Chapter 13 Partnership financial statements Flashcards
13.1 Characteristics of a partnership
A partnership is the relationship with subsists between persons carrying on a business in common with a view of making profit and has two or more joint owners. Profits are shared amongst owners.
A partnership usually have a partnership agreement saying how profits are shared. Salaries may be awarded, interest provided on capital invested, interest charged on drawings made by partners reducing their profits and the profit share ratio which determines how profits should be shared after salaries and interest has been allocated. A partnership salary is not an expense against profits, however.
In absence of a partnership agreement, the Partnership Act 1890 states no partner receives a salary, no interest on capital allowed, profits shared equally and where a partner advances funds in excess of the agreed capital amount (such as a loan), they are entitled to interest on the excess at 5% per annum.
2.1 Accounting for partnerships
The profit and loss account for a partnership looks the same as that of a sole trader. An extra statement is required in which the profit from the profit and loss account is shared between the partners. This is referred to as an appropriation statement.
The profits allocated to each partner are credited to the partners’ current account. Drawings are also recorded in this account. The current account is usually a credit balance but if the partner has drawn more funds than allocated profits, the account is overdrawn and would be a debit.
The partner’s capital account records the initial capital invested in the business by each partner, transactions in this account are rare, being the injection of further capital or withdrawal of capital by a partner.
The closing balances on the partners’ current and capital accounts form the capital section of the balance sheet. The remainder of the balance sheet is presented in exactly the same way as a sole trader’s statement of financial position.
2.2 Partnership losses
The appropriation for partnership losses works the same way as if a profit were made. The salaries and interest on capital are allocated and the balance is divided according to the PSR.
2.3 Interest on drawings
Some partnership agreements require interest to be charged on drawings by partners:
- This is charged in order to discourage excessive drawings
- This is added back to profit in the appropriation statement and deducted from the partners’ total share
- Interest on drawings is time apportioned for the number of months in the year that the drawings were taken
- If no dates are given, we assume all drawings took place at the start of the year and charge a full year’s interest
2.4 Guaranteed minimum profit share
A partner may be guaranteed a minimum share of the profits, if they do not receive this after allocating profits in the usual way, shortfall should be given to the partner. This amount is funded by other partners in accordance with the profit share ratio.
2.5 Loans from partners
A partner may loan the business money and receive interest. The double entry is Dr Cash Cr Loan.
The interest is treated as a business expense which is charged to profits before the profits are shared between the partners. The double entry for the loan interest is:
- Dr interest expense (P+L)
- Cr Bank (if paid) or Cr current account (if outstanding)
2.7 Changes in partnership structure
If the partnership structure changes during the year, we treat the accounting year as two sections and appropriate the profit, for the number of months with the old structure and the number of months for the new structure. The partner’s profits for these two periods combined give their total profit structure for the year.
3.1 Partnerships in the adjusted trial balance
The adjusted TB may be used in the preparation of partnership accounts. The process is largely as for a sole trader, although the following entries will be required in the adjustments column:
- Account for interest accrued on a loan from a partner: Dr Interest expense Cr Current Accounts
- Transfer drawings to the current account: Dr Current accounts Cr Drawings
- Divide profits as calculated in the appropriation statement: Dr Profit and loss account Cr Current accounts
4.1 Retirement or death of a partner and admission of a new partner
When a partner retires from a partnership the full amounts due to them must be calculated, these being capital account balance, current account balance and share of any goodwill in the partnership.
Goodwill is an asset not recorded in the ledger accounts. Goodwill comes about due to the reputation of the business, quality of products, good after sales service, good location and excellence of employees. Other than purchased goodwill, this is not recognised in the financial statements. A share should be allocated to a retiring partner. A share is also allocated to current partners when a new partner joins to reflect the goodwill in the business at the time they join. As well as the capital introduced by the new partner, they will also be purchasing some of the existing goodwill.
4.2 Accounting adjustments made on retirement or admission of partners
- Calculate the profit up to date of change and allocate it to the old PSR. Transfer any retiring partner’s current account balance to their capital account
- Determine the goodwill built up, temporarily set up a goodwill account and credit all partners before the change with their share in the PSR. Dr Goodwill account with the value of goodwill, Cr Partners’ capital accounts using PSR
- If a partner is retiring, he has the total balance due to him in the capital account. This must be paid to them. Dr Retiring partners’ capital account Cr bank or Cr Loan account with the remaining as a loan
- Remove the goodwill from the ledger: Dr Partners’ capital accounts using PSR after change Cr Goodwill account with the value of the goodwill
