Partnership
PARTNERSHIP
Partnership is an agreement between 2 to 20 people who join together with an intention of sharing, profits and bearing losses. When the partnership is formed, a partnership agreement is made in which it is decided how much will be the interest of capital, interest on drawings, salary to partners, bonus or commissions and whether any partners will be a dormant partner or not. And if the partner has provided loan and its interest conditions.
Advantages of partnership are that it is easy to form and requires low start up cost, relatively higher capital with greater loan taking ability, business affairs are kept private and flexible legal structure.
Disadvantages are that liability of partners is unlimited, partners are liable for actions of their partners and their debts, mismanagement, dissolution or a partner leaving is costly.
In the absence of partnership agreement, partnership Act 1890 will come under consideration and the contents of Partnership Act 1890 are:
1. No interest on capital.
2. No interest on drawings.
3. No salary to partners.
4. No bonus to partners.
5. No commissions to partner.
6. No partner to be treated as dormant partner.
7. Interest on loan by the partner at the rate of 5%.
8. Residual profits to be distributed amongst partners equally.
Interest on Capital:
It is given to the partner as an incentive to invest more into partnership. Usually this interest rate is equal to the market rate of interest so as to attract the partners so that by joining the partnership not only will they earn the normal interest, but they will also reap benefits of partnership.
Interest on Drawings:
It is charged to the partners as a restriction to withdraw unnecessarily, otherwise the partners will withdraw huge amounts causing liquidity crisis of partnership.
Salary to Partners:
It is given to the partners against services provided by them.
Bonus/Commissions:
It is given against their performance or the performance of the business.
Interest on Loan by the Partners:
When the partners provide loans to the partnership, they are not considered to be the partner for the amount of loan. Instead, they are liability of the partnership and hence interest on loan is not the distribution of profit, it is an expense of the business.
Residual Profit:
Once the profits are distributed in the forms of interest, salary, bonus, commission. The remaining profits are residual profits which are to be distributed amongst the partners in their predetermined rates decided in the partnership agreement.
Dormant Partner:
It is also known as “Sleeping Partners”, such a partner is not actively involved in the running of the partnership, but it is not part of the decision making process. Since the dormant partner is not actively involved, his liability is limited.
Limited Liability:
It means that in case of bankruptcy or insolvency, the maximum amount that can be snatched from a partner is his investment. His personal belongings would not be affected.
In a partnership all partners cannot be sleeping partners there has to be at least one active partner, who will be responsible of running the business. The liability of the active partner is unlimited. Unlimited liability means that in case of bankruptcy of insolvency, the personal belongings of the partner would be at stake.
Accounting treatment of partnership involves the preparation of:
• Income statement
• Profit and loss Appropriation account
• Partners’ Current account
• Partners’ Capital account
• Statement of Financial Position
Income Statement:
Made as normally like any other business, the only thing to be taken into consideration is interest on loan by the partner will be treated as expense and hence it is not the distribution of profit.
Profit and Loss Appropriation Account:
It shows the distribution of profit amongst the partners in the form of salary, bonus and commission. It also identifies the distribution of residual profit and how it is distributed amongst the partners.
Current Account:
It is also known as fluctuating capital Account and shows movement in capital account of distribution of profits and drawings. The current account can have both a debit and credit balance. If the distribution of profit is more than drawings the current account will have a credit balance, where as if the drawings are more than the distribution of profits than current account will have debit balance. Credit balance in the current account – the +ve balance and -ve balance in the current account is debit balance.
Partners Capital Account:
It is also known as fixed capital account because it usually does not change. And the changes in the capital account only occurs:
1. When partner introduces additional capital
2. When no separate current accounts are made (in this case all entries regarding current account pass through the capital account)
3. When there is a partnership change (in case of a partnership change, we have to prepare and adjust goodwill accounts and revaluation accounts into capital account)
Statement of Financial Position:
Made as normally except for the financial by the section in which we have to take into consideration the closing capital and current account balances. Moreover, if there’s any goodwill maintained in the books it has to be incorporated in the statement of financial position as intangible non-current assets.
Goodwill:
It is the good reputation of the business an is an intangible non-current asset. Formula to calculate goodwill is:
Goodwill = Purchase price – fair value of net asset acquired |
Goodwill is recorded amongst old partners in their old profit and loss sharing ratio and the double entries to record goodwill are:
Good will DR
Partners’ Capital Account CR
A
B
C (Amongst old partner’s in their old profit and loss sharing ratio)
Once goodwill is recorded it can either be maintained in the books or will be written off. If the goodwill is maintained it is shown on the face of Statement of Financial Position as Intangible Non-Current asset and is treated just like any other non-current asset. If goodwill is maintained, then each year we need to check whether the value of goodwill has decreased or not. Decrease in the value of goodwill is called loss in the value of goodwill and loss in the value of goodwill occurs because of two reasons:
1. Impairment
2. Amortization
Impairment is the drastic fall in value of goodwill because of an unforeseen event. Amortization is a slow and gradual fall in the value of goodwill just like depreciation. Whatever the reason is for fall in goodwill, it is an expense for the business and the double entries to record for loss in the value of goodwill are:
Income Statement DR – Expense
Goodwill CR – Asset is losing its value
If goodwill is not maintained in the books, then it is immediately written off and it is also termed as goodwill not recorded, goodwill is not to be kept in the books or goodwill is written off. Goodwill is written off amongst the new partners in their new profit loss sharing ratio and the double entry to write off goodwill are:
Partners’ capital Account DR
A
B
C
Goodwill CR (Amongst new partner’s in their old profit and loss sharing ratio)
PARTNER’S CURRENT ACCOUNT
CAPITAL ACCOUNT
If interest on loan is already paid to the partner, then it will not be part of current account. If it is not yet paid, then it will only be part of Partner’s Current account but will not be part of Accruals in Current Liabilities. Whatever the situation is, it will always be part of expense in Income Statement.
MANUFACTURING ACCOUNTS
Some organizations do not indulge into trading activities instead they manufacture goods in order to sell them. The obvious reason to indulge into manufacturing activities is to earn higher profits but other reasons for manufacturing goods other than buying it from an outside vendor are:
• To ensure good quality product
• To maintain the brand image
• The products are not easily available in the market
• To reduce dependence on the supplier
• If the business has better manufacturing skills than trading skills
• To introduce the product or service not available in the market
• Availability of raw material
• Learning by doing – economies of scale
• Diversification
When the business indulges into manufacturing activities, it has to access its cost structure. The cost structure of any business is as follows:
Total Cost and Variable Cost are always parallel.
Vertical distance between Total Cost and Variable Cost is Fixed Cost.
When output is Output, Total Cost and Fixed Cost.
The accounting treatment of questions involving maufacturing business compromise of preparation of:
1. Preparation of manufacturing account
2. Income statement
3. Statement of financial service
MANUFACTURING ACCOUNTS FOR THE YEAR ENDED …
INCOME STATEMENT:
In manufacturing business is made as normally. It is very important that we only take into consideration those expenses that are not related to manufacturing.
STATEMENT OF FINANCIAL POSITION:
Statement of financial position is made as normally except that the inventory in current assets will compromise of all 3 inventories i.e. (inventory of Raw material, inventory of work in progress and inventory of finished goods. If inventory of finished goods is given at transfer price, closing provision of unrealized profit will be deducted from it.
EXAMPLE: The following information is provided by Kane Manufacturing Company on 30 April 2006.
Prepare a manufacturing account (30 April 2006)
The following information was provided by the company on 30 April 2006
Prepare a manufacturing account (30 April 2006)
The business makes one identical product. The production cost of goods completed during the year ended 30 April 2006, was $475,000. 20,000 articles were completed. Calculate unit cost.
Unit cost = Production cost of goods completed/ number of units produced= 475000/20000 = $23.75 |
The following information was provided at 30 April 2006.
Prepare a trading account section of the income statement of Kane Manufacturing Company (30 April 2006)
On 30 April 2006 the Kane Manufacturing Company had inventories valued as follows:
Prepare a relevant extract from the balance sheet of Kane Manufacturing Company.
NON-PROFIT ORGANIZATION
Some organizations come into business, not to make profits but to serve people, such organizations are referred to as Non- Profit organizations and are usually clubs. Since there is no profit motive hence there are no owners thus there is no capital or drawings. Such organizations are financed by accumulating funds from members in order to run the club or non profit organization. Furthermore, such organizations do not have a profit and loss account instead they have Income and Expenditure Account with the help of which it is identified whether the business has surplus of income over expenditure or deficit of income over expenditure. The major source of income of the club are member subscription. Even if the club involves into commercial activities or Trading activities the intention is still not to make profits but to facilitate the members. The accounting treatment of questions involving non-profit organization comprise of preparation of the following:1. Accumulated funds account.
It is an alternative for Capital Account and is prepared by deducting opening liabilities from opening assets. It is made as follows:
2. Receipts and Payments account:
It is an alternative for bank account when cash comes into the business it is recorded as receipts when cash goes out of the business it is recorded as payments. Like Bank account receipts and payment accounts can have both a debit or credit balance, where debit balance is an asset and credit balance are a liability.
Most clubs only prepare receipts and payment account and consider it sufficient to be presented to the members, but this is not an appropriate method and incomplete information is being provided to the members as there are many expenses and incomes that are either noncash, accrued or prepaid. Receipts and payment account are made as follows:
3. Subscription Account
It is the major source of income for the club they are monthly or annual contributions made by the members to run the club. Subscriptions can either be paid in advance or can be accrued.
Arrears:
They are the subscription earned but yet not received by the non-profit organization. These are current assets for the non-profit organization.
Advance:
These are the subscription received but yet not earned by the non-profit organization and hence they are current liabilities for the business.
Bad Debts:
If a member fails to pay back his due subscription then he will consider to be bad debts which will be treated as an expense by the nonprofit organization.
NOTE: when making the subscription account we will consider all amounts of subscription received during the year as receipt of subscription despite the fact which ever year it belongs to:
Subscription Account is made as follows:
4. TRADING ACCOUNT
Some clubs or nonprofit organizations indulge into trading activities but the motive behind those trading activities is not to make profits but to serve. And sometimes they are purposely run at a loss so that members could take benefit of the facility. When making trading account we only take into consideration those expenses that are directly associated to trading. Other expenses of the club are not part of the trading account. It is made as follows:
5. ADJUSTMENT OF EXPENSES & REVENUES:
If expenses have prepayments or accruals and revenues have advanced or accruals then we need to adjust expenses and revenues then they need to be adjusted with the help of PAAP and APPA. And they are made as follows:
The depreciation needs to be adjusted even if it is not written in the question. In order to do so we need to apply the revaluation method of depreciation as follows:
6. PREPARATION OF INCOME AND EXPENDITURE ACCOUNT:
In a nonprofit organization, income and expenditure account is made instead of Profit and Loss account as there is no profit motive, no profit and loss account are needed. Income and expenditure account help in identifying how much income is generated and through what sources and how much expenses are made and by what means. If incomes are more than expenses, we generate surplus of income over expenditure whereas, if expenses are more than income, we have deficit of income over expenditure. Income and expenditure account are made as:
7. STATEMENT OF FINANCIAL POSITION
It is made as normally except for the Equity and Liability Section includes some capital receipts such as gifts, donation and legacy for a specific purpose, life subscription and so on.
Loan to a member is treated as an asset whereas loan from members is treated as a liability. If the club has made some investment it will be treated as an asset which will neither be treated as current nor non-current and hence will be recorded in between non-current and current asset.
TREATMENT OF GIFT/ DONATION OR LEGACY
If gift, donation and legacy are without any purpose then they are revenue receipts and are part of income and expenditure account but if gift, donation or legacy are for a specific purpose then they are capital receipts and are part of Statement of Financial Position.
COMMON ERRORS MADE:
• When making accumulated funds Account students tend to forget the opening bank balance or opening receipt and payments account balance as it is usually written separately from other assets and liabilities.
• When making receipts and payments account students tend to write the opening balances as a debit balance but there is a possibility that the opening balance might be an overdraft.
• When making subscription account, students do not differentiate between life members and ordinary members. Ordinary members subscription account and life membership accounts should be made separately.
• When making trading accounts, students usually incorrectly record purchases. It must be ensured that if there are any opening and closing payables then purchase ledger accounts should be made to calculate purchases.
• When adjusting expenses and revenues, students fail to take into consideration the depreciation, if the question is silent regarding it. Instead, if nothing is mentioned regarding depreciation then we must apply revaluation method of depreciation.
• When making Income Statement & Statement of Financial Position, students do not distinguish between capital and revenue receipts specially gift, donation or legacy.
EXAMPLE:
John started a business on 1 November 2004. In the first year of transactions no accounting records were maintained. Following information was provided about the business on 1 November 2005.
Assets: premises 56,000, fixtures 19,400, motor vehicles 12,500, inventory 3,100, trade receivables 4,700, cash 200
Liabilities: trade payables 5,600, bank overdraft 2,300
Prepare an opening journal entry for John at 1 November 2005.
John’s financial year ends at 31 October. Prepare the journal entries to record the following transactions on 1 September 2006.
Purchased additional fixtures, $1300, on credit from Office Supplies
Sold the motor vehicle (cost $12,500) for $7,400 on credit to Umar Vehicles Limited.
John’s financial year ends on 31 October. Prepare journal entries to record the following.
On 30 September 2006 he wrote off $50 owing by Aaron Stores as a bad debt. At 31 October 2006 John’s ledger accounts include the following –
Purchases for the year $39,000
Bad Debts for the year $190
Insurance $1500, which includes a prepayment of $300
Inventory at 1 November 2005 $3100
On 31 October 2006
Inventory was valued at $3900
Fixtures are to be depreciated by $270
A provision for doubtful debts is to be created of $250
Johns financial year ends of 31 October.
The totals of the trial balance prepared on 31 October 2007 agreed, but the following errors were later discovered.
(a) The purchase of stationery, $30, had been debited to the purchases account.
(b) A Cheque, $500, received from K Singh had been credited to the account of H Singh.
(c) The wages account had been under cast by $100 and the purchases account had been over cast by $100.
Johns financial year ends on 31 October.
The total of the trial balance prepared on 31 October 2008 failed to agree. The difference of $260 was a shortage on the debit side. This was entered in a suspense account.
The following errors were later discovered
(a) The purchases account had been over cast by $110
(b) No entry had been made for office expenses, $20, paid in cash.
(c) Credit Sales, $630, to Anil had been correctly entered in the sales account but debited as $360 in Anil’s Account.
(d) Capital introduced by John, $5000 (paid into the bank), has been debited to the capital account and credited back to the bank account
(e) A cheque, $200, received from a debtor, Yuvi, has been correctly entered in the bank account but no other entry has been made.
(f) Sales returns, $150, have been correctly entered into the debtors account but have been credited to the purchases returns account.
Prepare the necessary journal entries to correct these errors.
Write up the suspense account in Johns Ledger.
Johns
Nominal Ledger
Suspense Account
Johns financial year ends at 31 October.
The totals of the trial balance prepared on 31 October 2008 failed to agree. The difference was entered in a suspense account and draft financial statements were prepared. The net profit was $15,000.
The following errors were later discovered.
(a) The purchases account had been overcast by $110.
(b) No entry had been made for office expenses, $20, paid in cash.
(c) Credit Sales, $630, to Anil had been correctly entered in the sales account but debited as $360 in Anil’s Account.
(d) Capital introduced by John, $5000 (paid into the bank), has been debited to the capital account and credited back to the bank account
(e) A cheque, $200, received from a debtor, Yuvi, has been correctly entered in the bank account but no other entry has been made.
(f) Sales returns, $150, have been correctly entered into the debtors account but have been credited to the purchases returns account.
Prepare a statement to show the corrected profit for the year ended 31 October 2008.
Johns
Statement of corrected profit for the year ended 31 October 2008
INCOMPLETE RECORDS
The benefit of maintaining all sets of records is that it allows the owner of the business to have all the information of assets, liabilities, revenues and expenses making it easier to create financial statements. It is very common for some businesses, mostly small ones to have an incomplete set of records which requires certain calculations to be done to create a full set of Financial Statement.
STATEMENT OF AFFAIRS:
It is not possible to prepare an income statement when the only records available are of assets and liabilities. The assets and liabilities in the statement of affairs are the same as of balance sheet. The only difference is that in the statement of affairs the asset and liability records are made without the double entry.
There are a few ways to calculate profit using limited information. When profits are made capital increases and it decreases when losses are incurred. The formula for determining profit is:
Closing Capital – Opening Capital = Profit |
The formula will require an addition if drawings were made by the owner during the financial period:
Closing Capital – Opening Capital + Drawing = Profit |
If capital has been inducted into the business the formula would be:
Closing Capital – Opening Capital + Drawing – Capital Introduced = Profit |
A capital account can also be made to determine profits over the financial period:
The 1st and 31St Dec signify first and last dates of a financial period.
Sometimes, businesses do not maintain double entry records yet are still able to provide additional details regarding assets and liabilities. Financial statements can be prepared if details of money received and paid are available.
QUESTION
Anna is a sole trader. She maintains a bank account, but not a full set of double entry records. The following information is provided.
During the year ended 30June 2005 Anna took goods costing $4000 for her own use.
On 30 June 2005 equipment should be depreciated by 10% on the cost of equipment owned at the date. On this date, it was decided to create a provision for doubtful debts of 2.5% of the trade receivables.
Prepare the income statement of Anna for the year ended 30 June 2005 and a balance sheet at 30 June 2005.
SOLUTION
Sales for the Year
The amount to be collected from debtors don’t always equal the sales, some of the money received is to settle previous financial year amounts. Money is owed at the end of the year for all the goods sold in the present financial year.
Credit sales can be calculated as follows:
The credit sales can be found by another way through total trade receivables account:
Purchases for the Year
Credit Purchases
The amount paid to creditors is not necessarily equal to the actual purchases. Some of the money paid is to settle the amount owed to the creditors for goods purchased in the previous financial year.
Credit Purchases can also be calculated through the trade payables account:
The total purchases are equal to credit purchases as there are no cash purchases.
Closing Bank Balance
The Bank balances are given and so with the help of receipts and payments closing bank balances can be calculated.
Anna
Income Statement for the year ended 30 June 2004
General Expense (19620-200-340)Provision for Doubtful Debts (2.5% * 26800)Depreciation of Equipment (10% * (22500 + 8000)) |
Anna
Balance Sheet at 30 June 2005
Depreciation to date on equipment (4500+3050)Drawings (38400 + 4000) |
Cash discounts given or received will affect the calculations for credit purchases and sales.
QUESTION
Anna is a sole trader. She maintains a bank account, but not a full set of double entry records. Following information is provided.
Receipts from Debtors $331,600 after deduction of 8200 cash discounts.
Payments to creditors $249,400 after deduction of $6780 cash discounts.
Calculate credit sales and credit purchases for the year ended at 30 June 2005.
Sales and purchases amounts would show up in trading accounts in income statement.
Discount allowed and received would show up in profit and loss account in income statement.
Rate of Inventory Turnover
This is the number of times a business buys/ reorders or replaces its inventory in a given period of time.
Cost of Sales/ Average Inventory |
MARGIN, MARK UP AND INVENTORY TURNOVER
Margin and Mark up are a measure of gross profit as a percentage.
Margin = Gross Profit/Sales * 100Mark up = Gross Profit/ Cost of Sales * 100 |
EXAMPLE:
The financial year for Nemo Traders end at 30 November. The following information is provided
The markup is at a standard rate of 25%.
Calculate by means of a trading account section of an income statement, the purchases for the year ended 30 November 2003.
SOLUTION
Mark up is 25%. Selling Price is 125%. The gross profit is therefore 25/125. 20% of $72,000. The gross profit is 14,400. Cost is therefore, 57,600. Cost of Sales added with opening inventory was 62,800 and so purchases accounted for 58,200.
REVALUATION AND REALISATION:
At the time of partnership change, all assets and liabilities must be revalued so that each partner could be aware of the new worth of the business.UPWARDS REVALUATION OF THE ASSET:
If the asset increases over and above its net book value it is called upward revaluation of asset and the double entries to record upward revaluation of asset are:Asset DR Revaluation CRExample: Inventory increases from 1200 to 1500
Inventory 300 Revaluation 300
If the asset that which is being revalued has appropriation attached to it, we will first write off depreciation then revalue the asset and hence double entries to record revaluation will be:
Depreciation DRAsset DR Revaluation CR
Revalued to 90,000
Depreciation DR 30,000
Asset DR 10,000
Revaluation CR 40,000
Revaluation to 75,000
Depreciation DR 30,000
Asset CR 5,000
Revaluation CR 25,000
Revalued to 80,000
Depreciation DR 30,000
Revaluation CR 30,000
Revalued to 50,000
Depreciation DR 30,000
Asset CR 30,000
Revalued by 60,000
Depreciation DR 30,000
Asset DR 30,000
Revaluation CR 60,000
DOWNWARD REVALUATION OF ASSET:
If the value of asset falls below its Net Book Value, it is called downward revaluation of assets and hence the double entries to record downward revaluation of assets are:
Revaluation DR
Asset CR
Example: Receivables 35,000 revalued to 30,000
Revaluation DR 5,000
Receivables CR 5,000
If the asset which is being revalued, has depreciation attached to it than it is referred to as double entries to record depreciation will be:
Depreciation DR
Revaluation DR
Asset CR
Example:
Revalued to 25,000
Depreciation DR 30,000
Revaluation DR 25,000
Asset CR 55,000
Sam and Vick are in Partnership. The following balances were extracted from the books of the partnership on 31 October 2015:
The following additional information is also available:
1) Stock at 31 October 2015 was valued at $16,300
2) The rent and insurance account include an insurance premium of $800 for the twelve months to 31 January 2016.
3) Bad Debts of $400 are to be written off.
4) The provision for Doubtful Debts is to be adjusted to 5% of the outstanding debtors’ balance at 31 October 2015.
5) Equipment and Fittings are to be depreciated by 10%
6) The bank statement was received on 3 November 2015. It includes an entry of $200 for bank charges. This matter has not been dealt with in the partnership’s books.
7) The partnership agreement provides that:
a) Interest is to be allowed on partners fixed capital at the rate of 10% per annum.
b) Vick is to be credited with an annual salary of $5,000.
c) The remaining profit is to be shared between Sam and Vick in the ratio 3:2 respectively.
SOLUTION
W1: Closing inventory 16,300
W2: Rent and insurance 5400-(800) =4600
800/12 x 3 =200 – Prepayments
4600+600 =5200
W3: Bad Debts- 400
Receivables: 16,400 – (400) =16000
W4: 16,000 x 5% = 800 – (900) = (100) – Income statement
W5: equipment and fitting =11,000 x 10% = 1,100
W6: 200 – Bank charges
7,400-200=7,200
Statement of Financial Position as at 31 October 2015
EQUITY AND LIABILITIES
