Partnership accounts

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Partnership accounts by Neil Stein 27 May 2004 Professional Scheme, Certified Accounting Technician scheme Relevant to Paper 1.1, Paper 6

This article concentrates on the preparation of partnership financial statements. This is the only aspect of partnership accounts examinable in Paper 1.1. CAT Paper 6 also requires knowledge of the accounting entries necessary to record changes in partnership personnel and dissolution of partnerships. There are no material differences between UK and international practice in partnership accounts apart from minor variations in terminology and format. This article uses UK terminology. For students taking the international paper the conversion is: UK term International equivalent Profit and loss account Income statement Appropriation account Statement of division of profit Differences between sole traders' accounts and partnership accounts If you can handle the financial statements of sole traders, with adjustments for accruals, prepayments, depreciation and the like, it is an easy matter to add the requirements for partnership accounts. The differences are: Balance sheet - there is a separate capital account for each partner instead of just the one required for a sole trader we often maintain a separate current account for each partner, recording drawings and profit shares. If this is done, the capital account is only used for 'capital' transactions such as the introduction of extra long-term capital by partners. Profit and loss account - the division of the net profit among the partners has to be shown. There are several possibilities: profit is shared in agreed proportions as (a), but partners are credited with a 'salary' to allow for the work they put into the partnership as (a) or (b), but partners are credited with 'interest on capital' to allow for differences in the amounts of fixed capital partners have contributed. It is important to note that partners' salaries and interest on capital are not charges in the main part of the profit and loss account. They are simply part of the process of dividing up the profit among the partners. The division is shown in an additional section of the profit and loss account called the appropriation account. This may be presented in a tabular format as shown in the next section. Preparing partnership financial statements Profit and loss account The main part of the profit and loss account is prepared exactly as for a sole trader. Points to watch: Do not put partners' salaries or interest on capital into the main profit and loss account. They belong only in the appropriation account section. Do not include drawings anywhere in the profit and loss account or appropriation account. Drawings are debited to partners' current accounts. Profit and loss appropriation account The easiest format to adopt here is a simple columnar presentation. See Figure 1 below (figures invented). Points to watch: One partner may guarantee that another partner's total profit share is not less than a certain minimum amount. To deal with this, make a transfer from one column to another in the tabulated appropriation account. Changes to the profit-sharing arrangements or changes in partnership personnel part way through the year. You have to divide the profit on a time basis between the periods, then apply the details given to the apportioned profits. Remember to take half a year's salary for a half-year period. Your table then shows the total profit shares for the year calculated for the two periods involved. Change in partnership personnel part way through the year, with an agreement that certain expenses charged in the profit and loss account relate to one part of the year only. This is a variation on (b) above and always causes problems for candidates in the Paper 1.1 examination. What you have to realise is that for the partners not bearing the expense, the profit is that shown by the profit and loss account plus the special expense. You have to split that increased profit among the partners, then deduct the special expense from the partners who are to bear it.

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Figure 1: profit and loss appropriation account A £ B £ C £ Total £ Salaries 20,000 15,000 - 35,000 Interest on capital 4,000 3,000 2,000 9,000 Share of balance 3:2:1 90,000 60,000 30,000 180,000 114,000 78,000 32,000 224,000

Try this multiple-choice question from the December 2003 exam:

P, after having been a sole trader for some years, entered into partnership with Q on 1 July 2002, sharing profits equally. The business profit for the year ended 31 December 2002 was £340,000, accruing evenly over the year apart from a charge of £20,000 for a bad debt relating to trading before 1 July 2002, which it was agreed P should bear entirely.

How is the profit for the year to be divided between P and Q?

	P £000	Q £000
A	245	95
B	250	90
C	270	90
D	255	85

Decide what you think the answer should be, and then read on.

Discussion
A little clear thinking is required. The profit excluding the £20,000 is to be used, then £20,000 deducted from P's share.Thus we have:

	P £000	Q £000
6 months to 30 June 2002	180
6 months to 31 December 2002	90	90
	270	90
less: bad debt	20
	250	90

The answer is B. If you didn't get it right, re-read note (c).

d the question states that there is no partnership agreement and tells you nothing about profit shares. In this case, the Partnership Act 1890 applies (UK only). This means:

1. no partnership salaries
2. no interest on capital
3. profit shared equally among the partners
   but
4. if any partner has loaned money to the partnership (as opposed to introducing capital), the loan carries interest at 5 per cent per year, charged in the profit and loss account. Questions rarely bring in this point, because it makes the question easier.
   e Interest on drawings - partners sometimes agree that interest should be charged on drawings made. In reality, partners will agree the amount of drawings the business can stand rather than charge interest. If the point should come up, calculate the total interest due from all partners and add that to the net profit in the appropriation account. Then deduct each partner's interest charge from the individual shares at the end of the appropriation account.

Balance sheet
Each partner has to have a capital account and, probably, a current account in the balance sheet. The easiest way to present these is to use columns. See Figure 2 (figures invented).

Capital accounts A £ B £ C £ Balance at 1 January 40,000 30,000 20,000 Capital introduced 20,000 10,000 - Balance at 31 December 60,000 40,000 20,000 120,000 Capital accounts A £ B £ C £ Balance at 1 January 14,800 16,100 12,400 Profit share (the total from the appropriation account) 68,000 49,000 46,000 82,800 65,100 58,400 Drawings (70,000) (60,000) (60,000) Balance at 31 December 12,800 5,100 (1,600) 16,300 If a partner has a debit balance, as C does here, it is easy to include it in the tabulation as shown. There's no need to complicate matters by putting C's account on the assets side of the balance sheet.figure 2: balance sheet

Important point
If the question asks you to prepare the partners' capital accounts and current accounts as they would appear in the ledger, do them first, before completing the balance sheet. Then you can enter the final balances into the balance sheet. You obviously don't want to waste time copying all the details again into the balance sheet.

A practice question
Here is a question from the June 2003 Paper 1.1 exam. Try to complete it for yourself, then take a look at the discussion and answer below.

Alamute and Brador have been in partnership for several years, compiling their financial statements for the year ended 31 March and sharing profits in the ratio 60:40 after allowing for interest on capital account balances at 5 per cent per year. Extracts from their trial balance at 31 March 2003 are given in Figure 3.

Figure 3: extract from alamute and brador trial balance Reference to notes £ Capital accounts: Alamute 50,000 Brador 50,000 Current accounts: Alamute 3,800 credit Brador 2,600 debit Drawings: Alamute 48,400 Brador 36,900 Office equipment: cost 1 48,300 accumulated depreciation, 1 April 2002 12,800 Stock, 1 April 2002 2 15,600 Trade debtors 3 68,400 Provision for doubtful debts, 1 April 2002 3 3,800 Sales revenue 448,700 Purchases 184,600 Rent paid 4 30,000 Salaries 88,000 Insurance 5 4,000 Sundry expenses 39,400

Notes to Figure 3

1. Office equipment should be depreciated at 20 per cent per year on the reducing balance basis.
2. Closing stock amounted to £21,400.
3. Debts of £2,400 are to be written off, and the provision for doubtful debts is to be adjusted to 5 per cent of trade debtors.
4. Rent paid of £30,000 is the amount for the nine months to 31 December 2002. From that date the rent was increased by 10 per cent.
5. Insurance paid in advance amounted to £1,500.

Required:

1. Prepare the partnership's trading and profit and loss account and appropriation account for the year ended 31 March 2003 (9 marks)
2. Write up the partners' current accounts for the year ended 31 March 2003
   (3 marks) (12 marks in total).

Discussion
This is quite a simple question, but care is needed on several points:

1. The drawings figures are given. They go into the current accounts and do not appear in the profit and loss account or appropriation account.
2. Note 3 gives details of bad and doubtful debts. The charge in the profit and loss account is:

   		£	£
   Debts written off			2,400
   Movement in provision / allowance
   	Original provision	3,800
   	New provision required 5% x (68,400 - 2,400)	3,300	(500)
   			1,900

   
   
3. Note 4 explains the rent. £30,000 is the cost for nine months. That means £10,000 per quarter. The fourth quarter must therefore be £11,000, giving a total of £41,000.

Neil Stein is examiner for Paper 1.1