Businesses that are run by more than one owners are call partnership. Partnership account is a very hard topic, it is probably way harder than manufacturing account but I will try my very best to point out what you should be aware of and what are some of the usual mistakes that you will probably made!
Why is partnership account harder than sole-proprietorship account? The answer is because there are too many topics too be covered (and so many things to remember!) along in partnership and it will therefore easily messed up someone mind! So what are the special topics? In partnership, there exist a capital account (which is also in sole-proprietorship account) and a current account (which is not in sole-proprietorship account), calculation of goodwill (when a partner resigned or additional partner is admitted) and partnership dissolution (occurs when the business wants to cease (or stop) trading). In A level, this will probably be mind-blowing. 🙂
So as an introduction to this partnership account, you first need to know what is the advantages of having a partnership! (You could be tested with this kind of questions during exam.)
1) The ability to obtain more capital from various partners. Imagine you and your friends setting up a small business, pooling every friends cash (known as capital) will give you more money!
2) Contribution of skills, knowledge and experiences to the business by different partners. This is rather important because one person could be more knowledgeable in certain skills, say some partner is good with cooking, some is good with counting money (yeah, useless skills, maybe he/she is good with mathematics?) and some is good with communicating and even managing business.
I didn’t point out the need to memorize disadvantages but that doesn’t mean you need not to read it but I would say it has rarely been asked. But I will point it out anyway, 1) the liability of the business is still unlimited and that the partners are jointly responsible for all debts and 2) there is more room for disagreement between partners.
Let me re-explain the first point, if you invest $10,000 in a business, but your business went bankrupt with a debt of $12,000, you will have to pay the $12,000 regardless of how much you have originally invested. With partnership, lets say you invested the same amount of $10,000, and your 3 partners invested $10,000 each too, so you have a total of $40,000. Say the business suffers from major loss and the business is in a debt of $50,000, if one of your partners cannot afford to pay a total of $12,500, you and the other partner will have to pay out $16,667 each regardless of how much you have initially invested and regardless of whether every partner(s) could pay the debts or not.
SO, what is different in partnership account?
Well, there will be profit sharing ratio (which is also a loss sharing ratio). This is definitely easy. Let’s start with an example of profit sharing ratio of 3:2:1 between Allen, Ben and Catty and the net profit is $30,000.
Other than Profit Sharing Ratio, you will also have interest on capitals. This works quite similar to the money you put in bank and received a % as interest. Interest on capital is decided by the partners itself and will be stated in the partnership agreements. The purpose of interest on capital is to motivate partners to invest more money to the business. To calculate interest on capital, simply used the formula below:
Interest on Capital = Contributed Capital x Interest Rate on Capital
If Allen has been contributing $10,000 into the business then his Interest on Capital will be $1,000 (i.e. $10,000 x 10%).
In partnership, you will also see Interest on Drawing. It works similarly with interest on capitals just that the purpose is to deter partners from drawing excessively. In order to stop your partner from taking cash from your business (i.e. drawing), interest on drawing is set up in partnership. The more you draw, the more you pay.
Interest on Drawing = Cash Withdraw x Interest Rate on Drawings
So say if Allen withdraw $1,000 and Ben withdraw $4,000 throughout the year, the interest on drawing (at 10%) will be:
Allen = $1,000 x 10% = $100
Ben = $4,000 x 10% = $400
As you can see from the above calculation, the more you withdraw, you will actually need to pay more in the interest.
How about salaries to partners? Occasionally, partners will be paid fixed salaries when they have direct involvement in the day-to-day operations of their business (and this is just as simple as it is.)
Now, putting everything back to perspective and this is what you will have to do during exam (to link what you have learned above into showing them in a partnership account!) The example below does not linked to the values as calculated above.
Note 1: Why add interest on drawing?
You just have to assume that cash is going in to the business (partners pay cash into the business). At such this is interest received and interest received is a gain to the company!
Note 2: Why subtract interest on capitals?
You just have to assume that cash is going out to the business (business pay cash to the partners). At such this is interest paid and interest paid is an expenses to the company!
This post is consider finished but might be review in the future.
2 thoughts on “Introduction to Partnership Account”
Interest on capital and drawings
Tom nd John are partnership sharing profits equally..Provision exists in the partnership agreement gor charging interest on capital at the rate of 4% per annum and interest on drawings at 6% p.a. Capital and account balance are:
Tom capital $36 000
John capital $26 400
Tom drawings $12 000
John drawings $9 600
Prepare journal entries account for interest on capital and drawing.
Please i am confused her me with this.
Provision for Capital for Tom will be $1440 and whilst for John will be $1056. This is an incentive from business to reward how much you have invested to the business, the more you invest, the more return you earned. Since the business is paying out, it’s an expense to the business (debit entry).
Profit & Loss Appropriation Account 2496
Tom’s Current Account 1440
John’s Current Account 1056
Provision for Interest on Drawing for Tom will be $720 and whilst for John will be $576. Interest drawing is what both Tom and John will have to pay to the business (it’s a form of penalty for business owner(s) to withdraw lesser from the business). Since you are paying to the business, it’s an income to the business (credit entry).
Tom’s Current Account 720
John’s Current Account 576
Profit & Loss Appropriation Account 1296
If no current account is supposed to be opened, you can replaced the “Current Account” above to “Capital Account”.
Hope this helps.