Partnership Accounting – Essential Concepts for Successful Business Partnerships

Table of Contents

1. Introduction

GENERAL POINTS RELATING TO PARTNERSHIP

2. Partnership

3. Partnership Deed

4. Minor as Partner

5. Issues on Which Partnership Deed is Silent

6. System of Capital Account Maintenance

7. Final Accounts of Partnership Firm

8. Partnership and Joint Venture Comparison

9. Sharing Profit/losses

CHANGE IN THE CONSTITUTION

10. Meaning

11. Ratios

12. Accounting for Change in Constitution

13. Profit/loss Till the Date of Change in Constitution

14. Other Adjustments

15. If Deceased or Retired Partner’s Dues are Not Settled Immediately

GOODWILL: MEANING, CALCULATION & ACCOUNTING

16. Meaning of Goodwill

17. Methods of Goodwill Calculation

18. Alternative Treatment Of Goodwill Accounting

19. Special Points Related to Goodwill

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CA Foundation | New Syllabus | June 2023 Exams

1. Introduction

Many businesses are constituted (organized) in partnership form. The terms and conditions as mutually agreed upon, govern inter-relationship among partners as well as accounting. There is Indian partnership Act that also provides certain useful norms.

When change in constitution takes place (i.e. Admission, Retirement, Death or Change in profit sharing ratio) partner’s mutual rights may get disturbed (i.e. somebody will be gainer and somebody will be looser) unless certain adjustment related to unaccounted or undivided old profits/loss is made.

The new ratio has been agreed to apply to future profits/losses. But if there exists any unaccounted or undivided profit or loss of old period, then that also will get divided in future, in new ratio instead of old ratio, to that extent someone will gain and someone will loose. This is to be adjusted at the time of change in constitution.

Dissolution of firm is not included in foundation syllabus. Dissolution and other advance features are covered in Intermediate syllabus.

GENERAL POINTS RELATING TO PARTNERSHIP

2. Partnership

• • Partnership is a relationship between two or more persons to do some commercial activity for mutual benefit.
  • The activity is carried as mutually agreed for and on behalf of all.
  • The organisation so created is commonly known as firm.

3. Partnership Deed

• • Partners may put in writing the details of their mutually agreed terms and conditions to run and manage the partnership.
  • Such document is known as partnership deed.
  • This will help to avoid misunderstanding or future disputes among the partners.

4. Minor as Partner

• • Minor being not eligible to enter into any contract cannot become a partner.
  • But section 30 of partnership Act permits that a minor can be included to the benefit of partnership.
  • Hence, minor will not be liable for losses.
  • When he becomes major, within 6 months he has to decide either to become partner or not.

5. Issues on Which Partnership Deed is Silent

• • In the absence of any provision in partnership deed, following provisions of partnership Act are applicable :

1. 1. 1. Profit/Loss sharing ratio will be equal,
      2. No interest is to be allowed on capital,
      3. No interest is to be charged on drawings,
      4. 6% per annum interest is to be given on partner’s loan,
      5. No salary is to be paid to any partner,
      6. Interest and salary, if payable, will be paid only if there is profit unless agreement provides otherwise.

• • Student should use above, whenever question is silent with regard to this items.

6. System of Capital Account Maintenance

• • To run the business the partners bring in cash, goods or other assets etc. which is called as their capital.
  • Capital Accounts are maintained under two system (methods).
  • 1. Fluctuating capital system & 2. Fixed capital system.

6.1 Fluctuating Capital System

• • In this system only one A/c is maintained for each partner.
  • All the adjustments i.e. capital introduced, interest, salary drawings, profit/loss etc. is debited/credited in the same Account.
  • Therefore Capital Account balance keeps on fluctuating every time.

6.2 Fixed Capital System

• • For each partner two accounts will be maintained namely Capital a/c and Current a/c.
  • The capital introduced will be credited to capital a/c.
  • All other regular adjustments like interest, Salary, drawings, share in profit/losses will be made in the current a/c and
  • Hence capital a/c remains fixed from year to year unless their is withdrawal of capital or Addition to capital.

7. Final Accounts of Partnership Firm

• • Final Accounts of a Partnership Firm generally includes following.

1. 1. 1. Trading, Profit and Loss A/c
      2. Profit & Loss Appropriation A/c
      3. Balance Sheet.

• • Final accounts of Partnership firm are already covered in Chapter 13: Final Accounts.

i. These are prepared according to the normal principles of accounting. ii. The interest on capital, salary to partners, interest on drawing, interest on partners loan, transfer to reserves etc. are debited/credited to P&L Appropriation Account and not to the P&L Account. The balance of profit in P&L appropriation A/c will be then transferred to Partners capital A/cs in profit sharing ratio. iii. The goods withdrawn by the partners for personal use should be debited to their drawings A/c and credited in trading A/c as separate item or reduced from purchases and not to be clubbed with the sales.

8. Partnership and Joint Venture Comparison

• • When two or more persons join together, to do business on joint account on regular basis & to share the profits or losses such relationship is known as partnership & the persons are known as partners.
  • When two or more persons join temporarily to do a particular job or work & to share profits or losses, is known as joint venture & the persons are known as co-venturer’s.
  • Partnership is a relationship between persons who have agreed to share profits or losses of a business carried on by all or any of them acting for all.
  • Whereas, a joint venture is a contractual agreement whereby two or more parties undertake an economic activity which is subject to joint control.
  • Thus joint venture is a temporary partnership formed for a particular economic activity or venture.
  • The following additional differences exist between joint venture and other forms of partnership.

1. 1. 1. Accrual basis of accounting is followed in case of partnership and a joint venture generally follows cash basis of accounting.
      2. The financial results of a partnership are obtained at regular intervals i.e. on annual basis. On the other hand, the financial results of a joint venture are obtained generally at the end of the venture.

However, there may be ventures in certain areas, which may last for a longer period, for example, joint ventures in key areas like power, petroleum, telecommunication etc. In these cases, the ventures may even last for ten/fifteen years. For these long-term joint ventures, financial statements are prepared periodically by following accrual basis of accounting. Therefore, the line of distinction between long-term joint ventures and other forms of partnership is very thin.

9. Sharing Profit/losses

• • Usually profit sharing is given by way of ratio like 5:3:2 or in % form like 20%, 40%, 40%, etc.
  • If question is silent about profit sharing then consider them as equal partners as per the provision of partnership act.
  • Profit should be shared in the ratio of capital only if specifically mentioned in the question, not otherwise.
  • Partners can decide mutually any basis or mode of sharing profits and losses, there is no limit to it.
  • You will see some illustration on profit sharing by different ways in this chapter.
  • So whenever question contains some new basis of sharing, read and interpret it correctly and make calculations according to it.

CHANGE IN THE CONSTITUTION

10. Meaning

10.1 Change in the constitution of the firm

• • If any of the following happens, it is said to be change in the constitution of the firm.

(1) Admission of the new partner.
(2) Retirement/Death of a partner.
(3) Change in the profit sharing ratio.

10.2 The common factor in above cases and its significance

The common factor in all above i.e. in Admission, Retirement, Death or change in ratio is that Profit Sharing Ratio Changes.

• • Hence, if there is any old profit or loss unaccounted or undivided then the same should be adjusted at the time of change.
  • Otherwise these profits/losses whenever divided in future, the same will be shared by new partners in New Ratio.
  • To that extent some partner will be gainer and the other will be looser.
  • This shouldn’t happen hence, we make adjustment at the time of change.
  • The value of Building, Land or goodwill may be more than the value appearing in account books (in balance sheet) the increase in the value is an example of unaccounted profit.
  • Sometime whole of the profit earned is not transferred to capital account, the balance appears in account like general reserve, it is an example of undivided profit.
  • Divide old profit/loss among old partners in old ratio. or
  • If we want to keep the unaccounted/undivided profit or loss as it is then calculate the consequent gain and loss (it is the amount of difference between the share as per old ratio and new ratio) and adjust the same either in cash or by accounting.

10.3 Old profits/losses referred to above may be classified under the following heads

• • When there is a change in the constitution basically six under mentioned adjustments (to the extent applicable) will be required.

1. 1. 1. Goodwill. (Goodwill is an asset but increase in its value otherwise than by purchase will have effect of profit)
      2. Revaluation of Assets & Liabilities. (Increase in value of asset over its book value will be a profit and decrease will be a loss. For liability it will be exactly opposite)
      3. Reserves/Profit & Loss a/c balance etc. (These are undivided profits or losses)
      4. Joint Life Policy. (Increase in its value/claim amount over its book value will be a profit)
      5. Profit or loss till the date of change. (When change in constitution takes place other than exactly on year end, then profit or loss from the beginning of year to the date of change is a old profit or loss)
      6. Others: Some old rectification items. (May result into profit or loss)

All the above items have effect of unaccounted or undivided profit/loss of the period till the date of change referred here as old profit/loss.

In accounting profits or losses also means the difference between the book value (i.e. the value/balance as per account books) and the real value (market value or today’s value) of any asset or liability including goodwill, joint life policy etc.

10.4 The other financial items which are not adjustment of old profits/losses as described above

• • The Financial transactions like:

1. 1. 1. contributing capital in case of admission,
      2. repayment of capital in case of retirement/death,
      3. sale/realization of any asset,
      4. settlement/payment of any liability etc. will be made as given in the question.

• • Similarly adjustment of capitals in profit sharing ratio or in any other specified ratio will be made only if required by the question.
  • These are not those adjustments of old unaccounted profit or loss which are necessarily required to be accounted otherwise mutual rights of partners will be disturbed.
  • These are normal financial transactions not resulting into old profits or losses.

11. Ratios

11.1 Ratio of sacrifice

• • Ratio of Sacrifice = Old ratio (-) New Ratio.
  • Sacrifice to a partner is the reduction in his profit sharing ratio compared to old ratio.
  • When a partner is admitted, he gets some share in profits therefore he is the gainer and one or more old partner may be sacrificed.
  • But it is not necessary that all the old partners will be sacrificer because ratio of some old partner may also increase.

11.2 Ratio of gain

• • Ratio of gain = New Ratio – old Ratio
  • Gain to a partner is the increase in his profit sharing ratio compared to his old ratio.
  • When a partner retires/dies, he looses his share in profits therefore he is the sacrificer and one or more continuing partner may be gainer.
  • But it is not necessary that all the continuing partners will be gainer because ratio of some of continuing partner may also decrease.

The term sacrifice or gain is used keeping in mind the amount of profit. But if applied to losses it will be exactly opposite i.e. a partner whose ratio increases will bear more loss thus will be a looser and one whose ratio decreases will bear less loss thus will gain.

11.3 Calculation of New profit sharing ratio

• • Whenever change in constitution takes place, the new profit ratio may be specified in the question.
  • Basis of calculating the new ratio may be given in the question, according to which new ratio will have to be calculated by the student.
  • There is no limit to such alternative basis, some illustrations are given below.
  • While solving ratios make their base i.e. denominators equal.
  • Multiplying numerator and denominator by same number will not change the value but will convert it to the required base.
  • In multiplication, simply multiply both the numerators and both the denominators and the result is ready.
  • In case of addition or substraction if the base that is denominators are same, then simply add or substract the numerators as the case may be, the result will have the same base.

(1) When we say new partner is purchasing share that means old partners are selling their share. Similarly in case of death/retirement, outgoing partner will sell his share and other will purchase it. (2) Similarly ratios will be worked out in case of Retirement/Death. In such cases wording may be like outgoing partners sells his share or other partner purchases share from the outgoing partner. When nothing is specified, it can be assumed that the remaining partner will continue to share in their old ratio.

12. Accounting for Change in Constitution

12.1 The alternative modes to make adjustments for change in constitution

The above adjustments (item 1 to 6 mentioned in para 20.9.3) can be made in any of the following ways

Alternative methods for Accounting Adjustment

Note: We will refer the above as method (1) to (4) in our later discussion.

Any one of this method can be applied to all the above items of adjustment (namely goodwill, revaluation, reserves, profits, joint life polity, etc.) or different methods can be applied to different items. Examination questions are mostly solved by method (4) above except goodwill adjustment which is commonly solved by method (2) or (3). All these are for the old unaccounted/undivided profits or losses i.e. profits or losses upto the date of change. The profit or losses after the date of change in constitution will naturally belong to new partners in new profit sharing ratio. These are equally applicable to admission, retirement, death or change in profit sharing ratio. The amount in method (4) above will be the total old profit/loss, whereas in method (1), (2) & (3) the amount will be the net amount of gain or sacrifice to partner (it is the difference of old profit/loss divided into old ratio and new ratio). In method (1), (2) & (3) even though the mutual rights of the partners gets adjusted, but the old unaccounted/undivided profits or losses still remains unaccounted/undivided.

12.2 Accounting of Revaluation of Assets/Liabilities

• • Revaluation a/c is prepared.
  • All the assets and liabilities on the date of change in constitution are revalued.
  • The revaluation difference is debited/credited to the Revaluation a/c.

(a) If value of asset is increased: (profit)

(b) If value of asset is decreased: (loss)

(c) If there is increase in the value of liabilities: (loss)

(d) If there is decrease in the value of liabilities: (profit)

• • The balance in Revaluation A/c will be profit (if credit is more) or loss (if debit is more).
  • It will be transferred to the old partners in their old profit sharing ratio (method 4).

12.3 Memorandum Revaluation Account: (Method 3)

• • If the value of assets and liabilities are not to be changed in the books of Account.
  • But at the same time the rights of the partners have to be properly adjusted on the admission/death/retirement/change in profit sharing ratio of the partners.
  • In such a case a Memorandum Revaluation A/c will be prepared.

(1) It will prepared in the same way as the Revaluation a/c, only difference is that debit/credit to asset/liability a/c’s will not be made, whatever is the balance will be the profit or loss to which the old partners are entitled in their old profit sharing ratio.

(2) Then whatever was credited to Memorandum Revaluation a/c will be taken on debit side. And whatever was debited to the Memorandum Revaluation a/c as per above will be taken on credit side.
The balance will be the same amount as in the above, but it will be loss, if earlier there was a profit and vice versa.
This balance is to be transferred to New partners in their new profit sharing ratio.

• • The Net difference of (1) & (2) above will be Debited/Credited to Partners a/c.
  • Thus there will be no debit/credit to asset and liability accounts.
  • In the same way adjustment for Reserves etc. can also be made, if the book values are not to be changed (method 3).
  • If instead of book adjustment cash is paid or received equal to the net difference calculated above it becomes method (1) if privately settled and method (2) if cash is paid/received through firm.
  • This amount is in the ratio of gain/sacrifice.

12.4 General Reserve, P&L a/c., etc.

• • At the time of any change in constitution the accumulated profit/loss balance laying in General Reserve, P&L a/c or in other a/c should be transferred to the old partners in their old profit sharing ratio (method 3).
  • It is commonly followed, although other methods can also be followed.

12.5 Joint life policy: Meaning and purpose

• • A life insurance policy taken by a firm on the life of its partners is known as joint life policy.
  • It can be either

1. 1. 1. one combined policy on the life of all partners or
      2. separate policy on the life of each partner.

• • Expenditure of insurance premium is borne by the firm hence this policies are the firm’s assets.
  • Death is an uncertain and unpredictable event.
  • In case of death of any partner, his family members may be interested to take back their dues.
  • The purpose of joint life policy is to help financial settlement in such eventuality.

Hence, even when question is silent, the claim money received should be utilized to settle the account (dues) of deceased partner.

• • In case of combined policy the policy amount (face value/insurance value) will be received if any partner dies.
  • But in case of separate policy, claim will be received of the policy on deceased partner’s life only.

12.6 Accounting for Joint Life Policy Premium and adjustment in case of change in constitution

• • The firms can take joint life policy on the life of one or more partners.
  • The premium will be paid out of the firm’s income.
  • Accounting of such premium can be done in either of the following four ways:

(1) Premium paid is debited in the respective years P&L a/c. No Policy (Asset) a/c is opened. It means that LIP paid & written off by debit to P&L a/c of the year.

• • In such cases whenever claim is received (on death of a partner) from the Insurance Co. the total amount received will be a profit and will be shared by all the old partners. OR
  • Whenever constitution of the firm is changed otherwise than by death then the Policy (asset) a/c may be created at surrender value by following entry:

(2) Policy a/c created: Whenever premium is paid the Policy a/c is created at surrender value and the balance is written off by passing following entry.

• • In this case when amount is received (on death of a partner) it will be credited to Policy a/c. Balance will be profit and will be transferred to old partners in old profit sharing ratio.
  • In case of change other than death, no adjustment will be required because policy already appears at surrender value, hence no profit on revaluation.

(3) Joint life policy reserve account: It is only a modified version of method (1) above. Here also full amount is written off to P & L but still policy account and policy reserve account appear on the asset and liability side of balance sheet at surrender value,

• • At the time of change in constitution JLP reserve account will be transferred to old partners account in old ratio.
  • Alternatively it can be transferred to policy a/c. rest of the treatment will be same as in (1) above.
  • Note: if this entry (b) is passed, with full value then policy and reserve both will appear at full value but still effect is same.

(4) Joint life policy reserve account: modified version of (2) above.

• • As a consequence of above P&L is debited with premium in excess of surrender value and net balance of policy a/c. (-) Joint life policy reserve a/c, at any time is equal to surrender value. Thus it is same as (2) above.
  • At the time of change in constitution

1. 1. 1. the balance of Joint life policy reserve can be either transferred to old partners like other reserves or
      2. it can be credited to Policy a/c rest of the accounting is same as in (2) above.

12.7 Chart explaining treatment of Joint life policy

When premium is paid every year

At the time of change in constitution

Net effect

Note:

1. 1. Transfer above profit to old partners in old ratio.
   2. Utilize claim money to settle deceased partners dues.
   3. R.V. = Revalued value, S.V. = Surrender value, B.V. = Book value
   4. In case J.L.P. reserve is created then B.V. = Policy a/c. – J.L.P. reserve a/c. Alternatively J.L.P. reserve can be separately transferred to old partners a/c in old ratio.

13. Profit/loss Till the Date of Change in Constitution

• • In case change in constitution takes place in between a Financial year, then

1. 1. 1. profit/loss till the date of change belongs to old partners in old ratio and
      2. profit/loss after the date of change belongs to new partners in new ratio.

• • Such profit/loss can be ascertained by preparing an Interim P&L a/c for that period otherwise average profit of the earlier years may be taken as basis for calculating profit/loss for the period.
  • Generally this adjustment is given in case of death, although it can be applicable in the same way in any other type of change in constitution.
  • In case of death/retirement the outgoing partner is also entitled to share profits/losses from the closure of last accounting year till the date of retirement/death.
  • The outgoing partners share in the profit is accounted by way of the following entry. It should be proportionate to the No. of days/months he was partner in relation to whole year.

• • Alternatively share of all old partners can be accounted.

When the profit sharing ratio in between remaining partners has changed then we must transfer total profit to all old partners a/c and not the outgoing partners share only.

While preparing balance sheet, 2nd effect of such profit must be taken either on 1) cash or 2) working capital or 3) P&L adjustment a/c as it is can be shown in balance sheet.

14. Other Adjustments

• • In addition to the adjustments discussed above some other adjustments/entries may come if given in the question.
  • For Example entry for rectification of some old errors, which gives rise to profit/loss.

15. If Deceased or Retired Partner’s Dues are Not Settled Immediately

• • As per provisions of section 37 of the Partnership Act if full or part amount of outgoing partner is still balance then

(a) He will be entitled to Interest or profit share or nothing as may be mutually agreed among them.

(b) If nothing is agreed then outgoing partner or his representatives have choice to get either of the following until final settlement

(i) Interest @6% p.a. on the balance amount
(ii) Share in the profit earned proportionate to their amount outstanding to total capital.

• • Normally he will select the better of (i) or (ii).
  • Hence, if required student should calculate both and give higher one.
  • If concern incurs losses then he will opt for interest.

GOODWILL: MEANING, CALCULATION & ACCOUNTING

16. Meaning of Goodwill

• • Goodwill is the value of reputation of the firm.
  • It is the total of those unidentified benefits which firm enjoys, which help it to earn profit higher than normal profit.
  • It is an intangible asset, hence difficult to value when it is self generated.
  • But following are the methods which can be used for valuation.
  • a. Average profit method
    b. Super profit method
    c. Capitalization method
    d. Annuity method
  • The firm’s goodwill may have value, but in the books of account it may be nil, hence it represents an unaccounted profit.
  • Therefore at the time of change in constitution it needs to be valued and adjusted by any of the four methods discussed later.
  • The Accounting Standard No. 26 on Intangible Assets issued by the ICAI does not allow recognition of self generated goodwill in the books of account.

17. Methods of Goodwill Calculation

17.1 Average Profit Method

• • Goodwill is calculated as a certain number of years purchase of the average profit of last few years.
  • Number of year of purchase means that many times.
  • Average profit is basically a future maintainable profit.
  • Goodwill = Average Profit X number of year’s purchase.

17.2 Super profit method

• • Super profit is the excess of average profit (profit earned/future maintainable profit) over the normal profit (i.e. normally expected in the business).
  • Goodwill is calculated as certain number of years purchase of super profit.

17.3 Capitalization Method

• • Capitalised value of the business =
  • From this capitalized value the amount of the net assets or capital employed (i.e. fixed assets + current asset – Current liabilities) are subtracted the balance is the value of the goodwill.

17.4 Annuity method

• • In the annuity method the effect of interest on the extra profit to be earned due to goodwill in the future years, is considered.
  • Goodwill = Super Profit × Cumulative Present value annuity factor

If in any of the above methods the figure of profit earned includes the effect of abnormal/extra-ordinary/non- re-occurring profits/losses the same should be eliminated. In fact the profit should be future maintainable profit which can be earned in normal course of business. The past average normal profit is taken as equal to future maintainable profit.

18. Alternative Treatment Of Goodwill Accounting

Following are the different ways in which goodwill may be accounted in case of Admission.

1st Alternative goodwill settled by the Partners privately. (method 1)

2nd Alternative the new partner bring in his share in goodwill in the form of cash. (method 2)

3rd Alternative:

(a) Total goodwill of the firm is raised & then written off. (method 3) or
(b) Goodwill a/c is not to be raised/direct adjustment to be made in capital a/c (method 3)
Net effect of (a) and (b) will be same.

4th Alternative goodwill to be adjusted without bringing cash. Total goodwill of the firm is to be raised. (method 4)

Notes:

(1) All the above alternatives can be applicable in case of retirement/death or change in profit sharing ratio also.

(2) Detailed accounting entries for all this alternatives is explained in illustration below.

(3) Alternatives 4 is not in compliance with AS-26 which permits raising of goodwill a/c only when it is purchased. Hence, student should follow it only when specifically required by the question.

19. Special Points Related to Goodwill

19.1 Inference of Goodwill

• • ‘Inference of Goodwill’ is calculation of goodwill when apparently it is not given in the question.
  • This is done only when Capitals are said to be in Profit Sharing ratio and the New Partner brings in cash more than the proportionate Capital.
  • Then the extra amount contributed is inferred as his contribution towards goodwill.

19.2 Calculation of partners share from firms goodwill and vice-a-versa

(1) Calculation of partners share from total goodwill of the firm:

• • • Total goodwill is `1,00,000.
    • There are three partners A, B, & C Sharing profit/losses in the ratio of 2:3:5.
    • Then Share in goodwill of each partner will be calculated as follows.
    • A’s Share = 1,00,000 × 2/10 = 20,000, B= 1,00,000 × 3/10 = 30,000, C = 1,00,000 × 5/10 = 50,000

(2) Calculation of total goodwill from a partners share:

• • Mr. A is admitted as partner with 1/5 share and has brought ` 10,000 towards his share in goodwill.
  • Total goodwill of the firm = 10,000 × 5/1 = ` 50,000

19.3 Withdrawal of Goodwill by Partners

• • Sometimes it will be given in the question that old partners withdraws full or part of the goodwill.
  • It simply means that they are withdrawing Cash equal to either full or part of their share in goodwill.
  • In such cases also the above accounting of goodwill will remain same and
  • one additional entry for drawings will come as follows:

Thus withdrawal of goodwill has no effect on the goodwill a/c. It is so because goodwill is not a tangible asset which someone can withdraw, in reality partners have withdrawn money equal to share in goodwill.

19.4 Goodwill in books which is worthless

• • Suppose goodwill appearing in the balance sheet is stated to be worthless.
  • Then it will be written off by debiting to old partners in old ratio because it is an old loss.

19.5 Goodwill of Incoming partner

• • If incoming partner has experience and name in that field then he can also have goodwill.
  • He will get credit for his goodwill like partners of existing firm get credit for their goodwill.
  • The debit of it can be kept in goodwill a/c (i.e. goodwill is raised or it can be written off to new partners in new ratio).