Chapter 11: Partnerships Flashcards
A PARTNERSHIP is a business where two or more individuals carry on a trade jointly to make a profit
The individuals are known as partners, and they are joint owners of the business.
The profits of a partnership may be shared in different ways. A PARTNERSHIP AGREEMENT that states each partner’s profit share is drawn up when the partnership is created.
Advantages of partnership
An individual may choose to work with a business partner rather than operate as a sole trader for many reasons, including:
- The total capital introduced is higher
- The business risks are shared between more owners
- Different partners bring different skillsets to the business
- If a partner is deceased or retires, the business can continue operating (does not cease automatically)
Disadvantages of a Partnership
Disadvantages of working in a partnership rather than as a sole trader include:
- Decision-making takes a longer time
- Disputes and disagreements may arise about the strategy of the business
In a partnership, each partner is jointly and severally liable for the actions of the other partners. If one of the partners is penalised, the other partners can all be required to pay damages.
The Partnership Agreement
Purpose of a Partnership Agreement
The partnership agreement is a document agreed upon by the partners to create the partnership.
It sets out terms on how the partnership will operate and how the profits will be shared to reduce disputes between the partners.
Content of a Partnership Agreement
The content of each Partnership Agreement may differ in detail, but it will include the following points:
- the name of the partnership
- the type of business activity it carries out
- the duration of the business
- the capital each partner must introduce
- the profit-sharing arrangements
- the amount of drawings each partner can take out of the business.
The profit-sharing arrangements are essential in the partnership agreement when preparing financial statements. The partnership agreement includes the following details:
- Each partner’s salary
- Interest on capital
- Interest on drawings
- Profit-Sharing Ratio (PSR)
There are cases where partners have verbal agreements instead of drawing up a written partnership agreement. Where there is no agreement, the partners will share profits equally and will not pay salaries or interest on capital.
It is best practice to draw up a formal partnership agreement rather than rely on oral or informal agreements to avoid uncertainty and disputes between partners.
Profit Sharing Agreements
A business’s net profits are shared among the partners through salaries, interest on capital and profit-sharing ratios. The calculations for allocating the profit to the individual partners are made using the STATEMENT OF APPROPRIATION OF PROFIT.
Salaries
Partners may be entitled to a fixed salary for taking responsibility for the partnership’s operations. For example, the partner is the managing partner.
Partner salaries are not accounted for in the same way as employee salaries. Salaries to employees are treated as a wage expense in the Statement Of Profit Or Loss. The Statement Of Appropriation Of Profit accounts for salary to a partner.
Different partnerships have different policies for paying salaries. In some partnerships, all partners are entitled to salaries but differing amounts. In others, only active partners receive a salary.
Interest on Capital
Each partner may be asked to introduce capital into the partnership. To reward each partner for investing in the partnership, interest is awarded to each partner based on the amount of capital invested. The interest is a return on their investment.
Interest on Drawings
Partners should make drawings from their account at year-end when the Statement of Appropriation of Profit has been prepared.
However, partners may withdraw cash to cover their living expenses at regular intervals throughout the year. The partnership agreement includes a clause that provides interest to be charged on drawings made before the year-end.
Drawings reduce a business’s capital (debit) and cash (credit). The interest on drawings reduces the partner’s profits and is accounted for in the Statement of Appropriation of Profit.
Profit Sharing Ratio (PSR)
After deducting salaries and interest on capital from the net profit, the residual profit (the amount left over) for the year is split between the partners in a predetermined ratio
For example, the PSR for three partners in a partnership is 4:3:2. This means the first partner receives 4/9, the second receives 3/9 and the third 2/9.
Some partnership agreements may include a clause stating that a specific partner is entitled to a guaranteed MINIMUM SHARE OF THE PROFITS.
Suppose the partner entitled to the guaranteed minimum share is calculated to receive less than the minimum amount. In that case, the difference is extracted from other partners using their profit-sharing ratio.
eXAM - Interest on capital and drawings are usually given as an ANNUAL percentage in the FA2 exam. The interest charge may need to be pro-rated for the months since the capital or drawings were made.
Statement of Appropriation of Profit
Once the Statement of Profit or Loss is completed and the net profit established, the Statement of Appropriation of Profit is drawn up.
The Statement of Appropriation of Profit is a calculation that shows how much profit each partner is entitled to. The figures derived from it are used to complete the current accounts of each partner.
A typical Statement of Appropriation of Profit has the below template:
Salaries [partner 1; partner 2; total$]
Interest on capital
interest on drawings
profit sharing ratio
—–
total
(see examples!)
Capital vs Current Account
In the Statement of Financial Position of a partnership, the capital section highlights each partner’s Capital and Current account.
The Capital Account is the total amount invested by the partner (Capital), while the Current account is the amount each partner has earned through the trading activities of the partnership.
Capital Account
A partner joins a partnership by investing a capital sum in the business. This investment can be in cash or other assets such as a building or vehicle.
The Capital Account records the CAPITAL CONTRIBUTIONS and WITHDRAWALS by the partner. The Capital Account remains typically constant from year to year.
- Capital withdrawals occur when a partner dies or retires. Their entire investment is returned to the partner or partner’s appointee to remove the ownership.
This differs from drawings taken from the partnership, which is recorded in the Current Account.
Each partner has a capital account. For a partnership that is a going concern (where there is no evidence of the business going bankrupt), the balances on the capital account will be a CREDIT (positive) balance.
Current Account
Each of the partners in a partnership has a Current Account. The current account shows each partner’s PROFIT SHARE LESS DRAWINGS.
The profit share is the amount attributable to the partner as calculated in the Statement of Appropriation of Profit.
The balance for each partner in the Current Account is usually a credit balance at the end of the period. This credit balance represents the amount of profits attributable to the partner that has yet to be withdrawn.
*eXAM - in exam questions, the current account balance for a partner may be a debit balance.
This occurs when the partner has withdrawn more cash from the current account than their profit share entitlement.
Partnership Loans
Partnership loans are a method of raising finance, similar to bank loans. Partnership loans are usually provided due to cash shortages faced by the partnership and are usually less expensive than a bank loan.
Partnership loans are not Capital invested into the business. Therefore, it is recognised like any other 3rd party lender as Liabilities.
The table below compares the journal entries needed to record cash paid to the partnership as capital introduced and as a partnership loan.
[see table]!
TThe partner’s loan is recorded as a current or non-current liability, depending on the due date for repayment.
With a partnership loan, any interest payments payable to the partner are treated as expenses in the Statement of Profit or Loss, not the Statement of Appropriation of Profit.
