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 learning outcomes in Section H of the detailed Study Guide for FA2.
There are a number of ways in which a partnership may be defined, but there are four key elements.
Two or more individuals
A partnership includes at least two individuals (partners). In certain jurisdictions, there may be an upper limit to the number of partners but, as that is a legal point, it is not part of the FA2 syllabus.
Business arrangement
A partnership exists to carry on a business.
Profit motive
As it is a business, the partners seek to generate a profit.
Unincorporated business entity
In FA2, a partnership will always be an unincorporated business entity. This means:
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
This is the amount of profit available to be shared between the partners in the profit or loss sharing ratio, after all other appropriations have been made. The profit or loss sharing ratio is sometimes simply called the ‘profit sharing ratio’ or ‘PSR’.
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
As there is no requirement for all of the appropriations considered below to be included by a specific partnership, exam questions may only include some of them. That means that you only need to deal with the appropriations referred to in the question.
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
In some ways, the term ‘salaries’ is a misleading description. The salaries of employees are business expenses that are written off to the statement of profit or loss, thereby reducing profit for the year. However, as partners are the owners of the business, any amounts that are paid to them under the partnership agreement are part of their share of the profit. As the amount is guaranteed, it must be dealt with through a credit entry in the partner’s account (usually the current account) before the residual profit is shared.
The double entry is completed by a debit entry in the appropriation account.
Interest on capital
Almost always, interest on capital will be paid on partners’ capital balances only – although the balances on the current accounts are actually part of the total capital balance, it is normal to exclude them from the value of capital on which interest is paid.
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 or 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
Charging interest on drawings is a means of discouraging partners from withdrawing excessive amounts from the business. From this, it follows that interest on drawings is a debit entry in the partners’ current accounts and a credit entry in the appropriation account.
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.
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 or loss, less drawings.
Remember that a partner’s drawings will be a debit entry in the partner’s current account.
When a new partner is admitted to the partnership, the new partner effectively buys the assets of the old partnership from the old partners.
The admission of a new partner will also mean that the profit or loss sharing ratio will change.
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 or loss sharing ratio.
If goodwill is to be retained in the partnership and therefore continue to be recognised as an asset in the partnership accounts, then no further entries are required.
If goodwill is not to be retained in the partnership, 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 or 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.
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
Based on the information provided, complete the following tasks:
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:
| Capital | Current | |
|---|---|---|
| Amit | $120,000 Cr | £15,655 Cr |
| Burton | $80,000 Cr | $4,137 Dr |
During the year, Amit’s drawings were $18,000 and Burton’s drawings were $31,000.
Solution
The closing balances are thus:
Amit – $38,443 Cr
Burton – $10,465 Dr
(ii) – Change in partnership
Andrew and Binta have been in partnership, sharing profits or losses in the ratio 4:3. They agreed to admit Chen to the partnership, with profits or losses being shared between Andrew, Binta and Chen in the ratio 3:2:1. On the date of the change in partnership, the partners’ capital and current account balances were:
| Capital | Current | |
|---|---|---|
| Andrew | $60,000 Cr | £12,800 Cr |
| Binta | $40,000 Cr | $9,500 Cr |
It was agreed that, at the date of Chen’s admission, the goodwill in the partnership was valued at $42,000.
Step 1 – Recognise goodwill asset
The goodwill account is created by a debit entry of $42,000.
This value is credited to the old partners in the old profit or loss sharing ratio – ie 4/7 (or $24,000) to Andrew and 3/7 (or $18,000) to Binta.
Thus, the new capital balances are:
| Andrew | $84,000 Cr | ($60,000 Cr and $24,000 Cr) |
| Binta | $58,000 Cr | ($40,000 Cr and $18,000 Cr) |
If goodwill is to continue being recognised in the partnership accounts, no further entries are needed in relation to goodwill, as the only change is that a new asset of goodwill has been created, and the capital balances of the old partners have increased by the same value.
Step 2 – Eliminate goodwill (if required by question)
If goodwill is not recognised going forward, it is eliminated by a credit entry in the goodwill account, and debit entries in the partners’ capital accounts, based in the new profit or loss sharing ratio:
| Andrew | $21,000 | ($42,000 x 3/6) |
| Binta | $14,000 | ($42,000 x 2/6) |
| Chen | $7,000 | ($42,000 x 1/6) |
As a result, the new capital balances are:
| Andrew | $63,000 Cr | ($84,000 Cr and $21,000 Dr) |
| Binta | $44,000 Cr | ($58,000 Cr and 14,000 Dr) |
| Chen | $7,000 Dr | (share of goodwill eliminated) |
Step 3 – Contribution of capital by new partner (if required by question)
If the question requires a contribution by any of the partners (or a repayment of capital) we simply need to follow the normal principles of double-entry bookkeeping.
For example, the question may require the new partner to contribute cash so that the opening capital balance is nil.
In this case, a credit of $7,000 would be needed in Chen’s capital account, so this is the amount of cash that must be contributed.
The entries will therefore be:
Debit Bank $7,000
Credit Capital – Chen $7,000
Table 1 – Summary of journal entries
| Profit for the year | Dr Statement of profit or loss Cr Appropriation account |
| Partners’ salaries | Dr Appropriation account Cr Partners’ current accounts |
| Interest on capital | Dr Appropriation account Cr Partners’ current accounts |
| Interest on drawings | Dr Partners’ current accounts Cr Appropriation account |
| Residual profit | if profit for the year is greater than total of appropriations: |
| Dr Appropriation account Cr Partners’ current accounts |
|
| if total of appropriations is greater than profit for the year: | |
| Dr Partners’ current accounts Cr Appropriation account |
|
| Interest on loan from partner | Dr Statement of profit or loss Cr Bank account*/Accrued expenses** |
| Loan made by partner | Dr Bank account†/Capital account‡ Cr Loan payable |
* if the interest has been paid to the partner
** if the interest remains unpaid
† if funds were deposited in the partnership bank account
‡ if capital was converted into a loan
Written by a member of the FA2 examining team