L1: Partnership

Prepared by: Puan Mahfuzah Binti Ahmad

PREPARED BY: MAHFUZAH BINTI AHMAD (DIPLOMA) 1

Lecture 1: Table of content
1.1 Concept
1.2 Characteristics
1.3 Types of partners
1.4 Partnership agreement
1.5 Advantages and disadvantages
2.0 Partnership – Accounting for partnership

PREPARED BY: MAHFUZAH BINTI AHMAD (DIPLOMA) 2

1.1: Partnership - concept
PARTNERSHIP is defined as:
 Partnership is a relationship which exists between persons carrying on a
business in common with a view of profit. Or

 Partnership also can be defined as an arrangement between two or more

individuals in which they undertake to share the risks and rewards of a
joint business operation. Or
 Partnership is an association of any kind between parties and who have
agreed to combine any of their rights, powers, property, labour or skill
for the purpose of carrying on a business and sharing the profits. Or

 Partnership will have three (3) stages in the cycle of a partnership business:
1. Formation of a partnership.
2. Changes in partnership
3. Dissolution of a partnership
 Normally, partnership was established through a partnership agreement.
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1.2: Partnership – Characteristics
1. Two or more individuals
 A partnership includes at least two individuals (partners).
 Maximum 20 partners except for professional partnership maximum up to
unlimited partners (no maximum limit).
 In certain jurisdictions, there may be an upper limit to the number of
partners.

2. Business arrangement
A partnership exists to carry on a business.

3. Profit motive
As it is a business, the partners seek to generate a profit.

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1.2: Partnership – characteristics, cont’d
4. Unincorporated business entity
 A partnership is an unincorporated business entity. That means:
 The reporting entity (i.e. business entity) principle applies to a
partnership, so for accounting purposes, the partnership is a separate
entity from the partners.
 The partners have unlimited liability, and
 If the partnership is unable to pay its liabilities,
• the partners may be called upon to use their personal assets to clear
unpaid liabilities of the partnership.
5. Others -
 Partnership has a limited life;
 Term of operation for partnership are set out under partnership
agreement;
 profit of partnership subject to tax and liable under each partners, etc.

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1.3: Partnership – Types of partners
1. General partner/ Full partner
 Partners who shares in the profits and losses of the partnership.
 Actively involved in the conduct of the partnership business.
 The partner involved in the management and control of the
partnership.
 Has unlimited liability where he bears full personal responsibility of the
business in the event the business unable to pay the debts.

2. Salaried partner
 Partner merely receives a fixed salary with or without a commission or
share of profit (merely an employee).
 The partner does not share in the losses of the partnership and not
entitle any partnership goodwill nor any right to direct the partnership.
 The partner is not regarded as general or full partner.
 Thus, the admission or retirement of the partner does not result in a
change of the partnership.
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1.3: Partnership – types of partners, cont’d
3. Sleeping partner
 Partner does not participate in the conduct of the partnership business
which is left to others.
 The partner merely received a share of the partnership profit through
his/her capital contribution.
 Known as dormant partner.
 Has full liability for the partnership debts.

4. Limited partner
 Partner merely subscribes to a fixed amount of capital for the
partnership.
 Therefore, the partner is liable only up to the amount of capital
invested into the partnership (opposite with unlimited liability).
 The partner does not take part in the management of the partnership
business and has no power to bind the partnership.

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1.3: Partnership – types of partners, cont’d
5. Corporate partner
 A company become the partner in the partnership either general partner
or a limited partner.
 The features of the general or limited partner follow the above slide note.

PREPARED BY: MAHFUZAH BINTI AHMAD (DIPLOMA) 8

1.4: Partnership – Partnership agreement
 Partnership agreement is a written agreement in which the terms of the
partnership are set out, and in particular the financial arrangements as
between partners.
 The items it should cover include the following:
1. Capital. Each partner puts in a share of the business capital.
 If there is to be an agreement on how much each partner should put in and
keep in the business, as a minimum fixed amount, this should be stated.

2. Profit-sharing ratio. Partners can agree to share profits in any way they
choose.
 For example, if there are three partners in a business, they might agree to
share profits equally
 but on the other hand, if one partner does a greater share of the work, or has
more experience and ability, or puts in more capital, the ratio of profit sharing
might be different.
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1.4: Partnership – Partnership agreement, cont’d
 The items it should cover include the following:
3. Interest on capital. Partners might agree to pay themselves interest on
the capital they put into the business.
 If they do so, the agreement will state what rate of interest is to be applied.

4. Partners' salaries. Partners might also agree to pay themselves salaries.

 These are not salaries in the same way that an employee of the business will
be paid a wage or salary,
because partners’ salaries are an appropriation of profit, and NOT
AS NORMAL EXPENSES in the income statement of the business.
 The purpose of paying salaries is to give each partner a satisfactory basic
income before the residual profits are shared out.

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1.4: Partnership – Partnership agreement, cont’d
 The items it should cover include the following:
5. Drawings. Partners may draw out their share of profits from the
business.
 However, they might agree to put a limit on how much they should draw out in
any period.
 If so, this limit should be specified in the partnership agreement.
 To encourage partners to delay making withdrawals from the business until
the financial year has ended, the agreement might also be that partners should
be charged interest on their drawings during the year.

6. Others – loan by partners into partnership, nature of business, name

of partner, name of partnership, method valuing goodwill upon
admission, retirement or death of a partner, etc.

 If the list of the partnership agreement is not sufficient, the rule

stipulated in the Partnership Act 1961 can be referred.
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1.4: Partnership – Partnership agreement, cont’d
 However, if individuals act as though they are in partnership even if no
written agreement exists,
 then it will be presumed that a partnership does exist and that its
terms of agreement are reflected in the way the partners conduct the
business, i.e. the way profits have been divided in the past, etc.

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1.5: Partnership – Advantages and disadvantages
 Advantages of a partnership:
1. Risks are spread across a larger number of people.

2. The trader will have access to a wider network of contacts through the
other partners.

3. Partners should bring to the business not only capital but skills and
experience.

4. It may well be easier to raise finance from external sources such as

banks in comparison with sole trader.

5. Others

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1.5: Partnership – Advantages and disadvantages
 Disadvantages of a partnership:
1. While the risk is spread over a larger number of people, so are the
profits. The profit also will be sharing among the partners.

2. By bringing in more people the former sole trader dilutes control over his
business.

3. There may be disputes between the partners.

4. Others -> unlimited liability, limited capital among the partners unless
able to obtain the external loan, dissolution upon death, insolvency of a
partner, etc.

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2.0: Partnership – Accounting for partnership
 Accounting for a partnership include the following aspects:
1. Understand the nature and prepare the:
1. Capital account,
2. Current account (net of drawing) and
3. Appropriation account.

2. Calculate and record:

 partners’ drawing, interest on drawing, interest on capital, interest on loan and
partner salaries.
3. Account for guaranteed minimum profit shares.
4. Prepare statement of appropriation profit.
5. Prepare statement of financial position of a partnership.
6. Define goodwill and calculate goodwill for changes in the partnership.
7. Revaluation account for changes in the partnership.

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2.1: Different between partnership account with sole traders.
1. The funds put into the business by each partner are shown differently.
2. The net profit must be appropriated by the partners, i.e. shared out
according to the partnership agreement. This appropriation of profits must
be shown in the partnership accounts.
1. Net profit for the year (income minus expenses) as shown in sole trader
account is DIFFERENT with,
2. Residual profit in partnership (share of profit) -> residual profit is the
remaining profit after profit for the year has been adjusted by the
appropriations in accordance with the partnership agreement.

Items to be appropriated -> interest on capital, partners’ salaries,

interest on drawing and interest on loan by partners.
3. Appropriation of profit/ share of residual profit/ share of profit means
sharing out profits in accordance with the partnership agreement.
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2.2: Accounting – capital account, current account & appropriation a/c.
Capital account
 When a partnership is formed, each partner puts in some capital to the
business.

 These initial capital contributions are recorded in a series of capital accounts,

one for each partner.

 The balance for the capital account will always be a brought forward (b/f)
credit entry in the partnership accounts,
 because the capital contributed by proprietors is a liability of the
business.

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2.2: Accounting – capital account, current account & appropriation a/c.
Current account
 Used to record the profits retained in the business by each partner.
 Current account will:
1. increases in value when the partnership makes profits, and
2. falls in value when the partner makes drawings out of the business.

 The main differences between the capital and current account:

1.The balance on the capital account remains static from year to year (with
one or two exceptions).
2.The current account is continually fluctuating up and down, as the
partnership makes profits which are shared out between the partners,
and as each partner makes drawings.
3.Another difference is when the partnership agreement provides for
interest on capital, partners receive interest on the balance in their capital
account, but not on the balance in their current account.
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2.2: Accounting – capital account, current account & appropriation a/c.
Current account, cont’d
 The drawings accounts serve exactly the same purpose as the
drawings account for a sole trader.
 Each partner's drawings are recorded in a separate account.
 At the end of an accounting period, each partner's drawings are cleared to
his/her current account.
DEBIT Current account of partner
CREDIT Drawings account of partner

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2.2: Accounting – capital account, current account & appropriation a/c.
Appropriation of account –> appropriation of net profits
 The net profit of a partnership is shared out between them according to the
terms of their agreement. This sharing out is shown in an appropriation
account.

 The accounting entries are:

◦ DEBIT Income and expense account with net profit c/f
◦ CREDIT Appropriation account with net profit b/f

◦ DEBIT Appropriation account

◦ CREDIT Current accounts of each partner

PREPARED BY: MAHFUZAH BINTI AHMAD (DIPLOMA) 20

2.2: Accounting – capital account, current account & appropriation a/c.
Appropriation of account –> appropriation of net profits, cont’d
 The way in which profit is shared out depends on the terms of the partnership
agreement. The steps to take are as follows.
1.Establish how much the net profit is.
2.Appropriate interest on capital and salaries first. Both of these items are an
appropriation of profit and are not expenses in the income statement.
3.If partners agree to pay interest on their drawings during the year:
DEBIT Current accounts
CREDIT Appropriation of profit account
4.Residual profits: the difference between net profits (plus any interest charged on
drawings) and appropriations for interest on capital and salaries is the residual profit. This
is shared out between partners in the profit-sharing ratio.
5.Each partner's share of profits is credited to his current account.
6.The balance on each partner's drawings account is debited to his current
account.
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2.3: Accounting – Loan by partners
 Existing or previous partner will make a loan to the partnership in which
case he becomes a creditor of the partnership.
 On the SOFP, the loan is not included as partners' capital.
 The loan is treated the same way as loan from a third party. The interest on
such loans will be credited to the partner's current account.
 However, you should bear in mind the following.
1. Interest on loans from a partner is accounted for as an expense in the
income statement, and NOT AS AN APPROPRIATION OF PROFIT, even
though the interest is added to the current account of the partners.
2. If there is no interest rate specified, national legislation may provide for
interest to be paid at a specified percentage on loans by partners.

PREPARED BY: MAHFUZAH BINTI AHMAD (DIPLOMA) 22

2.3: Accounting – Loan by partners
 Journal entries:

1. Treat the same as loan from third party

Dr. Bank If partner deposited cash in the partnership.
Cr. Current liability (loan)

Dr. Capital account (partners) If partner transfer/convert a proportion of the

Cr. Current liability (loan) partner’s capital into loan

2. Interest from loan

Dr. Statement of profit or loss • Dr SOPL -> expenses for partnership
Cr. Bank/ Interest payable
account

PREPARED BY: MAHFUZAH BINTI AHMAD (DIPLOMA) 23

2.4: Accounting – Minimum guaranteed profit
 The partnership agreement may provide that one partner has a
guaranteed minimum profit share.

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2.5: Accounting – Changes in partnership
 When a partner retires or a new partner is taken on during the year,
 the profit for that year will have to be apportioned into the PERIODS
BEFORE AND AFTER THE CHANGE and
 the two or more sets of profit sharing arrangements applied.
 Unless told otherwise, assume that profits were earned evenly throughout
the year.

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2.5: Accounting – Changes in partnership - Goodwill
 Goodwill is defined as:
 the amount by which the FAIR VALUE of the net assets of the business
 EXCEEDS THE BOOK VALUE (i.e. statement of financial position) of the net
assets of the business.
 In other words fair value exceed the book value.
 In simple terms, ‘fair value’ can be thought of as being the same as ‘market
value’. Fair value = market value.
 There are 2 types of goodwill:
1. Purchased goodwill (goodwill generated during the acquisition of a
business) -> accounting entries must be accounted for.
 Goodwill is an example of an intangible asset for the above type.
2. Inherent goodwill (arises due to factors such as the reputation, location,
customer base, expertise or market position of the business, etc.) -> no
accounting entries is required for inherent goodwill because it only an
estimation.
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2.5: Accounting – Changes in partnership - Goodwill
 WHEN GOODWILL IS CALCULATED/ accounted in the SOFP?:
1. When the business is sold.
 When a buyer purchases an existing business, he will have to purchase
not only its long term assets and inventory but the goodwill of the
existing business.
2. When a partner retires or a NEW PARTNER IS ADMITTED IN THE
PARTNERSHIP.
 When a new partner is admitted to the partnership, the new partners
effectively buy the assets of the old partnership from the old
partners.
 Therefore, it is usual to calculate the 'goodwill' in the business.
 Goodwill is allocated to the partners before the change in the old PSR.
 After the change, goodwill is then written back to all the new partners in the
new PSR.

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2.5: Accounting – Changes in partnership - Goodwill
 Method of valuing goodwill:
1. Accounting profit/ average profit method
 The value of goodwill is equal to the value of the average annual net profit for a
specified past of number of years, which often referred to as x years purchase of
the net profits.

2. Super profit
 Super Profits are the profits earned above the normal profits.
 Value of net profit after taking into consideration of salary paid to the partners
and interest paid on capital invested by the partners (i.e. net profit minus
partners’ salary and interest on capital).
 Value of goodwill is arrived at by multiplying the super profit with an agreed
number of years.

3. Based on profit sharing ratio (paying premium for goodwill)

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2.5: Accounting – Goodwill – Accounting treatment
 The new partner is required to pay for his share of the tangible assets as well
as the goodwill, according to the profit-sharing ratio.
 On the admission of a new partner, goodwill must be revalued.
 However, not all business keep a goodwill account in their books. Goodwill
accounting treatment consist of 2 types:
1. Goodwill account opened/ goodwill is to be carried in the books/
goodwill is maintained.

2. Goodwill account not opened/ goodwill is not to be carried in the books/

goodwill is not maintained.

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2.5: Accounting – Goodwill – Accounting treatment
1. Goodwill account opened -> not tested in the syllabus
 The value of the goodwill will be credited to the old partners’ capital accounts,
which represents an increase in the resources they own, while the new partner
will not have a share of the goodwill.

Dr. Goodwill account With the value of goodwill

Cr. Capital account (old partners only) With their share of goodwill in old ratio

Dr. Goodwill account With the increase in the value of goodwill, share in the old
Cr. Capital account (old partner) ratio
Dr. Capital account (old partner) With the decrease in the value of goodwill, share in the old
Cr. Goodwill account ratio

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2.5: Accounting – Goodwill – Accounting treatment
2. Goodwill account NOT opened
 Goodwill is intangible in nature (i.e. Intangible assets). It cannot be disposed
of separately. Therefore, some businesses prefer not to maintain a goodwill
account.
 The new partner may be required to pay extra cash, or have his capital balance
reduced, for his share of goodwill.

Dr. Goodwill account Share goodwill among old partners in old profit-
Cr. Capital account (old partners only) sharing ratio

Dr. Capital account (all partners) Written off goodwill among all partners in the new
Cr. Goodwill account profit-sharing ratio

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