CHAPTER 20
PARTNERSHIPS
20.1 LEARNING OBJECTIVES
After studying this chapter, students are expected to define partnership and explain the purpose and content of a partnership agreement, explain, calculate and account for appropriation of partnership profit. Further they will be able to explain the difference between partner’s capital and current accounts and prepare the final accounts for a partnership as well as explain and account for the admission of a new partner including the treatment of any goodwill arising.
20.1 THE NATURE OF A PARTNERSHIP
A partnership can be defined as the relationship which subsists between persons carrying on a business in common with a view of profits. The people who own a partnership are called partners.
A partnership has the following characteristics
- It is formed to make profits
- It must obey the law as given in the partnership Act
- Normally there can be a minimum of two partners and a maximum of twenty partners except for banks where there cannot be more than ten partners, and there is no limit on the maximum number for firms of accountants, solicitors, stock exchange members, surveyors, auctioneers, valuers, estate agents, land agents, estate managers or insurance brokers.
- The personal liability of each partner for the firm’s liabilities is un limited except for limited partners. This means that individuals’ personal assets may be used to meet any partnership liabilities in the event of partnership bankruptcy.
- Partners who are not limited partners are known as general partners.
Limited partnerships are partnerships containing one or more limited partners. Limited partners have the following characteristics:
- Their liability for the debts of the partnership is limited to the capital they have contributed into the firm. They cannot be asked for more money than their capital to pay for the firm’s debts.
- They are not allowed to take part in the management of the partnership.
- They are not allowed to take out or receive back any parts of their contribution to the partnership during the life time of the partnership. All the partners cannot be limited partners, so there must be at lest one general partner with unlimited liability.
20.2 PARTNERSHIP AGREEMENT
A partnership agreement is usually drawn up in order to specify the provisions of the contract between the partners. The agreement is likely to specify the following:
- Capital to be contributed by each partner
- Ratio for sharing profits or losses
- Rate of interest if any to be paid on capital (d) Rate of interest to be paid charged on drawings (e) Salaries to be paid to partners.
- Arrangements for the admission of new partners
- Procedure to be carried out when a partner retires or dies.
- CAPITAL CONTRIBUTION
Partners must agree on how much capital each partner should contribute towards the firm operations.
- PROFIT OR LOSS SHARING RATIO
Partners can agree to share profit or losses in any ratio that they wish. However, sometimes profits or losses might be shared in proportion to the amount of capital contributed by each partner.
- INTEREST ON CAPITAL
If partners agree to pay interest on their capital the interest on capital is treated as a deduction prior to the calculation of profit and their distribution among the partners according to the profit ratio.
The rate of interest on capital is often based on the return which the partners would have received if they had the capital invested elsewhere.
- INTEREST ON DRAWINGS
To deter the partners from taking out cash unnecessarily, partners may agree to be charging interest at an agreed rate on each withdrawal of money by the partner from the firm. The rate of interest on drawings should be sufficient to achieve for this purpose without being too harsh.
- PARTNERSHIP SALARIES
One or more partners may have more responsibilities or tasks than the other partners, as a reward for this the partners may have a partnership salary which is deducted before sharing the balance of profits. Salaries for partners are treated as appropriation of profits, not as a charge against profit.
Performance – related payments to partners
Partners may agree that commission or performance – related bonuses be payable to some or all of the partners linked to their individual performance. As with salaries, these would be deducted before sharing the balance of profits.
PARTNERSHIP CAPITAL AND CURRENT ACCOUNTS
In the partnership statement of financial position, net assets are financed by partners’ capital and current accounts. A current account for each partner is maintained to record a wide range of items on a continuous basis for example to charge drawings and other personal benefits of the partners and to credit salaries, interest on capital, share of profits e.t.c. Each partner’s capital account normally remains constant from year to year. These are called fixed capital accounts
Sometimes partners may wish to use fluctuating capital accounts, where the distribution of profits are credited to the capital accounts, and drawings and interest on drawings are debited to the capital accounts. In this case the balance on the capital account does not remain the same from year to year.
PREPARING FINAL ACCOUNTS FOR PARTNERSHIPS
Income statement and the statement of financial position for partnership
- Income Statement
If sales, inventory and expenses of a partnership are the same as those of a sale trade, then the income statement would be identical with that prepared for the sole trader, however a partnership would have an extra section at the end of the income section known as the profit and loss appropriation account. This is where the distribution of profit among partners is shown.
- Statement of financial position
The statement of financial position for a partnership is similar to that of a sole trader with the only difference being on the capital part which is split between capital account and current account for different partners.
10 GOOD WILL
Good will is an intangible asset, which exist if the business was purchased and the amount paid was greater than the value of the net asset in most cases good will represents the value of the reputation of the business at the time it was purchased.
Purchased Good Will = Total prince less value of net identifiable assets.
Reasons for payment of good will
Purchased good will may exist for a business as a result of the following factors:
- If the business has a large number of regular customers who will continue to deal with the real owner.
- If the business has a good reputation.
- If the business has experienced and reliable employee’s.
- If the business is situated in a good location.
- If the business has good contacts with suppliers.
Methods of calculating goodwill
When an agreement has been made between the buyer and the seller concerning how much is to be paid for a business the amount by which the agreed price exceeds the value of the net assets represents the goodwill. Various methods are used to help the buyer and the seller to come up with an agreed figure for a business. The calculations give the buyer and the seller a figure with which to begin discussions of the value of the business.
SUMMARY OF THE CHAPTER
This chapter tackled accounting aspects of other forms of business, namely partnership accounts and manufacturing accounts. Characteristics of partnerships, current and capital accounts, and how the profits are shared were explained. Accounting for goodwill was also introduced