Week 10 - Accounting for partnerships and Incomplete records

Question 1

What is the legal definition of a partnership according to the Partnership Act 1890?

Answer 1

A partnership is “the relation which subsists between persons carrying on business in common with a view of profit.”

Question 2

What is an ordinary general partnership?

Answer 2

An ordinary general partnership is a business structure where two or more individuals share ownership, and each partner has unlimited liability for the debts and obligations of the business. The partnership is unincorporated, meaning it does not have a separate legal identity from its owners.

Question 3

What does ‘unlimited liability’ mean in the context of a partnership?

Answer 3

Unlimited liability means that each partner is personally responsible for the partnership’s debts, and their personal assets may be used to cover the business’s obligations.

Question 4

What is a Limited Liability Partnership (LLP)?

Answer 4

An LLP is a hybrid structure that combines elements of partnerships and corporations. It offers limited liability to its partners (protecting their personal assets), and is treated like a company for accounting and tax purposes.

Question 5

How are LLPs treated for accounting and tax purposes in the UK?

Answer 5

LLPs are treated similarly to companies—they must prepare financial statements and comply with tax regulations applicable to corporate entities.

Question 6

Why are LLPs popular among accounting firms?

Answer 6

LLPs offer the benefit of limited liability while retaining flexibility in management and profit-sharing, making them attractive to professional firms. Most of the UK’s Top 50 accounting firms operate as LLPs.

Question 7

What are the tax return obligations for partnerships?

Answer 7

Partnerships must file a partnership tax return with HMRC, which reports the income and expenses of the business. Additionally, each partner must file a personal tax return to declare their share of the profits or losses.

Question 8

What is a partnership agreement?

Answer 8

A partnership agreement is a legally binding document that outlines the terms and conditions of a partnership, including each partner’s rights, responsibilities, and profit-sharing arrangements.

Question 9

What does the capital section of a partnership agreement specify?

Answer 9

It states how much capital each partner contributes to the business. This determines the initial equity and can affect profit allocation (e.g., through interest on capital).

Question 10

How is profit allocated in a partnership (appropriation of profit)?

Answer 10

Profit is allocated based on a formula typically set out in the partnership agreement. It includes partner salaries, interest on capital, interest on drawings, and the residual profit-sharing ratio.

Question 11

What are partner’s salaries in a partnership agreement?

Answer 11

These are not actual cash payments but a way to allocate a portion of the profits to partners who contribute more time or effort to the business. They are not the same as employee wages.

Question 12

How does interest on capital work in a partnership?

Answer 12

Interest on capital is calculated by applying an agreed percentage to the amount of capital a partner contributes. It rewards partners for investing in the business.

Question 13

What is residual profit in a partnership agreement?

Answer 13

After salaries and interest on capital are deducted from the profit, the remaining (residual) profit or loss is divided between partners based on a pre-agreed profit-sharing ratio (e.g., 3:2:1).

Question 14

What is interest on drawings and how does it affect profit allocation?

Answer 14

If a partner withdraws money from the business (drawings), interest is charged on this amount to discourage excessive withdrawals. This interest is deducted from that partner’s share of profit.

Question 15

Are drawings considered part of profit allocation?

Answer 15

No, drawings are not part of the profit appropriation. They are cash taken out by the partner and will be accounted for separately in the partner’s capital or current account.

Question 16

How is ownership interest presented for sole traders?

Answer 16

The ownership interest includes capital introduced and accumulated profits, minus drawings. It reflects the sole owner’s equity in the business.

Question 17

How is ownership interest shown in a partnership (unlimited)?

Answer 17

Each partner has a separate capital account, and often a current account to track ongoing profits, drawings, and interest. The ownership interest is the balance in these accounts.

Question 18

How is ownership interest represented in a company?

Answer 18

Ownership is shown through share capital, share premium, retained earnings, and other reserves like revaluation reserves. These together form equity on the balance sheet.

Question 19

How is taxation treated for sole traders?

Answer 19

Sole traders are not taxed at the business level. Instead, the owner pays income tax on business profits through their personal tax return.

Question 20

How is taxation handled in partnerships?

Answer 20

Like sole traders, partnerships do not pay tax at the business level. Each partner pays personal tax on their share of the profit, and the partnership files an informational tax return.

Question 21

How is taxation handled in companies?

Answer 21

Companies are separate legal entities and must pay corporation tax on their profits. Shareholders may also pay tax on dividends received.

Question 22

What is the format of financial statements for sole traders?

Answer 22

There is no legal requirement for specific headings or formats in the income statement, but it usually includes basic profit/loss and capital changes.

Question 23

What format is used for partnership financial statements?

Answer 23

Similar to sole traders, but with an added Appropriation Account showing how profit is shared between partners.

Question 24

What format is required for company financial statements?

Answer 24

Companies must follow the Companies Acts and relevant accounting standards, with specific headings in financial statements (e.g. Statement of Profit or Loss, Statement of Financial Position).

Question 25

Who receives the profits in a sole trader business?

Answer 25

The sole owner. Profits belong entirely to them, and drawings represent withdrawals from those profits.

Question 26

How are profits distributed in a partnership?

Answer 26

Profits are allocated between partners via an Appropriation Account, considering salaries, interest on capital, and the profit-sharing ratio. Drawings are recorded separately.

Question 27

How are profits distributed in a company?

Answer 27

Profits are retained or distributed as dividends to shareholders, based on the company’s dividend policy and retained earnings.

Question 28

Why might a sole trader choose to form a partnership when their business is growing?

Answer 28

A growing business may require more resources, such as capital, time, and skills, than a sole trader can provide on their own.

Question 29

How does a partnership help with financial resources?

Answer 29

Each partner can contribute capital, increasing the total funds available for investment in the business, which can support expansion or operations.

Question 30

How does a partnership benefit from shared expertise?

Answer 30

Partners may bring different skills and experience, allowing for better decision-making, division of responsibilities, and access to wider markets or industries.

Question 31

How does time management improve in a partnership?

Answer 31

With multiple partners, the workload can be shared, making it easier to manage the business and free up time for strategic planning or personal life

Question 32

How can forming a partnership lead to economies of scale?

Answer 32

A larger business can reduce unit costs by buying in bulk, streamlining operations, and spreading fixed costs over more output.

Question 33

Why is setting up a partnership easier than forming a company?

Answer 33

Partnerships have fewer legal formalities, no requirement to register with Companies House, and more flexibility in how they operate.

Question 34

What are the tax advantages of partnerships over companies?

Answer 34

Partnerships do not pay corporation tax. Instead, partners pay income tax on their share of the profits, potentially reducing overall tax burdens depending on circumstances.

Question 35

How is privacy better maintained in partnerships compared to companies?

Answer 35

Partnerships are not required to publish detailed financial statements or disclose as much information to the public, unlike limited companies, which must file annual reports.

Question 36

How is partnership accounting similar to sole trader accounting?

Answer 36

Most accounting processes (e.g. recording income and expenses, preparing financial statements) are the same for both. The key differences lie in how equity is managed and shown.

Question 37

What are the main differences in accounting between partnerships and sole traders?

Answer 37

Appropriation of profit between partners The use of capital accounts and current accounts to track each partner’s interest in the business.

Question 38

What is a partner’s capital account?

Answer 38

A long-term account showing capital introduced and withdrawn by each partner since the partnership was formed. It reflects their fixed investment in the business.

Question 39

Are capital accounts usually fixed or variable?

Answer 39

Capital accounts are often fixed, with permanent balances. Day-to-day profit allocations and drawings are instead recorded in the current account.

Question 40

What is recorded in a partner’s current account?

Answer 40

The current account shows: – Share of profit (from appropriation) – Partner’s salary – Interest on capital – Interest on drawings (deduction) – Drawings made during the year

Question 41

What is the purpose of an appropriation account in a partnership?

Answer 41

It shows how the net profit is divided between partners, including salaries, interest on capital, and the remaining profit or loss using the agreed profit-sharing ratio.

Question 42

Can partners have loan accounts in a partnership?

Answer 42

Yes. If a partner lends money to the partnership, it is recorded in a loan account, separate from their capital. Interest may be payable on the loan as agreed.

Question 43

How is interest on drawings treated in partnership accounting?

Answer 43

Interest on drawings is deducted from the partner’s share of profit and recorded in their current account. It discourages early or excessive withdrawals.

Question 44

What is the journal entry when a partner contributes cash to the partnership?

Answer 44

Journal Entry: Dr. Cash XX Cr. Capital – Partner Name XX This increases the partnership’s cash and recognises the partner’s capital contribution.

Question 45

What is the journal entry when a partner contributes assets (instead of cash) to the partnership?

Answer 45

Journal Entry: Dr. Asset(s) XX (e.g., Equipment, Inventory) Cr. Capital – Partner Name XX This brings the non-cash asset into the partnership and credits the partner’s capital account with its agreed value.

Question 46

What happens if multiple partners contribute at startup?

Answer 46

Each partner’s contribution (cash or assets) is recorded individually using separate capital accounts. This keeps track of each partner's equity in the business from day one.

Question 47

Why is it important to record initial contributions properly in partnership accounting?

Answer 47

It sets the foundation for the equity structure of the partnership, impacts profit-sharing, and is crucial for resolving disputes, withdrawals, or dissolution in the future.

Question 48

When does the appropriation of profit occur in partnership accounting?

Answer 48

After the business has recorded all normal transactions and calculated net profit, the appropriation of profit happens to divide that profit among partners.

Question 49

What is the main difference between sole trader and partnership accounting in terms of profit?

Answer 49

In a sole trader business, all profit goes to the owner. In a partnership, profit must be appropriated (divided) between partners based on the terms of the partnership agreement.

Question 50

What determines how profits are split in a partnership?

Answer 50

The partnership deed (or agreement) outlines the rules, which may include: – Capital contributed – Partner salaries – Interest on capital – Profit-sharing ratios – Any special terms or bonuses

Question 51

How does capital contributed affect profit appropriation?

Answer 51

Partners may earn interest on capital based on their contribution. This rewards partners who invest more in the business.

Question 52

How do partner salaries affect profit allocation?

Answer 52

Partner salaries are a way to compensate those who put more time or effort into running the business. They are allocated from profit before sharing the residual profit.

Question 53

What is done with the remaining (residual) profit after salaries and interest are allocated?

Answer 53

The residual profit is divided according to the profit-sharing ratio agreed in the partnership deed (e.g., 2:1 or 40%/60%).

Question 54

What happens if there’s no partnership agreement?

Answer 54

According to the Partnership Act 1890, profits (and losses) are shared equally, regardless of capital contributions or effort.

Question 55

Is the appropriation of profit the same as drawings?

Answer 55

No. Appropriation refers to how profit is allocated, while drawings refer to the cash withdrawals made by partners, which may or may not equal their profit share.

Question 56

How is profit sharing agreed in a partnership?

Answer 56

Profit sharing is outlined in the partnership agreement (deed) and usually includes: Partner salaries Interest on capital Residual profit-sharing ratio Interest on drawings

Question 57

Why do partners receive a ‘salary’ from the profit?

Answer 57

The ‘salary’ compensates partners based on the time and effort they devote to the business. It’s a way to fairly reward more active partners.

Question 58

What is the purpose of interest on capital in a partnership?

Answer 58

To reward partners for their financial investment in the business. The more capital a partner contributes, the more interest they earn, usually at an agreed rate.

Question 59

How is the residual profit shared between partners?

Answer 59

After salaries and interest on capital are allocated, the remaining profit (called residual profit) is shared using a pre-agreed ratio (e.g., 50:50 or 2:1).

Question 60

What happens if no specific profit-sharing ratio is agreed upon?

Answer 60

If there is no agreement, profits (and losses) are shared equally among partners, as stated in the Partnership Act 1890.

Question 61

Why are partners charged interest on drawings?

Answer 61

Interest on drawings is charged to compensate partners who draw less, ensuring fairness by discouraging early or excessive withdrawals from the business.

Question 62

Are partner salaries and interest on capital actual payments?

Answer 62

No, they are not cash payments. They are allocations of profit shown in the appropriation account and reflected in the partners' current accounts.

Question 63

Q: What are the two main equity accounts used for each partner in a partnership?

Answer 63

Capital Account – for original and additional capital contributions. Current Account – for ongoing profit allocation and withdrawals.

Question 64

What is recorded in a partner’s capital account?

Answer 64

– Initial capital invested – Additional capital contributed later This account usually remains fixed unless more capital is introduced or withdrawn permanently.

Question 65

What does a partner’s current account track?

Answer 65

Day-to-day changes in their equity share, including: Credits (increases) – Interest on capital – Salaries – Interest on loans made to the partnership – Share of profits Debits (decreases) – Interest on drawings – Drawings – Share of losses

Question 66

Are drawings always recorded directly in the current account?

Answer 66

Not always. Sometimes drawings are recorded in a separate Drawings Account during the year and transferred to the current account at year-end (on the debit side).

Question 67

What is a partner’s loan account and how is it different?

Answer 67

If a partner lends money to the partnership, it’s recorded in a loan account, separate from their capital or current accounts. Interest may be paid on this loan, usually at an agreed rate.

Question 68

What is the purpose of maintaining separate capital and current accounts?

Answer 68

To clearly distinguish long-term investment (capital) from operational profit/loss allocations and withdrawals (current). This helps track each partner’s equity position accurately.

Question 69

How are balances in current accounts presented in the balance sheet?

Answer 69

– Credit balance: Shown as part of equity (positive value). – Debit balance: Treated as a reduction in equity (or even an asset if the partner owes money to the firm).

Question 70

Ali and Bella run a plumbing partnership. Their statement of profit or loss for the year ending 30.06.2019. showed net profit of £240,000. Step 1: Capital Accounts

Answer 70

Capital accounts only include capital introduced, not current year profits or drawings. Capital Account Ali (£) Bella (£) Capital Introduced 100,000 40,000 Closing Balance 100,000 40,000 Capital accounts stay fixed unless more capital is added or withdrawn.

Question 71

Ali and Bella run a plumbing partnership. Their statement of profit or loss for the year ending 30.06.2019. showed net profit of £240,000. Step 2: Profit Appropriation Account (from table on PP)

Answer 71

Net Profit = £240,000 We now allocate profit as per the agreement: 1. Partner Salaries Ali: £0 Bella: £120,000 2. Interest on Capital (10%) Ali: 10% of £100,000 = £10,000 Bella: 10% of £40,000 = £4,000 3. Interest on Drawings (5%) Ali: 5% of £60,000 = £3,000 (deducted) Bella: 5% of £130,000 = £6,500 (deducted) 4. Remaining profit Profit left after salaries & interest: Profit before residual = £240,000 – (£120,000 + £10,000 + £4,000) + (£3,000 + £6,500) = £240,000 – £134,000 + £9,500 = £115,500 Residual split 50:50 → Ali: £57,750 → Bella: £57,750 Total Appropriation 240,000

Question 72

Ali and Bella run a plumbing partnership. Their statement of profit or loss for the year ending 30.06.2019. showed net profit of £240,000. Step 3: Current Accounts

Answer 72

Let’s now update each partner’s current account: Ali’s Current Account: Opening Balance: £15,000 Add: Interest on capital = £10,000 Add: Share of residual profit = £57,750 Less: Interest on drawings = (£3,000) Less: Drawings = (£60,000) = Closing Balance: £15,000 + £10,000 + £57,750 – £3,000 – £60,000 = £19,750 Bella’s Current Account: Opening Balance: £2,000 Add: Salary = £120,000 Add: Interest on capital = £4,000 Add: Share of residual profit = £57,750 Less: Interest on drawings = (£6,500) Less: Drawings = (£130,000) = Closing Balance: £2,000 + £120,000 + £4,000 + £57,750 – £6,500 – £130,000 = £47,250

Question 73

Ali and Bella run a plumbing partnership. Their statement of profit or loss for the year ending 30.06.2019. showed net profit of £240,000. Current Accounts Summary

Answer 73

Current Account Ali (£) Bella (£) Opening Balance 15,000 2,000 Salary – 120,000 Interest on Capital 10,000 4,000 Residual Profit 57,750 57,750 Interest on Drawing (3,000) (6,500) Drawings (60,000) (130,000) Closing Balance 19,750 47,250

Question 74

What are common reasons a partnership may change?

Answer 74

Admission of a new partner Change in profit-sharing ratios Death or retirement of a partner Dissolution (closing) of the partnership

Question 75

What is a key financial implication of changes to a partnership?

Answer 75

Any change typically involves a transfer of an asset, specifically a share in the partnership (business ownership and profits).

Question 76

What happens when a new partner is admitted?

Answer 76

– They usually bring in capital and may pay a premium for goodwill. – A new profit-sharing ratio is agreed. – The partnership deed is amended or rewritten. – The existing partners may have to sacrifice part of their share of profits.

Question 77

What might trigger a change in profit-sharing ratios?

Answer 77

– Changes in capital contributions – Shifts in partner responsibilities or effort – Re-negotiations to reflect new business dynamics The change is formalised in an updated partnership agreement.

Question 78

What are the accounting steps when a partner retires or dies?

Answer 78

– Revalue assets and liabilities (especially goodwill) – Settle the retiring/deceased partner’s capital and current accounts – Either pay out or convert the balance into a loan account – Update profit-sharing ratios for remaining partners

Question 79

What is a partnership dissolution?

Answer 79

Dissolution means the partnership is closed and the business is wound up. All assets are sold, liabilities paid, and any remaining capital is returned to partners.

Question 80

What happens to goodwill during partnership changes?

Answer 80

Goodwill (the value of the firm’s reputation) may be: – Valued and accounted for when a partner joins or leaves – Paid for by the new partner if joining – Credited to old partners in the ratio they give up

Question 81

Are changes in a partnership automatic?

Answer 81

No. Any changes require: – All partners’ agreement – Legal updates to the partnership deed – Appropriate accounting entries to reflect reallocation of capital and profit shares