest is a share of the partnership profits. Like notional salaries, the notional
interest is awarded to each partner in accordance with the partnership agreement.
The residual profit shared between the partners in the profit-sharing ratio is the
profit after notional salaries and notional interest on capital are deducted.
Example
Partnership DEF has three partners, D, E and F. Partner D has contributed $100,000
of fixed capital, Partner E $120,000 and Partner F $60,000. They have agreed to share
profits in the following way.
Partner D should receive a salary of $4,000 and Partner F a salary of $7,000.
All three partners should receive interest at 5% on the fixed capital
contributed.
Residual profit should be shared between D, E and F in the ratio 3:5:2.
The profit of the partnership for the year is $95,000.
Required
Show how the partnership profits should be shared between the partners.
Answer
Profits are shared as follows:
Profit-sharing ratio for residual profits: 3 + 5 + 2 = 10; therefore 3/10 to D, 5/10 to E
and 2/10 to F.
Total D E F
$ $ $ $
Notionalsalary11,000 4,000 7,000
Notionalinterestat5%14,000 5,000 6,000 3,000
Residualprofit(balance)70,000
Dshare $70,000×3/1021,000
Eshare $70,000×5/1035,000
Fshare $70,000×2/1014,000
Profitshare
95,000 30,000 41,000 24,000
Note: Loans from partners and loan interest
If a partner makes a loan to the partnership, the loan is a long-term liability and
interest on the loan is an expense in the income statement. Loans from a partner and
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interest on loans are therefore different from partners’ capital and notional interest
on capital.
Exercise 2
G, H and I are in partnership. Partner G has contributed $50,000 of fixed capital,
Partner H $40,000 and Partner I $30,000. They have agreed to share profits in the
following way.
Partner H should receive a salary of $5,000 and Partner I a salary of $10,000.
All three partners should receive interest at 8% on the fixed capital contributed.
Residual profit should be shared between G, H and I in the ratio 3 : 2 : 1.
The profit of the partnership for the year is $114,600.
Required
Show how the partnership profits should be shared between the partners and write
up their capital accounts and current accounts.
2.4 Guaranteed minimum profit share
Occasionally, a partnership agreement might provide for a guaranteed minimum
profit share for one (or more) of the partners. In these cases:
The partnership profits should be shared according to the partnership
agreement, ignoring the minimum profit agreement.
Having shared the profits, a problem only occurs if the profit share for a partner
with a minimum guaranteed profit is less than this guaranteed amount.
In this situation, the partners who do not have a minimum guaranteed profit
must make up the shortfall. They do this out of their profit share, in their profit-
sharing ratio.
Example
The XYZ Partnership has three partners, X, Y and Z. The partnership agreement
provides for Partner X to receive a notional salary of $20,000 and residual profits are
shared between X, Y and Z in the ratio 2:4:6. In addition, the agreement guarantees a
minimum profit share of $32,000 to Partner Y.
The partnership profit for the current year is $80,000.
Required
Show how the profit for the year should be shared between the partners.
Answer
Profit-sharing ratio for residual profit: 2 + 4 + 6 = 12; therefore 2/12 to X, 4/12 to Y
and 6/12 to Z.
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Residual profit = $80,000 – $20,000 = $60,000.
Total X Y Z
$ $ $ $
Notionalsalary 20,00020,000
Residualprofit(balance) 60,000
Xshare $60,000×2/1210,000
Yshare $60,000×4/1220,000
Zshare $60,000×6/12 30,000
80,000 30,00020,000 30,000
Tomakeuptheminimum12,000
SharethisbetweenXandZ,ratio2:6(3,000) (9,000)
Profitshare
80,000 27,00032,000 21,000
2.5 Interest on drawings
Another provision that might occasionally be found in a partnership agreement is
an arrangement that partners should pay notional interest on any drawings they
make before the end of the financial year. The purpose of this type of arrangement is
to discourage partners from taking large drawings during the year, and to wait until
the end of the year before they take any money out of the business.
When an interest on drawings arrangement exists, the procedure for sharing profits
is as follows:
Calculate the notional interest payable by each partner on drawings during the
year.
Subtract this notional interest for each partner from the current account balance
of the partner. Add the notional interest to the partnership profit for the year.
Share out the partnership profit for the year, including this notional interest,
according to the rules of the partnership agreement.
Example
The ST Partnership has two partners S and T who share partnership profits in the
ratio 2:3. The partnership agreement also provides that interest will be charged at 6%
per annum on any drawings taken out by a partner before the end of the financial
year, which is 31 December.
As at 1 January Year 8, Partner S had a current account balance of $18,000 and
Partner T had a current account balance of $26,000.
In the year to 31 December Year 8 the partnership profit was $54,000. Partner S took
out $12,000 in drawings on 1 March Year 8 and Partner T took out $20,000 in
drawings on 1 September.
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Required
Calculate the profit share of each partner for the year, and the balance on each
partner’s current account at the end of the year.
Answer
The notional interest charge on drawings is calculated according to the number of
months in the year that the partner has had the benefit of the drawings. In this
example, Partner S has had the drawings for 10 months, since 1 March, and Partner T
has had his drawings for 4 months, since 1 September.
Interestondrawings
$
PartnerS ($12,000x6%x10/12) 600
PartnerT ($20,000x6%x4/12) 400
Total 1,000
Profitfortheyear 54,000
Adjustedprofitforthe
year
55,000
Profit share (2:3) = $22,000 to S and $33,000 to T.
Currentaccounts PartnerSPartnerT
$ $
Beginningoftheyear 18,000 26,000
Interestondrawings (600) (400)
17,400 25,600
Addshareofprofit 22,000 33,000
39,400 58,600
Deductdrawings (12,000) (20,000)
Endoftheyear 27,400 38,600
2.6 Profits, drawings and the partners’ current accounts
For each partner, the share of the annual profit is added to the partner’s current
account. Any drawings during the year are deducted.
Example
There are three partners in the ABC Partnership, A, B and C. The capital and current
accounts of the partners at the beginning of the year were as follows:
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Partner Capitalaccount Currentaccount
$ $
A 100,000 6,000
B 200,000 3,000
C 160,000 8,000
The profit for the year was $103,000. Profits are shared as follows:
Partner A is given a salary of $17,000 and Partner C has a salary of $15,000
The partners pay themselves interest on capital at 5% per year
The residual profit is shared between A, B and C in the ratio 1:3:2.
During the year, drawings by each partner were:
A $20,000
B $25,000
C $40,000
Required
Show how the profits should be shared between the partners, and show their capital
and current accounts as at the end of the year.
Answer
Profits are shared as follows:
Profit-sharing ratio: 1 + 3 + 2 = 6.; therefore 1/6 to A, 3/6 to B and 2/6 to C.
Total A B C
$ $ $ $
Notionalsalary 32,00017,000 15,000
Notionalinterestat5% 23,000 5,00010,000 8,000
Residualprofit(balance) 48,000
Ashare $48,000x1/68,000
Bshare $48,000x3/624,000
Cshare $48,000x2/6 16,000
Profitshare 103,00030,00034,00039,000
The partners’ capital accounts are the same at the end of the year as at the beginning
of the year.