Ch – 2 Accounting for Partnership Firms : Fundamentals

You have learnt about the preparation of final accounts for a sole proprietary concern. As the
business expands, one needs more capital and larger number of people to manage the
business and share its risks. In such a situation, people usually adopt the partnership form of
organisation.
Accounting for partnership firms has it’s own characteristics, as the partnership firm
comes into existence when two or more persons come together to establish business and
share its profits. On many issues affecting distribution of profits, calculation of interest on
capital, interest on drawings, there may not be any specific agreement between the partners. In
such a situation the provisions of the Indian Partnership Act 1932 apply. These specific
situations need specific treatment in accounting that need to be clarified.

Meaning and Definition of Partnership

When two or more persons join hands to set up a business and share its profits and
losses, they are said to be in partnership.
According to Section 4 of the Partnership Act 1932 “Partnership is the relation between
persons who have agreed to share the profits of a business carried on by all or any of them
acting for all”
Persons who have entered into partnership with one another are individually called
‘partners’ and collectively called ‘firm’. The name under which the business is carried is called
the ‘firm’s name’. A partnership firm has no separate legal entity, apart from the partners
constituting it. Thus, the essential features of partnership are:
Features of partnership Firm
Association of two or more persons: There must be at least two persons and
maximum of 50 persons to form a partnership and they must be competent to contract.
The Central government has prescribed the maximum number of partness in a firm to be
50 under Rule 10 of the Companies (Miscellaneous) Rules, 2014, So, a partnership firm
cannot have more than 50 partners.
Partnership Agreement or Deed: There must be an agreement among partners to
form a partnership. It can be written or oral. But in order to avoid disputes, it is
preferred that the partners have a written agreement.
Legal Business: The business of the partnership firm must be a legally allowed business.
Sharing of Profits or Losses: The partners must share profits or losses in a certain ratio.
Mutual Agency: The partners mutually take part in daily routine work or the work may
be carried on by one or more partners on behalf of the other partners. Every partner is
legally liable for the acts of all other partners, whether he is taking part in the activities of
the firm or not.
Unlimited Liability: Partners' liability to the third parties is unlimited. If there are losses,
and the firm is not able to pay its debts fully, then all the partners shall be jointly and
severally liable to pay the debts of the firm to an unlimited extent.
Partnership Deed: The document, which contains terms of the agreement, is called'
Partnership Deed'. It generally contains the details about all the aspects affecting the
relationship between the partners including the objective of business, contribution of capital
by each partner, ratio in which the profits and the losses will be shared by the partners and
entitlement of partners to interest on capital, interest on loan, etc.
 Contents of the Partnership Deed

The Partnership Deed usually contains the following details:

• Names and Addresses of the firm and its main business.
• Names and Addresses of all partners.
• Amount of capital to be contributed by each partner.
• The accounting period of the firm.
• The date of commencement of partnership.
• Profit and loss sharing ratio.
• Rate of interest on capital, loan, drawings, etc.
• Salaries, commission, etc, if payable to any partner.
• The rights, duties and liabilities of each partner.
• Settlement of accounts on dissolution of the firm.
• Method of settlement of disputes among the partners.
• Rules to be followed in case of admission, retirement, death of a partner.
• Rules regarding operation of Bank Accounts.
• Any other matter relating to the conduct of business.

Normally, the partnership deed covers all matters affecting relationship of partners
amongst themselves. However, if there is no express agreement on certain matters, the
provisions of the Indian Partnership Act, 1932 shall apply.

Provisions of Partnership Act, 1932 in the absence of Partnership Deed:

Profit Sharing Ratio: If the partnership deed is silent about the profit sharing ratio, the
profits and losses of the firm are to be shared equally by partners.
Interest on Capital: No interest on capital is payable if the partnership deed is silent on
the issue.
Interest on Drawings: No interest is to be charged on the drawings made by the
partners, if there is no mention in the Deed.
Interest on Partner’s Loan: If any partner has advanced some money to the firm
beyond the amount of his capital for the purpose of business, he shall been entitled to
get an interest on the amount at the rate of 6 percent per annum.
Salary / Commission to a Partner: No partner is entitled to get salary or other
remuneration for taking part in the conduct of the business of the firm.
Admission of a Partner: No new partner can be admitted without the consent of the
existing partners.

Liabilities of Partners

Indian Partnership Act specifies that subject to contract between the partners:
(i) If a partner derives any profit for him/her self from any transaction of the firm or from
the use of the property or business connection of the firm or the firm name, he/she shall
account for the profit and pay it to the firm.

(ii) If a partner carries on any business of the same nature as and competing with that of
the firm, he/she shall account for and pay to the firm, all profit made by him/her in that
business.
Accounting Aspects

Distribution of Profit among Partners

The profits and losses of the firm are distributed among the partners in an agreed ratio.
However, if the partnership deed is silent, the firm's profits and losses are to be shared equally by all
the partners.
You know that in the case of sole partnership the profit or loss, ascertained by the profit and loss
account is transferred to the capital account of the proprietor. In case of partnership, however, certain
adjustments such as interest on drawings, interest on capital, salary to partners, and commission to
partners are required to be made. For this purpose, it is customary to prepare a Profit and Loss
Appropriation Account of the firm and as certain the final figure of profit and loss to be distributed
among the partners, in their profit sharing ratio.
The Proforma of Profit and Loss Appropriation Account is given as follows:
Profit and Loss Appropriation Account
Dr. Cr.
Particulars Amount Particulars Amount
(Rs.) (Rs.)
To Profit and Loss xxx By Profit and Loss xxx
(if there is loss) (if there is profit)
To Interest on Capital By Interest on Drawings
A xxx A xxx
B xxx xxx B xxx xxx
To Salary to Partner xxx By Partners’ Capital Accounts
To Commission to Partner xxx (distribution of Loss)
To Reserve xxx A xxx
To Partners’ Capital Accounts B xxx xxx
(distribution of profit)
A xxx
B xxx xxx
xxxx xxxx

*Note: Interest on partner's loan & Rent paid to any Partner for using his/her property for
business purpose is to be treated as a charge against profits. It is debited to Profit & Loss
Account (not to the Profit & Loss Appropriation Account).

Journal Entries relating to Profit and Loss Appropriation Account

1. Transfer of the balance of Profit and Loss Account to Profit and Loss Appropriation Account:
(a) If Profit and Loss Account shows a credit balance (net profit):
Profit and Loss A/c Dr.
To Profit and Loss Appropriation A/c
(Being the profit transferred)
(b) If Profit and Loss Account shows a debit balance (net loss)
Profit and Loss Appropriation A/c Dr.
To Profit and Loss A/c
(Being the loss transferred)
2. Interest on Capital:
(a) For crediting interest on capital to partners’ capital account:
Interest on Capital A/c Dr.
To Partner’s Capital/Current A/cs (individually
(Being Interest on capital allowed to partners @__% p.a)
(b) For transferring interest on capital to Profit and Loss Appropriation Account:
Profit and Loss Appropriation A/c Dr.
To Interest on Capital A/c
(Being Interest on capital allowed to partners transferred to Profit & Loss Appropriation Account)
3. Interest on Drawings:
(a) For charging interest on drawings to partners’ capital accounts:
Partners Capital/Current A/c’s (individually) Dr.
To Interest on Drawings A/c
(Being Interest charged on drawings )
(b) For transferring interest on drawings to Profit and Loss Appropriation Account:
Interest on Drawings A/c Dr.
To Profit and Loss Appropriation A/c
(Being Interest charged on drawings transferred to Profit & Loss Account)
4. Partner’s Salary/ Commission:
(a) For crediting partner’s salary / commission to partner’s capital account:
Salary / Commission to Partner A/c Dr.
To Partner’s Capital/Current A/c’s (individually)
(Being salary / commission allowed to partners)
(b) For transferring partner’s salary / commission to Profit and Loss Appropriation Account:
Profit and Loss Appropriation A/c Dr.
To Salary / Commission to Partner’s A/c
(Being salary / commission allowed to partners transferred to Profit & Loss Appropriation Account)
5. Transfer of Reserve out of Profit:
Profit and Loss Appropriation A/c Dr.
To Reserve A/c
(Being amount transferred to Reserve)
6. Share of Profit or Loss after appropriations:
If Profit: Profit and Loss Appropriation A/c Dr.
To Partner’s Capital/Current A/c’s (individually)
(Being balance if profit transferred to Capital A/c’s of partners in their Profit–sharing Ratio)
If Loss: Partner’s Capital/Current A/c’s (individually) Dr.
To Profit and Loss Appropriation A/c
(Being balance if Loss transferred to Capital A/c’s of partners in their Profit–sharing Ratio)
 Maintenance of Capital Accounts of Partners
All transactions relating to partners of the firm are recorded in the books of the firm
through their capital accounts. This includes the amount of money brought in as capital,
withdrawal of capital, share of profit, interest on capital, interest on drawings, partner’s salary,
commission to partners, etc.
There are two methods by which the capital accounts of partners can be maintained.
These are: (i) fixed capital method, and (ii) fluctuating capital method.

Fixed Capital Method: Under the fixed capital method, the capitals of the partners shall
remain fixed unless additional capital is introduced or a part of the capital is withdrawn as per
the agreement among the partners. All items like share of profit or loss, interest on capital,
drawing, interest on drawings, etc. are recorded in separate accounts, called Partner's Current
Account.
The partners' capital accounts will always show a credit balance, which shall remain the
same (fixed) year after year unless there is any addition or withdrawal of capital.
The partners' current account on the other hand, may show a debit or a credit balance.
Thus under this method, two accounts are maintained for each partner viz., capital account
and current account, While the partners' capital accounts shall always appear on the liabilities
side in the balance sheet, the partners' current account's balance shall be shown on the
liabilities side, if they have credit balance and on the assets side, if they have debit balance.
The partner's capital account and the current account under the fixed capital method would
appear as shown below:

Dr. Partner’s Capital Account Cr.

Date Particulars J.F. (Rs.) Date Particulars J.F. (Rs.)
To Bank A/c (permanent xxx By Balance b/d xxx
withdrawal of capital) (opening balance)
To Balance c/d xxx By Bank A/c xxx
(closing balance) (fresh capital introduced)

Date xxx xxx

Dr. Partner’s Current Account Cr.

J.
Date Particulars F. (Rs.) Date Particulars J.F. (Rs.)
To Balance b/d (Op. Dr. Bal.) # xxx By Balance b/d (Op. Cr. Bal.) # xxx
To Drawings xxx By Salaries/Commission xxx
To Interest on drawings xxx By Interest on capital xxx
To Profit & Loss Appropriation By Profit & Loss Appropriation
A/c (for share of loss) # xxx A/c (for share of profit) # xxx
To Balance c/d (Closing Bal.) # xxx By Balance c/d (Closing Bal.) # xxx
xxxx xxxx
 Fluctuating Capital Method: Under the fluctuating capital method, only one account, i.e.
capital account is maintained for each partner. All the adjustments such as share of profit and
loss, interest on capital, drawings, interest on drawings, salary or commission to partners,
etc. are recorded directly in the capital accounts of the partners. This makes the balance in
the capital account to fluctuate from time to time. That's the reason why this method is called
fluctuating capital method. In the absence of any instruction, the capital account should be
prepared by this method. The proforma of capital accounts prepared under the fluctuating
capital method is given below:

Dr. Partner’s Capital Account Cr.

Date Particulars J.F. (Rs.) Date Particulars J.F. (Rs.)
To Balance b/d (Op. Dr. Bal.) # xxx By Balance b/d (Op. Cr. Bal.) # xxx
To Bank (permanent withdrawal
of capital) By Bank (fresh capital
introduced)
To Drawings xxx By Salaries/Commission xxx
To Interest on drawings xxx By Interest on capital xxx
To Profit & Loss Appropriation A/c xxx By Profit & Loss Appropriation xxx
(for share of loss) # xxx A/c (for share of profit) #

To Balance c/d (Closing Bal.) # xxx By Balance c/d (Closing Bal.) # xxx
xxxx xxxx

INTEREST ON PARTNERS LOAN

If a partner has given loan to the firm, he is entittled to receive interest on such loan at an
agreed rate.
It is a charge against profits. It is provided irrespective of profits or loss. It will also be provided
in the absence of Partnership Deed @ 6% per annum.
The following entries are passed to record the interest on partner’s loan
1. For allowing Interest on loan:
Interest on Partner’s Loan A/c…..Dr.
To Partner’s Loan A/c
(Being interest on loan allowed @ % p.a.)
2. For transferring Interest on Loan to Profit and Loss A/c:
Profit and Loss A/c …… Dr.
To Interest on Loan A/c
(Being Interest on loan transferred to P & L A/c)
It is always DEBITED to Profit and Loss A/c

Rent Paid to Partner.

Rent paid to a partner is also a charge against profits and it will also be DEBITED to Profit and
Loss A/c
 Calculation of Interest on Capital
No interest is allowed on partners’ capitals unless it is expressly agreed among the
partners. When the Deed specifically provides for it, interest on capital is credited to the
partners at the agreed rate with reference to the time period for which the capital remained in
business during a financial year. Interest on capital is generally provided for in two situations:
(i) when the partners contribute unequal amounts of capitals but share profits
equally,
(ii) where the capital contribution is same but profit sharing is unequal.

Interest on capital is calculated with due allowance for any addition or withdrawal of
capital during the accounting period. For example, Amar, Ramesh and Shyam entered into
partnership, bringing in Rs. 5,00,000, Rs. 4,00,000 and Rs. 3,00,000 respectively into the
business. They decided to share profits and losses equally and agreed that interest on capital
will be provided to the partners @10 per cent per annum. There was no addition or
withdrawal of capital by any partner during the year. The interest on capital works out to Rs.
50,000 (10% on 5,00,000) for Amar, Rs. 40,000 (10% on 4,00,000) for Ramesh, and Rs.
30,000 (10% on 3,00,000) for Shyam.

Interest on partners capital will be allowed only when it has been specifically mentioned in
the partnership deed. If interest on capital is to be allowed as per the agreement, it should be
calculated with respect to the time, rate of interest and the amount of capital. Interest on Capital
can be treated as either:
A. An Appropriation of profit; or
B. Charge against profit.

A. Interest on Capital: An Appropriation of Profits:

In case of
Losses
In cases of Sufficient Profits
In case of Insufficient Profits
Interest on Capital is NOT ALLOWED
Interest on Capital is ALLOWED IN FULL
Interest will be restricted to the amount of profit.
Hence, profit will be distributed in the ratio of
interest on capital of each partner.

B. Interest on Capital: As a Charge against Profits:

Interest on Capital is always allowed in full irrespective of amount of profits of losses.

Note: Interest on Capital is always calculated on the OPENING CAPITAL.

If Opening Capital is not given in the question, it should be ascertained as follows:

Particulars (Rs.)
Capital at the End xxxxxx
Add: Drawing xxxxxx
Interest on Drawings xxxxxx
Losses during the year xxxxxx xxxxxx
xxxxxx
Less: Additional Capital Introduced (xxxxxx)
Profits during the year (xxxxxx)
Any salary/commission received (xxxxxx) (xxxxxx)
Opening Capital …………… xxxxxx
For Additional capital interest is calculated for period for which capital is utilised.
When there are both addition and withdrawal of capital by of partners during a financial
year, the interest on capital is calculated as follows:

(i) On the opening balance of the capital accounts of partners, interest is calculated
for the whole year;
(ii) On the additional capital brought in by any partner during the year, interest is
calculated from the date of introduction of additional capital to the last day of the
financial year.
(iii) On the amount of capital withdrawn (other than usual drawings) during the year
interest for the period from the date of withdrawal to the last day of the financial
year is calculated and deducted from the total of the interest calculated under
points: (i) and (ii) above.

Alternatively, it can be calculated with respect to the amounts remained invested for the
relevant periods.

INTEREST ON DRAWINGS

Interest on drawing is charged by the firm only when it is clearly mentioned in

Partnership Deed. It is calculated with reference to the time period for which the money was
withdrawn. There are two cases in which calulation of interest on drawings may arise:

Case 1: When Rate of Interest on Drawings is given in %

Interest on Drawings is calculated on flat rate irrespective of period.

Interest on Drawing = Total Drawings X Rate

100

Case 2: When Rate of Interest on Drawings is given in % p.a.

1. When date of Drawing is not given

Interest on Drawing = Total Drawings X Rate X 6

100 12

Note: Interest is calculated for a period of 6 months, we assume drawings have been done
evenly during the year, that is why we take average six months tenure.

2. When date of Drawings is given

Interest on Drawing = Total Drawings X Rate X Months

100 12
Months refers to the period from the date of drawings to the closing date of the
accounting year. This method is suitable when different amounts are withdrawn at different time
intervals.

Case 3: When different amount are withdrawn on different dates:

We have the following two methods to calculate the amount of interest on Drawing:
1. Simple Interest Method

In this method, interest on drawing is calculated for each amount of drawing individually
on the basis of periods for which it remained withdrawn till the close of accounting period.

2. Product Method

Under product method, interest is calculated on the total of the products, that is, the
product of amount of drawings and the period for which the amount remained withdrawn. If the
product is calculated in terms of months, then interest is calculated on the total of products at
the rate per month. If the product is calculated in terms of days, then interest is calculated on
the total of products at the rate per day. This method can be used in all situations as an
alternative to direct method.

The procedure for calculating interest on drawings under product method is as follows:
a) Multiply each amount withdrawn by the relevant period (in months) to find out the
individual product.
b) Find out the sum of all the individual products.
c) Calculate interest at the prescribed rate for one month by using the following formula.
Interest on drawings = Sum of products x Rate of interest p.a. × 1/12

In this method, the amounts of drawings are multiplied by the period for which it
remained withdrawn during the period; Thereafter the products are added and interest is
calculated on the total of products so arrived at for one month. The advantage of this system is
that separate calculations are not required each time.

We can explain the above mentioned two methods with the help of an example.
Month Date Amount
May 1 12,000
July 31 6,000
September 30 9,000
November 30 12,000
January 1 8,000
March 31 7,000

Interest on drawings is to be charged @ 9% p.a.

Calculation of Interest on Drawings by Simple Method

DATE AMOUNT PERIOD INTEREST @9%
1-May 12,000 11 990
31-Jul 6,000 8 360
30-Sep 9,000 6 405
30-Nov 12,000 4 360
1-Jan 8,000 3 180
31-Mar 7,000 - -
TOTAL 54,000 2,295
 PRODUCT METHOD
DATE AMOUNT PERIOD PRODUCTS
1-May 12,000 11 132,000
31-Jul 6,000 8 48,000
30-Sep 9,000 6 54,000
30-Nov 12,000 4 48,000
1-Jan 8,000 3 24,000
31-Mar 7,000 0 -
TOTAL 54,000 306,000

Interest on Drawings = Total of products x 9 x 1

100 12
=3,06,000 x 9 x 1 = 2,295
100 12
Case 4: When an equal amount is withdrawn regularly
If the partners withdraw fixed amount at fixed time interval, interest on drawings may be
calculated on the basis of the average period. Fixed time interval refers to withdrawal
made monthly, quarterly, half-yearly, once in 2 months and once in 4 months. The
following formula may be used to calculate interest on drawings:

Average period is computed as follows:

The following table shows the average period in months for withdrawal made at the
beginning, in the middle and at the end of every month, quarter and half-year of the year.

This Method will be used only if all the following three conditions are satisfied:

1. Amount should be same throughout the period

2. Date of Drawings should be same throughout the period
3. Drawings should be made regularly without any gap.
PAST ADJUSTMENTS (ADJUSTMENTS FOR INCORRECT APPROPRIATIONS OF PROFITS
IN PAST) AFTER CLOSING THE BOOKS

Past Adjustments are concerned with the previous entries which were left out or ommitted
or wrongly entered in the accounts. If, after preparation of Final Accounts of firm, it is found that
some errors or omission in accounts has occurred than such errors or omissions are rectified in
the next year by passing an adjustment entry.
Sometimes after closing the accounts of a partnership firm, i.e., preparing the financial
statements, some errors or omissions in the accounts of the earlier years are noticed. For
example, interest on capital or drawings is omitted, allowed or charged at higher or lower rate,
profits or losses are distributed among the partners in a wrong ratio and so on. These errors and
omissions are rectified by adjusting the Capital Accounts of the affected partners by passing :
(a) an adjustment entry, or (b) adjustment entries.

(A) When an Adjustment Entry (Single Adjustment Entry) is passed: In this case, net effect
of the errors is determined and an adjustment entry is passed by debiting and crediting
the Partners’ Capital/Current Accounts.

Step 1: Prepare an analytical table with one column for particulars, one for each partner
separately and one for the firm. The columns for the partners and the firm are divided into two
parts - debit and credit. An outlay of the Analytical Table is as follows:
Particulars A B Firm
Dr. Cr. Dr. Cr. Dr. Cr.
Amount to be credited to partners xxx xxx xxx
(Interest +Salary + Commission + Profits etc.)
Amount to be Debited to Partners xxx xxx xxx
(Wrong Profit already received + Interest on
Drawings)
Now compare Step 1 and Step 2 and decide
Partner is gainer (Dr.>Cr.) or sacrificing (Cr.>Dr.)
After this make the following entry:
Gainer partner's A/c Dr.
To Sacrificing Partner's A/c

Step 2: Calculate interest on capital earlier omitted. Place interest due to individual Partners in
their respective credit columns and total interest so omitted in the debit column of the firm (as it
is an expense for the firm).
Step 3: Calculate interest on drawings earlier omitted to be considered. Place interest due from
individual partners in their respective debit columns and total interest so omitted in the credit
column of the firm (as it is an income for the firm).
Step 4: Repeat the process for any other expense or income omitted.
Step 5: Find out balance of the columns designed for the firm. This will disclose net profit or net
loss.
Step 6: Divide profit or loss (as per Step 5 above) among the partners in their profit-sharing
ratio.
Step 7: Find the balance of each partner separately. In case one partner has debit balance, the
other partner must have credit balance of the same amount.
Step 8: Pass Adjustment Journal entry with the amounts determined as per Step 7.
Note: If adjustments are to be made for more than one year, then ascertain the consolidated
position and then pass the required Journal entry.

GUARANTEE OF PROFITS TO A PARTNER

Guarantee is an assurance given to the partner of the firm that at least a fixed amount
shall be given to him/her irrespective of his/her actual share in profits of the firm. If actual share
in profits is less than the guaranteed amount in that case the deficit amount shall be borne either
by the firm or by any partner as the case may be.
Note : Guarantee to a partner is given for minimum share in profits. If the actual share in profits
is more than the minimum guaranteed amount then the actual profits will be allowed to the
partner.
Case- 1 When guarantee is given by FIRM (i.e., by all the Partners of the firm)
1. Guaranteed amount to a partner is written in Profit and Loss Appropriation A/C
2. Remaining profits are distributed among the remaining partners in their remaining ratio.
Case- 2 When guarantee is given by a partner or partners to another partner
1. Calculate the share in profits for the partner to whom guarantee is given
2. If share in profits is more than the guaranteed amount, distribute the profits as per the profit
and loss sharing ratio in usual manner.
3. If share in profits is less than the guaranteed amount, find the difference between the share in
profits and the guaranteed amount and the difference is known as Deficiency. Deficiency is
distributed among the partner or partners who guaranteed in a certain ratio and subtracted from
his or their respective shares.