partnership accounts 6. 2 formation of a partnership defined in the partnership act 1890 as the...

PARTNERSHIP ACCOUNTSPARTNERSHIP ACCOUNTS

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FORMATION OF A PARTNERSHIP

Defined in the Partnership Act 1890 as the relationship between two or more people engaging in business for profit

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FORMATION OF A PARTNERSHIP Three important factors must be

present in a partnership:

partners must be carrying on a business, not one isolated business transaction

must be agreement between two or more legally competent people who must be the business co-owners

partners must have intent to make a profit

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FORMATION OF A PARTNERSHIP Partnerships are separate accounting

entities to the partners (owners)

Owner’s Capital Accounts are kept for each individual partner

Each partner has the right to share in the profits and manage the business

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PARTNERSHIP AGREEMENT Partnership agreement

doesn’t always exist, making it difficult to establish if a partnership actually exists

if there is no formal partnership agreement then the Partnership Act applies

agreement is essential because partnerships:

have unlimited liabilityhave a limited life

• death of partner• insolvency of partner• retirement of partner

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PARTNERSHIP AGREEMENT name of business details of each

partner nature of business division of profit

and losses capital contributions authority, rights and

duties of partners details of salaries

drawings and interest on drawings

interest on capital voting and decision-

making procedures admission of new

partners resolution of disputes bankruptcy, death or

retirement of partners

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PARTNERSHIP ACT 1890 If there is no partnership agreement in

writing, or if it does not cover an area of dispute, matters may be resolved by reference to the Partnership Act

e.g. Act states all profits and losses are to be shared equally, so if profit ratio is not defined in an agreement, the Act is applied

Partners will receive interest at 5% on excess capital (ie over and above that which they have agreed to contribute)

No interest on drawings No salaries

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ADVANTAGES OF PARTNERSHIP

Creation and dissolution is easier than a company

Minimal statutory regulations Resources can be pooled Expertise can be utilised Co-ownership of assets Duties and responsibilities are shared

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DISADVANTAGES OF PARTNERSHIP Liability is unlimited (partners own personal

possessions can be used to pay debts owed by the business)

Partnership may cease if a partner dies, retires or becomes bankrupt

Disagreements between the partners can occur

Limits to raising large amounts of capital Partners can be sued by creditor, jointly or

individually Partners are likely to pay higher income tax

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LIMITED LIABILITY PARTNER Governed by the Limited Liability

Partnership Act 1907 Liability is limited to the amount of

capital invested by the partner A Limited Partner has no say in the

Management of the Partnership business

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PARTNERSHIP ACCOUNTS CURRENT ACCOUNTS

working accounts containing details of profit, loss, drawings and interest on capital invested or charged on drawings

CAPITAL ACCOUNTSpartner’s original capital put into the

business is considered to be ‘fixed’capital account of each partner is usually

unchanged unless additional capital is invested

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PARTNERSHIP ACCOUNTS CREATION OF NEW PARTNERSHIP -

ACCOUNTING ENTRIES

Can be created in two ways

the introduction of cash only, entered in the cash account and the partner’s capital account

the introduction of cash and other assets; entered in the cash and asset accounts and the partner’s capital account

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PROFIT DISTRIBUTION PROFIT-SHARING RATIOS

Profits and losses are shared in the way partners feel most appropriate

Profit share can be determined in various ways:

Amounts are shared on the basis of the amount of capital contributed by each partner

Higher profit may go to a partner bringing something of particular value into the business, such as specialised expertise

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PROFIT DISTRIBUTION PROFIT AND LOSS APPROPRIATION

ACCOUNTNet profit or loss is transferred to this

account from the profit and loss accountAdditions are made for Interest on

Drawings (this is to discourage partners from making drawings from the business)

Deductions are made for Interest on Capital or any Salaries paid to partners

Residual Profits are then shared, as agreed, according to Profit Sharing ratios

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PROFIT AND LOSS APPROPRIATION ACCOUNT

Profit and Loss Appropriation Account for Able, Bable and CableNet ProfitAdd Interest on Drawings

Less Interest on Capital Salary – Able

Residual Profit:Shared: Able 1/3

Bable 1/3 Cable 1/3

£16,000

500

16,500£2,500£5,000 £7,500

£9,000£3,000£3,000£3,000 £9,000

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PROFIT DISTRIBUTION ALLOCATION AS PER PARTNERSHIP

AGREEMENTInterest on capital may be payableInterest may be charged for drawings

taken out of the businessThere may be a provision for the payment

of a salary of a particular partnerInterest may be payable on loans to

partners by the business or loans by partners to the business

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PROFIT DISTRIBUTION LOAN ACCOUNTS

Where a partner makes a loan to the business, the debit is to bank and the credit to loan account in that partner’s name

DRAWINGSWhere a partner withdraws cash from the

business in anticipation of profits earned, the current account is debited and cash/bank is credited

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ADMISSION OF NEW PARTNER

REASONS FOR A NEW PARTNERMay bring in new products and/or customers

to the businessMay bring specialised expertise to the

businessAllows the business access to further capitalMay bring in additional assetsMay provide new business contactsMay be a requirement due to death,

retirement or bankruptcy of an existing partner

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ADMISSION OF NEW PARTNERNEW PARTNERSHIP AGREEMENT

ADJUSTING THE EXISTING BUSINESSAll existing partners must agree on the

admission of a new partnerAssets of the business should be revalued

before a new partner is admittedLiabilities need to be reviewed for

accuracy in valuationGains and losses to existing partners from

new business value will be made at the existing profit-sharing ratio

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STEPS TO ADMIT NEW PARTNER1. Review value of assets (see later slide)2. Consider inclusion of goodwill (see next slide)3. Record changes in the Ledger Accounts4. Open a Goodwill Account and adjust the

existing partners Capital Accounts according to their existing profit-sharing ratio

5. Prepare opening ledger entries for new partner6. Calculate partners’ new profit-sharing ratio7. Prepare a new Statement of Financial Position

ie Balance Sheet

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ADMISSION OF NEW PARTNER

GOODWILL

Goodwill can be defined as future benefits from assets that cannot be individually identified e.g. reputation, customer database, management ability, product, location

Goodwill is an asset and as such appears in the Balance Sheet as an Intangible Asset ie one which cannot be seen

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Recording Goodwill When the partnership is revalued:

Debit the Goodwill Account with the value of the increase in the value of the business (premium)

Credit the existing partners Capital Accounts according to their profit-sharing ratio

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REVALUATION OF ASSETS Before admitting a new partner to the

business, the Assets should be revalued:Some eg Buildings may have appreciated

in valueSome eg Machinery may not be worth as

much as the Net Book Value in the Balance Sheet – perhaps insufficient amounts for depreciation has been written off over the years

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Accounting for Revaluation Adjustments to the relevant accounts

should be madeEg If Buildings have appreciated, the

Buildings Account would be Debited and the Revaluation Account Credited

If there has been insufficient depreciation written off machinery, the Machinery depreciation account would be credited and the Revaluation Account Debited

The balance on the Revaluation Account would then be transferred to the Partners Capital Accounts according to their profit-sharing ratio

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PARTNERSHIP DISSOLUTION

REASONS FOR DISSOLVING A PARTNERSHIP

Partner(s) may give notice of intention to dissolve

Insolvency of a partnerOwnership changes e.g. converting to company Inability to trade profitablyDeath of partnerVoluntary agreement by partnersCourts may also rule to terminate the

partnership

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KEY TERMS

Capital Accounts Capital Adjustment Account Current Account Revaluation of Fixed Assets Fixed Capital Account

You should be aware of the following terms when dealing with Partnerships and be able to give clear definitions as well as know how to account for each:

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KEY TERMS Interest on Capital Interest on Drawings Partnership Act Partnership Agreement Profit and Loss Appropriation Account Profit-sharing Ratios