The purpose of this article is to assist candidates to develop their understanding of the topic of accounting for partnerships. As such, it covers all of the outcomes in Section H of the detailed Study Guide for FA2. It also provides underpinning knowledge for candidates studying FFA/FA but it is not intended to comprehensively cover the detailed Study Guides for those exams. What is a partnership?There are a number of ways in which a partnership may be defined, but there are four key elements. Two or more individuals Business arrangement Profit motive Unincorporated business entity
How is a partnership controlled?It is good practice to set out the terms agreed by the partners in a partnership agreement. While this is not mandatory, it can reduce the possibility of expensive and acrimonious disputes in the future. As a formal agreement is not mandatory, there is no definitive list of what it should contain, but FA2 exams will not go beyond the following: Share of residual profit Therefore, candidates need to be aware that there is a distinction to be made between the profit for the year (income minus expenses), which is calculated in exactly the same way as for a sole trader and residual profit (the remaining profit after profit for the year has been adjusted by the appropriations in accordance with the partnership agreement). It is worth pointing out that when a question states the profit or loss sharing ratio, that the proportions are always applied to the residual profit – not the profit for the year. Appropriations of profit Another point to remember is that the ‘appropriation account’ is an additional accounting statement that is required for a partnership. For a sole trader, the profit for the year is simply transferred to the credit side of the proprietor’s capital account (the double entry is completed by a debit entry in the statement of profit or loss, resulting in a nil balance on that statement). In the case of a partnership, the statement of profit or loss will still be debited, but the profit will be credited to the appropriation account, rather than the capital account. As each appropriation is dealt with, the double entry is completed through entries in both the appropriation account and the partner’s current account (if current accounts are not maintained by the partnership, the entries will be made in the capital accounts). Partners’ salaries The double entry is completed by a debit entry in the appropriation account. Interest on capital Paying interest on capital is a means of rewarding partners for investing funds in the partnership as opposed to alternative investments. As such, it reduces the amount of profit available for sharing in the profit and loss sharing ratio. This means that a debit entry is needed in the appropriation account. The double entry is completed by a credit entry in the current account of the partner to whom the salary is paid. Interest on drawings Depending on what the question is testing, it will either provide the amounts of interest on capital and drawings or give details of how to calculate the amounts. Remember to deal with each of these appropriations before sharing the residual profit between the partners. A final point in this context is that, if the total of the appropriations is greater than the profit for the year, the amount to be shared between the partners will be a loss. This will mean that the entries for the share of the residual profit will be a credit in the appropriation account (thus resulting in a nil balance) and debits in the partners’ current accounts. What is the difference between capital and current accounts?In one sense, there is no difference. A partner’s total capital is the sum of the balances on their capital account and their current account. In practice, however, it is convenient to separate the amount invested by the partner (the capital account) from the amount they have earned through the trading activities of the partnership (the current account). Therefore, the capital account is usually fixed, while the current account is the current total of appropriations and the share of residual profit/loss, less drawings. Remember that a partner’s drawings will be a debit entry in the partner’s current account. What happens when there is a new partner?When a new partner is admitted to the partnership, the new partners effectively buy the assets of the old partnership from the old partners. The admission of a new partner will also mean that the profit/loss sharing ratio will change. How does goodwill arise, and how is it treated?Goodwill is defined as the amount by which the fair value of the net assets of the business exceeds the carrying amount of the net assets. In simple terms, ‘fair value’ can be thought of as being the same as ‘market value’. Goodwill arises due to factors such as the reputation, location, customer base, expertise or market position of the business. In the FA2 exam, all relevant information will be provided and candidates will not be expected to calculate the value of goodwill. The first step for dealing with goodwill is to recognise an asset. This is a debit entry for the value of the goodwill in the goodwill account. The double entry is completed with credit entries in the old partners’ capital accounts. The value of each entry is calculated by sharing the value of the goodwill between the partners in the old profit and loss sharing ratio. If goodwill is to be retained in the partnership (sometimes referred to as ‘carried in the books’) no further entries are required. If goodwill is not to be carried in the books, it is eliminated by a credit entry in the goodwill account. The double entry is completed with debit entries in the partners’ capital accounts. The value of each entry is calculated by sharing the value of the goodwill between the new partners in the new profit and loss sharing ratio. If a partner is contributing (or withdrawing) capital, the relevant amount will be recorded in both the partner’s capital account and the bank account. A contribution will be a credit entry in the capital account and a debit entry in the bank account, and a withdrawal will be a debit entry in the capital account and a credit entry in the bank account. How are loans from partners treated?A loan is not part of the partner’s capital, and the loan is treated in the same way as a loan from a third party. The liability of the partnership will be recorded by the creation of a liability, resulting in a credit balance for the amount of the loan. The debit entry will depend on how the loan was made. If the partner deposited cash in the bank account, the debit entry will be in the bank account. If the loan was created by converting a proportion of the partner’s capital into a loan, the debit entry will be in the capital account. The interest on the loan will be a business expense and should therefore be debited to the statement of profit or loss. EXAMPLES (i) – Appropriations of profit
Amit and Burton are in partnership sharing profits in the ratio 3:2. The partnership’s profit for the year was $65,460. The partnership agreement provides for:
At the beginning of the year, the partners’ capital and current account balances were: |