UNIT 18: INTRODUCTION TO PARTNERSHIP ACCOUNTS

Nature of partnership, partnership agreement, partners capital accounts, current and loan
accounts, profit and loss appropriation account, interest on partners capital accounts, current
accounts, drawings, partners salaries, goodwill, admission and retirement of partners, change
in partnership agreement.

INTRODUCTION TO PARTNERSHIP ACCOUNTS (Partnership Act 1890)

Partnership is defined by the Partnership Act 1890 as relationship which exists between persons
carrying on a business in common with a view of profit. In other words, a partnership is an
arrangement between two or more individuals in which they undertake to share the risks and
rewards of a joint business operation. Partnerships are often used to organize retail and service
– type businesses, including professional practices (lawyers, doctors, architects, and certified
public accountants).

THE NEED FOR PARTNERSHIPS

There are various reasons for multiple ownership:

a) The capital required is more than one person can provide

b) Partnerships are often formed because one individual does not have enough economic
resources to initiate or expand the business.
c) Partners bring unique skills or resources to the partnership
d) Many people want to share management instead of doing everything on their own.

NATURE OF A PARTNERSHIP

A partnership has the following characteristics:

1. IT IS FORMED TO MAKE PROFITS.

2. VOLUNTARY ASSOCIATION

A partnership is a voluntary association of individuals rather than a legal entity in itself.

Therefore, a partner is responsible under the law for his or her partner’s action within the
scope of the business. A partner also has unlimited liability for the debts of the partnership.

3. PARTNERSHIP AGREEMENT

A partnership is easy to form. Two or more competent people simply agree to be partners in
some common business purpose. This agreement is known as a partnership agreement. The
partnership agreement does not have to be in writing.
However, it is good business practice to have a written document that clearly states the details
of the partnership, including the name, location and purpose of the business; the names of the
partners and their respective duties; the investments of each partner; the method of distributing
income and losses and procedures for admission and withdrawal of partners, the withdrawal of
assets allowed each partner, and the liquidation (termination) of the business.

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4. LIMITED LIFE

Because a partnership is formed by an agreement between the partners, it has a limited life. It
may be dissolved when a new partner is admitted; a partner withdraws, goes bankrupt, is
incapacitated (to the point that he or she cannot perform as obligated), retires, or dies; or the
terms of the partnership agreement are met (e.g. when the project for which the partnership was
formed is completed). The partnership agreement can be written to cover each of these
situations, thus allowing the partnership to continue legally.

5. MUTUAL AGENCY

Each partner is an agent of the partnership within the scope of the business. Because of this
mutual agency, any partner can bind the partnership to a business agreement as long as he or
she acts within the scope of the company’s normal operations. For example, a partner in a
used-car business can bind the partnership through the purchase or sale of used cars. But this
partner cannot bind the partnership to a contract for buying men’s clothing or any other goods
that are not related to the used car business.

6. UNLIMITED LIABILITY

Each partner has personal unlimited liability for all the debts of the partnership. If a partnership
cannot pay its debts, Trade payables must first satisfy their claims from the assets of the
business. If these assets are not enough to pay all debts, the Trade payables can seek payment
from the personal assets of each partner. If a partner’s personal assets are used up before the
debts are paid, the Trade payables can claim additional assets from the remaining partners who
are able to pay. Each partner, then, can be required by the law to pay all the debts of the
partnership.

7. CO-OWNERSHIP OF PARTNERSHIP PROPERTY

When individuals invest property in a partnership, they give up the right to their separate use
of the property. The property becomes an asset of the partnership and is owned by the partners.

8. PARTICIPATION IN PARTNERSHIP INCOME

Each partner has the right to share in the company’s income and the responsibility to share in
its losses. The partnership agreement should state the method of distributing income and losses
to each partner. If the agreement describes how income should be shared but does not mention
losses, losses are distributed in the same way as income. If the agreement does not describe
the method of income and loss distribution, the partners must be law share income and losses
equally (Partnership Act 1890).

PARTNERSHIP AGREEMENT

The partnership agreement is a written agreement in which the terms of a partnership are set
out and in particular the financial arrangements as between partners.

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Agreements in writing are not necessary. However, it is better if a lawyer or accountant draws
up a proper written agreement. Where there is a proper written agreement there will be fewer
problems between partners. A written agreement means less confusion about what has been
agreed.

It is usual for a partnership to be established formally by means of a partnership agreement.

Partnership agreements vary according the partnership concerned. However, if individuals act
as though they are in partnership even though no written agreement exists, then it will be
presumed in law that a partnership does exist and that its terms of agreement are the same as
those laid down in the partnership Act 1890.

CONTENTS OF A PARTNERSHIP AGREEMENT

The written agreement can contain as much, or as little as the partners want. The law does not
say what it must contain. The usual accounting contents are:

a) The capital to be contributed by each partner

b) The ratio in which profits (and losses) are to be shared.
c) The rate of interest, if any, to be paid on capital before profits are shared.
d) The rate of interest, if any, to be charged on partners’ drawings.
e) Salaries to be paid to partners.
f) Arrangements for the admission of new partners.
g) Procedures to be carried out when a partner retires or dies.
h) The dissolution of the partnership.
i) The resolution of disputes
j) The preparation of accounts

In the absence of a written partnership agreement, the provisions of the Partnership Act 1890
are presumed to apply between the partners. The Act includes the following provisions relating
to financial arrangements.

1. Profits are shared in equal proportions

2. There are no partners’ salaries
3. There is no interest on capital invested by partners
4. If partners advance loans to the business in addition to their agreed capital, they are
entitled to interest of 5% per annum on the amount of the loan.
5. All partners are allowed to play an equal part in managing the business.
6. Before a new partner can be admitted to the business all existing partners must consent
to the change. One dissenting voice will be sufficient to keep out the joining partner.
7. In all decisions of the partnership the majority is seen to rule.
8. The books of account of the partnership must be maintained at the partnership office,
and all partners must be able to view them on request.

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PARTNERS CAPITAL AND CURRENT ACCOUNTS

The liability of a partnership to its owners is recorded in two accounts

1. Capital account: records fixed capital of each partner

2. Current account: records each partner’s share of profits and losses less any drawings
made.

When a new partner is admitted, goodwill is brought in the old profit-sharing ratio and
eliminated in the new.

In the accounts of sole traders there would be:

1. A capital account and usually a drawings account. In the books of a partnership there
would be a capital account for each partner. Unlike the capital account of a sole trader,
this will only contain the original capital put into the business plus any further capital
introduced at a later date. Partners need not contribute equal amounts of capital. What
matters is how much capital each partner agrees to contribute.

2. A current account for each partner, in which is entered:

a. Drawings of money or goods taken by the partner for his or her own use (debit)
b. Interest charged on drawings (debit)
c. Interest on loans to the partnership (credit)
d. Salary (credit)
e. Interest on capital (credit)
f. The partner’s share of profit or loss

There may also be a drawings account for each partner in which all goods or money taken by
the partners during the year is entered instead of putting them in the partners’ current accounts.
However, at the end of the year these are transferred to the partners’ current accounts. Note
also that current accounts are sometimes labelled drawings accounts.

PROFIT (OR LOSS) SHARING RATIOS

Partners can agree to share profits/losses in any ratio or any way that they may wish. However,
it is often thought by students that profits should be shared in the same ratio as that in which
capital is contributed. E.G suppose the capitals were Manda K2 000 and Banda K1 000, many
people would share the profits in the ratio two-thirds to one-third even though the work to be
done by each partner is similar. A look at the division of the first few years’ profits on such a
basis would be:

YEAR 1 2 3 4 5 TOTAL

Net profits 1 800 2 400 3 000 3 000 3 600

Shared:
Manda 2/3 1 200 1 600 2 000 2 000 2 400 9 200

Banda 1/3 600 800 1 000 1 000 1 200 4 600

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It can now be seen that Manda would receive K9 200, or K4 600 more than Banda. To treat
each partner fairly, the difference between the two shares of profits in this case, as the duties
of the partners are the same, should be adequate to compensate Manda for putting extra capital
into the firm. It is obvious that K4 600 extra profits is far more than adequate for this purpose,
as Manda only put in an extra K1 000 as capital. Consider too the position of capital ratio
sharing of profits if one partner put in K99 000 and the other put K1 000 as capital.
To overcome the difficulty of compensating for the investment of extra capital, the concept of
interest on capital was devised.

INTEREST ON CAPITALS

If the work to be done by each partner is of equal value but the capital contributed is unequal,
it is reasonable to grant interest on the partners’ capitals. The interest is treated as a deduction
prior to the calculation of profits and their distribution according to the profit-sharing ratio.
The rate of interest is a matter of agreement between the partners, but it should equal the return
which they would have received if they invested the capital elsewhere.

INTEREST ON DRAWINGS

It is obviously in the best interest of the firm if cash is withdrawn from the firm by the partners
in accordance with the two basic principles of:

a) As little as possible
b) As late as possible

To deter the partners from taking out cash unnecessarily the concept can be used of charging
the partners interest on each withdrawal, calculated from the date of withdrawal to the end of
the financial year.

Suppose that Manda and Banda have decided to charge interest on drawings at 5% per annum,
and that the year-end was 31 December. The following drawings are made:

MANDA
Drawings Interest

1 January 100 100 x 5% x 12 months = 5

1 March 240 240 x 5% x 10 months = 10
1 May 120 120 x 5% x 8 months = 4
1 July 240 240 x 5% x 6 months = 6
1 October 80 80 x 5% x 3 months = 1
Interest charged to Manda 26

BANDA
Drawings Interest

1 January 60 60 x 5% x 12 months = 3
1 August 480 480 x 5% x 5 months = 10
1 December 240 240 x 5% x 1 months = 1
Interest charged to Banda 14

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SALARIES TO PARTNERS

One partner may have more responsibility than the others. As a reward for this, rather change
the profit and loss sharing ratio, the partner may have a salary which is deducted before sharing
the balance of profits.

AN EXAMPLE OF THE DISTRIBUTION OF PROFITS

Taylor and Clarke have been in partnership for one year sharing profits and losses in the ratios
3/5 and 2/5. They are entitled to 5% per annum interest on capitals, Taylor having K2 000
capital and Clarke K6 000. Clarke is to have a salary of K500. They charge interest on
drawings, Taylor being charged K50 and Clarke K100. (Business Accounting 1, F Wood)

The net profit, before any distributions to the partners, amounted to K5 000 for the year ended
31 December 1997.

K K K
Net profit 5 000
Add: charged for interest on drawings:
Taylor 50
Clarke 100 150

5 150
Less: Clarke’s salary 500
Less: Interest on capital
Taylor 100
Clarke 300
400
900
Balance of profits 4 250
Shared:
Taylor 3/5 2 550
Clarke 2/5 1 700
4 250

The K5 000 net profits have therefore been

shared
Taylor Clarke

Balance of profits 2 550 1 700

Interest on capital 100 300
Salary 500
2 650 2 500
Less: Interest on drawings 50 100
2 600 2 400

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THE FINAL ACCOUNTS

In partnership final accounts the profit and loss account contains exactly the same entries as
that of a sole trader.

After the profit and loss account has been prepared, the profit for the year is carried down to a
profit and loss appropriation account in which is shown the sharing of profits between the
partners. The basis for sharing may include partners’ salaries, interest on capital and interest
on drawings, as well as the division of any remaining amount in some agreed ratios.

FIXED AND FLUCTUATING CAPITAL ACCOUNTS

Fixed capital accounts plus current accounts

The capital account for each partner remains year by year at the figure of capital put into the
firm by the partners. The profits, interest on capital and the salaries to which the partners may
be entitled are the credited to a separate current account for the partner, and the drawings and
the interest on drawings are debited to it. The balance of the current account at the end of each
financial year will then represent the amount of undrawn (or withdrawn) profits. A credit
balance will be undrawn profits, while a debit balance will be drawings in excess of the profits
to which the partner was entitled.

For Taylor and Clarke, capital and current accounts assuming drawings of K2 000 each.

Taylor – Capital account

DATE DETAILS Dr Cr

01/01/97 Bank 2 000

Clarke – Capital account

DATE DETAILS Dr Cr

01/01/97 Bank 6 000

Taylor – Current account

DATE DETAILS Dr Cr

31/12/97 Drawings 2 000

31/12/97 Interest on drawings 50
31/12/97 Interest on capital 100
31/12/97 Share of profits 2 550
31/12/97 Balance c/d 600

2 650 2 650

01/01/98 600

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 Clarke – Current account
DATE DETAILS Dr Cr

31/12/97 Drawings 2 000

31/12/97 Interest on drawings 100
31/12/97 Interest on capital 300
31/12/97 Share of profits 1 700
31/12/97 Salary 500
31/12/97 Balance c/d 400

2 500 2 500

01/01/98 400

Notice that the salary of Clarke was not paid to him; it was merely credited to his account. If
in fact it was paid in addition to his drawings, the K500 cash paid would have been debited to
the current account, changing the K400 credit balance into a K100 debit balance.

Examiners often ask for the capital accounts and current accounts to be shown in columnar
form.

CAPITAL ACCOUNTS
Taylor Clarke Taylor Clarke
DATE DETAILS Dr Dr Cr Cr
01/10/97 Bank 2 000 6 000
31/12/97 Balance c/d 2 000 6 000

2 000 6 000 2 000 6 000

01/01/98 Balance b/d 2 000 6 000

CURRENT ACCOUNTS
Taylor Clarke Taylor Clarke
DATE DETAILS Dr Dr Cr Cr
31/12/97 Cash drawings 2 000 2 000
31/12/97 Interest on drawings 50 100
31/12/97 Interest on capital 100 300
31/12/97 Salary 500
31/12/97 Share of profits 2 550 1 700
31/12/97 Balance c/d 600 400

2 650 2 500 2 650 2 500

01/01/98 Balance b/d 600 400

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STATEMENT OF FINANCIAL POSITION (The capital side)

STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 1997

Capitals:
Taylor 2 000
Clarke 6 000
8 000
Current accounts:
Taylor 600
Clarke 400
1 000
If one of the current accounts had finished in debit, for instance if the current account of
Clarke had finished up as K400 in debit, the figure of K400 would appear in brackets so that
we have a net of K200.

If the net figure turned to be a debit figure then this would be deducted from the total of the
capital accounts.

EXAMPLE 1
Mendez and Marshall are in partnership sharing profits and losses equally. The following is
their trial balance as at 30 June 1996.
Dr Cr
Buildings (cost K75 000) 50 000
Fixtures at cost 11 000
Provision for depreciation: Fixtures 3 300
Trade receivables 16 243
Trade payables 11 150
Cash at bank 677
Stock at 30 June 1995 41 979
Sales 123 650
Purchases 85 416
Carriage outwards 1 288
Discounts allowed 115
Loan interest: King 4 000
Office expenses 2 416
Salaries and wages 18 917
Bad debts 503
Provision for bad debts 400
Loan from King 40 000
Capitals: Mendez 35 000
Marshall 29 500
Current accounts: Mendez 1 306
Marshall 298
Drawings: Mendez 6 400
Marshall 5 650

244 604 244 604

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Additional information:
a) Stock, 30 June 1996, K56 340
b) Expenses to be accrued: office expenses K96; wages K200
c) Depreciate fixtures 10% on reducing balance basis, buildings K1 000
d) Reduce provision for bad debts to K320
e) Partnership salary: K800 to Mendez; not yet entered
f) Interest on drawings Mendez K180; Marshall K120
g) Interest on capital account balances at 10 %

Prepare a trading and profit and loss appropriation account for the year ended 30 June 1996
and a Statement of financial position as at that date.

EXAMPLE 2
The following list of balances as at 30 September 1990 has been extracted from the books of
Brick and Stone, trading in partnership sharing the balance of profits and losses in the
proportion 3:2 respectively.

K
Printing, stationery and postages 3 500
Sales 322 100
Stock in hand at 1 October 1989 23 000
Purchases 208 200
Rent and rates 10 300
Heat and light 8 700
Staff salaries 36 100
Telephone charges 2 900
Motor vehicle running costs 5 620
Discounts allowable 950
Discounts receivable 370
Sales returns 2 100
Purchases returns 6 100
Carriage inwards 1 700
Carriage outwards 2 400
Fixtures and fittings at cost 26 000
Provision for depreciation 11 200
Motor vehicles at cost 46 000
Provision for depreciation 25 000
Provision for doubtful debts 300
Drawings: Brick 24 000
Stone 11 000
Current account balances at 1 October 1989
Brick 3 600 credit
Stone 2 400 credit
Capital account balances at 1 October 1989
Brick 33 000
Stone 17 000
Trade receivables 9 300
Trade payables 8 400
Balance at bank 7 700

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Additional information:

a) K10 000 is to be transferred from Brick’s capital account to a newly opened Brick loan
account on 1 July 1990. Interest at 10% per annum on the loan is to be credited to Brick.
b) Stone is to be credited with a salary at the rate of K12 000 per annum from 1 April
1990.
c) Stock in hand at 30 September 1990 has been valued at cost at K32 000.
d) Telephone charges accrued due at 30 September 1990 amounted to K400 and rent of
K600 prepaid at that date.
e) During the year ended 30 September 1990 Stone has taken goods costing K1 000 for
his own use.
f) Depreciation is to be provided at the following annual rates on the straight line basis:
Fixtures and fittings 10%
Motor vehicles 20%

REQUIRED:

i. Prepare a trading and profit and loss account for the year ended 30 September 1990
ii. Prepare a Statement of financial position as at30 September 1990 which should include
summaries of the partners’ capital and current accounts for the year ended on that date

Vertical forms of presentation should be used.

GOODWILL

Usually the largest intangible asset that appears on a company’s Statement of financial position
is goodwill. Goodwill represents the value of all favourable attributes that relate to a business.
These include exceptional management, desirable location, good customer relations, skilled
employees, high-quality products, fair pricing policies, and harmonious relations with labour
unions. Goodwill is therefore unusual: Unlike other assets such as buildings, plant and
machinery which can be sold individually in the market place, goodwill can be identified only
with the business as a whole.
Therefore, goodwill is recorded only when there is an exchange transaction that involves the
purchase of an entire business. When an entire business is purchased, goodwill is the excess of
cost over the fair market value of the net assets (assets less liabilities) acquired.

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