Partnerships

1 Introduction

A sole trader is when a person sets up an unincorporated business himself or herself. The sole trader is responsible for introducing proprietor’s capital and can enjoy all of the profits and can withdraw money from the business (drawings). There is a single capital account showing how much the trader is owed by the business.

By contrast, a partnership is where several people trade together with a view to making profits. All the partners can introduce capital and they will have a share of the profits. Each will have their own capital account and can make their own drawings.

2 Definition

A partnership is when two or more people carry on a business in common with a view to making profits.

The personal liability of the partners in most partnerships is unlimited, though some countries do have legislation permitting limited partnerships. In general all of the partners participate in the management of the business.

No formal agreement is needed to form a partnership. Simply by carrying on a business together two people can find themselves regarded as partners by the operation of the law.

3 Capital and current accounts

Each partner will have a capital account and often a current account. These accounts keep track of how much capital a partner has introduced, earned or withdrawn from the business. There is no fundamental difference between capital and current accounts: both record partners’ capital. However, amounts in the capital account tend to be relatively stable and constant whilst amounts in the current account are liable to be more volatile. The current accounts will usually contain the partners’ share of profits and any drawings that have been made.

Note that these entries are in principle no different from those of a sole trader. Profits increase capital, drawings decrease capital, introducing more capital obviously increases capital

Remember also that the current accounts are simply subsidiary capital accounts

4 Profit shares

The partners are the owners of the business. Any money they receive from the business is a share of profits. Sometimes sole traders and partners will refer to themselves as receiving a salary or a wage but this only means a regular withdrawal of profits to live on. These amounts are not expenses of the business because sole traders and partners are not employees. They are drawings and are simply one way in which profits can be appropriated.

Remember also that profits and drawings are not linked. Profits can be made, yet no drawings need be made and all profits can be left in the business. Alternatively, drawings can be made even if no profits are made. This will reduce the capital of the business.

Partnership profits can be appropriated in four ways:

1. Partners can be entitled to salaries (remember, not real salaries)
   

2. Partners can be entitled to interest on their capital (again, this is not a real interest expense, it is simply part of the appropriation formula)
   

3. Partners can be charged interest on their drawings (this is added back to the profit available for sharing — see below)
   

4. Profits left after (1) to (3) above are then shared out in an agreed profit sharing ratio.
   

If there is a partnership agreement, the salaries, interest and profit sharing ratios will be stipulated there.

If there is no partnership agreement and the partners have just drifted into a partnership then there will be no salaries, no interest on capital, and profits or losses will be shared equally.

5 Interest on drawings

The fourth appropriation runs the other way. A partnership agreement will often charge the partners interest on what they draw out, to discourage them from taking money early and to be fair to the partner who leaves his or her share in the business.

Interest on drawings is not an expense of the business. Like the other appropriations it is part of dividing up the profit - but it is a DEBIT to the partner and is added BACK to the profit available for sharing. Get that direction right and the arithmetic looks after itself:

• Dr Partner's current account with the interest charged on his or her drawings;

• Cr the appropriation of profit, increasing the amount left to share in the profit sharing ratio.

Illustration. A and B share profits equally after salaries of $10,000 each. Profit for the year is $46,000. A drew $24,000 and B drew $12,000, and the agreement charges interest on drawings at 5%.

A is charged more interest because A drew more, so A ends up with less than B even though their salaries and profit shares are identical - which is exactly what the clause is for. Check: 22,700 + 23,300 = 46,000, the profit you started with.

6 What a partnership agreement is for, and what it contains

A partnership can exist without a written agreement, but relying on the default rules is risky: no salaries, no interest on capital, no interest on drawings, and profits and losses shared equally however unequal the partners' contributions are. The purpose of an agreement is to replace those defaults with terms the partners have actually chosen, and to settle in advance the things partners fall out about.

A partnership agreement will normally deal with:

• how much capital each partner contributes, and whether any part of it may be withdrawn;

• partners' salaries, and the rate of interest on capital;

• the rate of interest charged on drawings, and any limit on drawings;

• the profit sharing ratio, and whether losses are shared in the same ratio;

• the duties and hours each partner is expected to give to the business, and any restriction on competing with it;

• how a new partner is admitted, how goodwill is to be valued and dealt with, and what happens on the retirement or death of a partner;

• how the accounts are to be prepared and audited, and how disputes are to be settled.

Note that the profit appropriation formula (salary, interest and profit sharing ratio) is followed even if a loss has been made, or there are not enough profits to cover the salaries and interest.

7 Loan interest

Occasionally a partner will make a loan to a partnership in addition to investing capital.

Such loans will usually earn interest, but that interest is an expense of the business and will have to be deducted from profits before they are appropriated to the partners. All that’s happened is that the business has borrowed from a partner rather than borrowing from a bank. Bank interest would be an expense, so interest paid on loans from partners is an expense.

Note carefully the two types of interest and their treatment:

Interest on partners’ capital:   not an expense and not deducted from profits. This is part of the appropriation of profits.

Interest on loans from partners:   an expense of the business that has to be deducted to find the profits. Then appropriation can begin.

8 Admission of a new partner

When a new partner is admitted to a partnership, that person gets immediate access to the profit earning ability of the partnership. Assuming the partnership is successful, that profit earning ability will be much greater than would be found in a new business starting from scratch.

This is because a successful and established business will have a reputation, knowhow, a customer list and loyal customers. Collectively these qualities give rise to goodwill.

When the new partner is admitted, the old partners are essentially sharing some of this goodwill with the new partner: they are giving up some of that goodwill to the new partner. It is only fair that the new partner should pay for access to goodwill and the benefits it brings, and that the old partners should be compensated for giving some of it up to the new partner. A goodwill adjustment is therefore needed.

You do not have to calculate the value of the goodwill. In practice this is a matter for negotiation between the people involved. Because the value of goodwill is therefore arbitrary, it is usually not left in the books and will not appear as an asset in the statement of financial position.

The adjustment needed can be thought of as being in two parts:

1. Establish the goodwill belonging to the old partners. This is done by:
   

   Dr   Goodwill to the goodwill account
   

     Cr   Goodwill to the old partners’ capital accounts in their old profit sharing ratio
   

2. Admit the new partner then write-off the goodwill in the new profit sharing ratio
   

   Dr   Goodwill to the new partners’ capital accounts in their new profit sharing ratio
   

     Cr   Goodwill to the goodwill account
   

   The goodwill account can be ignored here and the two journal entries merged to give:
   

   Cr   Goodwill to the old partners’ capital accounts in their old profit sharing ratio
   

   Dr   Goodwill to the new partners’ capital accounts in their new profit sharing ratio
   

   Remember: credit in the old; debit in the new

The net effects of these adjustments are:

Partner A

Capital net increased by $4,000 ($64,000 - $60,000).

Partner A had enjoyed profit benefits arising from 2/5 of the goodwill and now enjoys only 3/8. This is a decrease of 16/40 – 15/40 = 1/40^th.

The $4,000 net credit is equivalent to 1/40 x $160,000. The adjustment therefore compensates A for giving up part of the benefit arising from goodwill.

Partner B

Capital net increased by $16,000 ($96,000 - $80,000).

Partner B had enjoyed profit benefits arising from 3/5 of the goodwill and now enjoys only 4/8. This is a decrease of 6/10 – 5/10 = 1/10^th.

The $16,000 net credit is equivalent to 1/10 x $160,000. The adjustment therefore compensates B for giving up part of the benefit arising from goodwill.

Partner C

Capital has been charged with $20,000.

Partner C now enjoys access to profits arising from 1/8 of the goodwill and this is worth $160,000/8 = $20,000. So C has been charged for gaining access to goodwill.

9 Pro forma partnership accounts

Statement of profit or loss

Statement of financial position

10 Preparing the partners' accounts and the financial statements

The pro formas above are all Xs, so work one through with figures. Take the partnership in the interest on drawings illustration - A and B, profit $46,000, salaries $10,000 each, interest on drawings at 5%, residual profit shared equally. Add that their capital accounts stand at $60,000 (A) and $40,000 (B), that their current accounts were $3,400 credit (A) and $1,900 credit (B) at the start of the year, and that drawings were $24,000 (A) and $12,000 (B).

The capital accounts are unchanged - no capital was introduced or withdrawn:

The current accounts collect everything that changes year by year - the appropriations on the credit side, the drawings and the interest on drawings on the debit side:

A has drawn almost everything he was appropriated and has $2,100 left in the business; B has drawn far less and has $13,200. Both balances are credits - amounts the business owes the partners.

The appropriation, set out under the statement of profit or loss, is the table from the interest on drawings illustration above. The capital section of the statement of financial position is then:

Two points the examiner looks for. A DEBIT balance on a current account - a partner who has drawn more than he was appropriated - is shown as a deduction from the partners' funds, not as an asset. And a loan from a partner is never shown here: it sits with the liabilities, and the interest on it is an expense before the profit is appropriated, which is the distinction made earlier in this chapter.