Week 10 - Accounting for partnerships and Incomplete records Flashcards
What is the legal definition of a partnership according to the Partnership Act 1890?
A partnership is “the relation which subsists between persons carrying on business in common with a view of profit.”
What is an ordinary general partnership?
An ordinary general partnership is a business structure where two or more individuals share ownership, and each partner has unlimited liability for the debts and obligations of the business. The partnership is unincorporated, meaning it does not have a separate legal identity from its owners.
What does ‘unlimited liability’ mean in the context of a partnership?
Unlimited liability means that each partner is personally responsible for the partnership’s debts, and their personal assets may be used to cover the business’s obligations.
What is a Limited Liability Partnership (LLP)?
An LLP is a hybrid structure that combines elements of partnerships and corporations. It offers limited liability to its partners (protecting their personal assets), and is treated like a company for accounting and tax purposes.
How are LLPs treated for accounting and tax purposes in the UK?
LLPs are treated similarly to companies—they must prepare financial statements and comply with tax regulations applicable to corporate entities.
Why are LLPs popular among accounting firms?
LLPs offer the benefit of limited liability while retaining flexibility in management and profit-sharing, making them attractive to professional firms. Most of the UK’s Top 50 accounting firms operate as LLPs.
What are the tax return obligations for partnerships?
Partnerships must file a partnership tax return with HMRC, which reports the income and expenses of the business. Additionally, each partner must file a personal tax return to declare their share of the profits or losses.
What is a partnership agreement?
A partnership agreement is a legally binding document that outlines the terms and conditions of a partnership, including each partner’s rights, responsibilities, and profit-sharing arrangements.
What does the capital section of a partnership agreement specify?
It states how much capital each partner contributes to the business. This determines the initial equity and can affect profit allocation (e.g., through interest on capital).
How is profit allocated in a partnership (appropriation of profit)?
Profit is allocated based on a formula typically set out in the partnership agreement. It includes partner salaries, interest on capital, interest on drawings, and the residual profit-sharing ratio.
What are partner’s salaries in a partnership agreement?
These are not actual cash payments but a way to allocate a portion of the profits to partners who contribute more time or effort to the business. They are not the same as employee wages.
How does interest on capital work in a partnership?
Interest on capital is calculated by applying an agreed percentage to the amount of capital a partner contributes. It rewards partners for investing in the business.
What is residual profit in a partnership agreement?
After salaries and interest on capital are deducted from the profit, the remaining (residual) profit or loss is divided between partners based on a pre-agreed profit-sharing ratio (e.g., 3:2:1).
What is interest on drawings and how does it affect profit allocation?
If a partner withdraws money from the business (drawings), interest is charged on this amount to discourage excessive withdrawals. This interest is deducted from that partner’s share of profit.
Are drawings considered part of profit allocation?
No, drawings are not part of the profit appropriation. They are cash taken out by the partner and will be accounted for separately in the partner’s capital or current account.
How is ownership interest presented for sole traders?
The ownership interest includes capital introduced and accumulated profits, minus drawings. It reflects the sole owner’s equity in the business.
How is ownership interest shown in a partnership (unlimited)?
Each partner has a separate capital account, and often a current account to track ongoing profits, drawings, and interest. The ownership interest is the balance in these accounts.
How is ownership interest represented in a company?
Ownership is shown through share capital, share premium, retained earnings, and other reserves like revaluation reserves. These together form equity on the balance sheet.
How is taxation treated for sole traders?
Sole traders are not taxed at the business level. Instead, the owner pays income tax on business profits through their personal tax return.
How is taxation handled in partnerships?
Like sole traders, partnerships do not pay tax at the business level. Each partner pays personal tax on their share of the profit, and the partnership files an informational tax return.
How is taxation handled in companies?
Companies are separate legal entities and must pay corporation tax on their profits. Shareholders may also pay tax on dividends received.
What is the format of financial statements for sole traders?
There is no legal requirement for specific headings or formats in the income statement, but it usually includes basic profit/loss and capital changes.
What format is used for partnership financial statements?
Similar to sole traders, but with an added Appropriation Account showing how profit is shared between partners.
What format is required for company financial statements?
Companies must follow the Companies Acts and relevant accounting standards, with specific headings in financial statements (e.g. Statement of Profit or Loss, Statement of Financial Position).
Who receives the profits in a sole trader business?
The sole owner. Profits belong entirely to them, and drawings represent withdrawals from those profits.
How are profits distributed in a partnership?
Profits are allocated between partners via an Appropriation Account, considering salaries, interest on capital, and the profit-sharing ratio. Drawings are recorded separately.
How are profits distributed in a company?
Profits are retained or distributed as dividends to shareholders, based on the company’s dividend policy and retained earnings.
Why might a sole trader choose to form a partnership when their business is growing?
A growing business may require more resources, such as capital, time, and skills, than a sole trader can provide on their own.
How does a partnership help with financial resources?
Each partner can contribute capital, increasing the total funds available for investment in the business, which can support expansion or operations.
How does a partnership benefit from shared expertise?
Partners may bring different skills and experience, allowing for better decision-making, division of responsibilities, and access to wider markets or industries.
How does time management improve in a partnership?
With multiple partners, the workload can be shared, making it easier to manage the business and free up time for strategic planning or personal life
How can forming a partnership lead to economies of scale?
A larger business can reduce unit costs by buying in bulk, streamlining operations, and spreading fixed costs over more output.
Why is setting up a partnership easier than forming a company?
Partnerships have fewer legal formalities, no requirement to register with Companies House, and more flexibility in how they operate.
What are the tax advantages of partnerships over companies?
Partnerships do not pay corporation tax. Instead, partners pay income tax on their share of the profits, potentially reducing overall tax burdens depending on circumstances.
How is privacy better maintained in partnerships compared to companies?
Partnerships are not required to publish detailed financial statements or disclose as much information to the public, unlike limited companies, which must file annual reports.
How is partnership accounting similar to sole trader accounting?
Most accounting processes (e.g. recording income and expenses, preparing financial statements) are the same for both. The key differences lie in how equity is managed and shown.
What are the main differences in accounting between partnerships and sole traders?
Appropriation of profit between partners
The use of capital accounts and current accounts to track each partner’s interest in the business.
What is a partner’s capital account?
A long-term account showing capital introduced and withdrawn by each partner since the partnership was formed. It reflects their fixed investment in the business.
Are capital accounts usually fixed or variable?
Capital accounts are often fixed, with permanent balances. Day-to-day profit allocations and drawings are instead recorded in the current account.
What is recorded in a partner’s current account?
The current account shows:
– Share of profit (from appropriation)
– Partner’s salary
– Interest on capital
– Interest on drawings (deduction)
– Drawings made during the year
What is the purpose of an appropriation account in a partnership?
It shows how the net profit is divided between partners, including salaries, interest on capital, and the remaining profit or loss using the agreed profit-sharing ratio.
Can partners have loan accounts in a partnership?
Yes. If a partner lends money to the partnership, it is recorded in a loan account, separate from their capital. Interest may be payable on the loan as agreed.
How is interest on drawings treated in partnership accounting?
Interest on drawings is deducted from the partner’s share of profit and recorded in their current account. It discourages early or excessive withdrawals.
What is the journal entry when a partner contributes cash to the partnership?
Journal Entry:
Dr. Cash XX
Cr. Capital – Partner Name XX
This increases the partnership’s cash and recognises the partner’s capital contribution.
What is the journal entry when a partner contributes assets (instead of cash) to the partnership?
Journal Entry:
Dr. Asset(s) XX (e.g., Equipment, Inventory)
Cr. Capital – Partner Name XX
This brings the non-cash asset into the partnership and credits the partner’s capital account with its agreed value.
What happens if multiple partners contribute at startup?
Each partner’s contribution (cash or assets) is recorded individually using separate capital accounts. This keeps track of each partner’s equity in the business from day one.
Why is it important to record initial contributions properly in partnership accounting?
It sets the foundation for the equity structure of the partnership, impacts profit-sharing, and is crucial for resolving disputes, withdrawals, or dissolution in the future.
When does the appropriation of profit occur in partnership accounting?
After the business has recorded all normal transactions and calculated net profit, the appropriation of profit happens to divide that profit among partners.
What is the main difference between sole trader and partnership accounting in terms of profit?
In a sole trader business, all profit goes to the owner. In a partnership, profit must be appropriated (divided) between partners based on the terms of the partnership agreement.
What determines how profits are split in a partnership?
The partnership deed (or agreement) outlines the rules, which may include:
– Capital contributed
– Partner salaries
– Interest on capital
– Profit-sharing ratios
– Any special terms or bonuses
How does capital contributed affect profit appropriation?
Partners may earn interest on capital based on their contribution. This rewards partners who invest more in the business.
How do partner salaries affect profit allocation?
Partner salaries are a way to compensate those who put more time or effort into running the business. They are allocated from profit before sharing the residual profit.
What is done with the remaining (residual) profit after salaries and interest are allocated?
The residual profit is divided according to the profit-sharing ratio agreed in the partnership deed (e.g., 2:1 or 40%/60%).
What happens if there’s no partnership agreement?
According to the Partnership Act 1890, profits (and losses) are shared equally, regardless of capital contributions or effort.
Is the appropriation of profit the same as drawings?
No. Appropriation refers to how profit is allocated, while drawings refer to the cash withdrawals made by partners, which may or may not equal their profit share.
How is profit sharing agreed in a partnership?
Profit sharing is outlined in the partnership agreement (deed) and usually includes:
Partner salaries
Interest on capital
Residual profit-sharing ratio
Interest on drawings
Why do partners receive a ‘salary’ from the profit?
The ‘salary’ compensates partners based on the time and effort they devote to the business. It’s a way to fairly reward more active partners.
What is the purpose of interest on capital in a partnership?
To reward partners for their financial investment in the business. The more capital a partner contributes, the more interest they earn, usually at an agreed rate.
How is the residual profit shared between partners?
After salaries and interest on capital are allocated, the remaining profit (called residual profit) is shared using a pre-agreed ratio (e.g., 50:50 or 2:1).
What happens if no specific profit-sharing ratio is agreed upon?
If there is no agreement, profits (and losses) are shared equally among partners, as stated in the Partnership Act 1890.
Why are partners charged interest on drawings?
Interest on drawings is charged to compensate partners who draw less, ensuring fairness by discouraging early or excessive withdrawals from the business.
Are partner salaries and interest on capital actual payments?
No, they are not cash payments. They are allocations of profit shown in the appropriation account and reflected in the partners’ current accounts.
Q: What are the two main equity accounts used for each partner in a partnership?
Capital Account – for original and additional capital contributions.
Current Account – for ongoing profit allocation and withdrawals.
What is recorded in a partner’s capital account?
– Initial capital invested
– Additional capital contributed later
This account usually remains fixed unless more capital is introduced or withdrawn permanently.
What does a partner’s current account track?
Day-to-day changes in their equity share, including:
Credits (increases)
– Interest on capital
– Salaries
– Interest on loans made to the partnership
– Share of profits
Debits (decreases)
– Interest on drawings
– Drawings
– Share of losses
Are drawings always recorded directly in the current account?
Not always. Sometimes drawings are recorded in a separate Drawings Account during the year and transferred to the current account at year-end (on the debit side).
What is a partner’s loan account and how is it different?
If a partner lends money to the partnership, it’s recorded in a loan account, separate from their capital or current accounts.
Interest may be paid on this loan, usually at an agreed rate.
What is the purpose of maintaining separate capital and current accounts?
To clearly distinguish long-term investment (capital) from operational profit/loss allocations and withdrawals (current). This helps track each partner’s equity position accurately.
How are balances in current accounts presented in the balance sheet?
– Credit balance: Shown as part of equity (positive value).
– Debit balance: Treated as a reduction in equity (or even an asset if the partner owes money to the firm).
Ali and Bella run a plumbing partnership. Their statement of profit or loss for the year
ending 30.06.2019. showed net profit of £240,000.
Step 1: Capital Accounts
Capital accounts only include capital introduced, not current year profits or drawings.
Capital Account Ali (£) Bella (£)
Capital Introduced 100,000 40,000
Closing Balance 100,000 40,000
Capital accounts stay fixed unless more capital is added or withdrawn.
Ali and Bella run a plumbing partnership. Their statement of profit or loss for the year
ending 30.06.2019. showed net profit of £240,000.
Step 2: Profit Appropriation Account (from table on PP)
Net Profit = £240,000
We now allocate profit as per the agreement:
- Partner Salaries
Ali: £0
Bella: £120,000
- Interest on Capital (10%)
Ali: 10% of £100,000 = £10,000
Bella: 10% of £40,000 = £4,000
- Interest on Drawings (5%)
Ali: 5% of £60,000 = £3,000 (deducted)
Bella: 5% of £130,000 = £6,500 (deducted)
- Remaining profit
Profit left after salaries & interest:
Profit before residual =
£240,000 – (£120,000 + £10,000 + £4,000) + (£3,000 + £6,500)
= £240,000 – £134,000 + £9,500 = £115,500
Residual split 50:50
→ Ali: £57,750
→ Bella: £57,750
Total Appropriation 240,000
Ali and Bella run a plumbing partnership. Their statement of profit or loss for the year
ending 30.06.2019. showed net profit of £240,000.
Step 3: Current Accounts
Let’s now update each partner’s current account:
Ali’s Current Account:
Opening Balance: £15,000
Add: Interest on capital = £10,000
Add: Share of residual profit = £57,750
Less: Interest on drawings = (£3,000)
Less: Drawings = (£60,000)
= Closing Balance:
£15,000 + £10,000 + £57,750 – £3,000 – £60,000 = £19,750
Bella’s Current Account:
Opening Balance: £2,000
Add: Salary = £120,000
Add: Interest on capital = £4,000
Add: Share of residual profit = £57,750
Less: Interest on drawings = (£6,500)
Less: Drawings = (£130,000)
= Closing Balance:
£2,000 + £120,000 + £4,000 + £57,750 – £6,500 – £130,000 = £47,250
Ali and Bella run a plumbing partnership. Their statement of profit or loss for the year
ending 30.06.2019. showed net profit of £240,000.
Current Accounts Summary
Current Account Ali (£) Bella (£)
Opening Balance 15,000 2,000
Salary – 120,000
Interest on Capital 10,000 4,000
Residual Profit 57,750 57,750
Interest on Drawing (3,000) (6,500)
Drawings (60,000) (130,000)
Closing Balance 19,750 47,250
What are common reasons a partnership may change?
Admission of a new partner
Change in profit-sharing ratios
Death or retirement of a partner
Dissolution (closing) of the partnership
What is a key financial implication of changes to a partnership?
Any change typically involves a transfer of an asset, specifically a share in the partnership (business ownership and profits).
What happens when a new partner is admitted?
– They usually bring in capital and may pay a premium for goodwill.
– A new profit-sharing ratio is agreed.
– The partnership deed is amended or rewritten.
– The existing partners may have to sacrifice part of their share of profits.
What might trigger a change in profit-sharing ratios?
– Changes in capital contributions
– Shifts in partner responsibilities or effort
– Re-negotiations to reflect new business dynamics
The change is formalised in an updated partnership agreement.
What are the accounting steps when a partner retires or dies?
– Revalue assets and liabilities (especially goodwill)
– Settle the retiring/deceased partner’s capital and current accounts
– Either pay out or convert the balance into a loan account
– Update profit-sharing ratios for remaining partners
What is a partnership dissolution?
Dissolution means the partnership is closed and the business is wound up. All assets are sold, liabilities paid, and any remaining capital is returned to partners.
What happens to goodwill during partnership changes?
Goodwill (the value of the firm’s reputation) may be:
– Valued and accounted for when a partner joins or leaves
– Paid for by the new partner if joining
– Credited to old partners in the ratio they give up
Are changes in a partnership automatic?
No. Any changes require:
– All partners’ agreement
– Legal updates to the partnership deed
– Appropriate accounting entries to reflect reallocation of capital and profit shares
