Partnership account – accountingexplained

Partnership Dissolution

This will be the last sub-topic for partnership account and will be relevant to GCSE ‘A’ Level.

You will need to be able to realise that any profit or loss on dissolution should be shared by all the partners in their profit and sharing ratios. If there are circumstances where the partner’s final balance on his capital and current accounts is in deficit, the partner will have to pay that amount into the partnership bank account.

When dissolving the business, you will need to get rid of the assets by either 1) disposing it or 2) the partner(s) to take it. All these entries will need to be made into realisation account.

realisation-account

Net realisable amount is the amount that you will receive in disposing assets. You will need to use this amount because it will be the actual amount that the business will receive.

Do not forget about dissolution costs! You must include them in the realisation account (debit) and bank account (credit).

T-accounts for disposing the assets are only recommended if the question asks you to do so! Otherwise, there is no need to do so! Here is an example of how to do it.

disposing-assets-in-dissolution-of-partnership

Next, you will need to open up capital account for each partner. This is to calculate how much each partner will receive or pay the business as a result of the dissolution. Remember that all partners have unlimited liability, if the business runs out of cash in dissolving the business, all the partners will have to settle the additional liabilities from their own pockets.

Here is the format for capital account.

partner-capital-account-in-dissolution-of-partnership

Finally, you will need to open a bank account. Bank account will be your last step in dissolution because there are no more extra calculations required, you only need to put all the numbers in the right places. It therefore act as your check if you have done everything correctly.

bank-account-in-dissolution-of-partnership

Things to note in order to score well,

You must include dissolution costs.
You must be able to remember all the formats (including the bank account).
Remember to use only net book value in the debit side and net realisable amount in the realisation account.
Do remember to include asset taken by partner into their respective capital account.
You must pay your creditors from your bank account.

Treatment of Goodwill in Partnership

What is a goodwill? A simple realistic example is when you have something (maybe a toy, shirt, PC games or etc) that you wouldn’t want to give away to your friend, but your friend insisted on having them. In that case, you might be selling them at a higher price, say a limited edition toy that you purchased originally at $100 and your friend are willing to use $120 to purchase the toy (and it is also the price you are willing to give away.) You settled the deal because $120 is attractive! This extra $20 is actually the goodwill.

As for businesses, goodwill arises when the following events happened,

1) existing partners wanted to change profit and loss sharing ratios,

2) new partner is introduced, and

3) one of the partners retires or dies.

There are two ways in showing goodwill, one is to show them in the balance sheet (open a goodwill account) and the other one is to not show them in the balance sheet (do not open a goodwill account).

So, let’s start with opening a goodwill account. In the events (shown above), there will be a change in profit and loss sharing ratio. Something to note in mind that you don’t just ignore the OLD profit and loss sharing ratio, but you will need to do something with it. The steps to opening a goodwill account can be summarised as shown below:

1) Open a goodwill account and Dr the Goodwill amount based on old profit sharing ratio (Note that goodwill is an intangible asset)

2) Open up a capital account with opening balance and CR goodwill in Capital Account.

Here is an example with opening a goodwill account with partners A. B and C changing their profit sharing ratio from existing 2:1:1 to 2:2:1 and that the business has a goodwill value of $4,000. The capital brought forward from A, B and C are $5,000, $4,000 and $2000 respectively.

For second step, you will need to transfer goodwill above to it’s respective partners’ capital account (remember double entry) in which you have already done a Debit entry above and now you will need to Credit Capital account (shown below).

And that’s just it. It is pretty simple but for additional information, you will need to know the before and after adjustment of goodwill which is shown below.

So, if goodwill account is to be opened, you will actually find goodwill to be included in the balance sheet, increasing the total assets and that the two steps that you have done earlier will also help you to arrive at the new capital balances.

For the complicated bit will be where goodwill account is not to be opened. Even though it’s complicated but you don’t actually need to do a lot of work! It’s really just a one step working.

Step 1 (and ONLY) is to open up a capital account and then apportion goodwill account based on both OLD and NEW profit sharing ratio.

Then that’s done. Since goodwill account is not to be maintained, you skipped the need to open up a goodwill account and then did all the adjustments required in the capital accounts by debiting and crediting capital accounts (increase and decrease by $4,000 resulting in no movement in capital account – see below) but does affect the individual partners.

What happens to treatment of goodwill on new admission of a partner?

Same things applies as shown above for both ways but this new partner will never have apportionment using OLD profit sharing ratio. You will only need to apportion the new profit sharing ratio to this new partner.

What happens to treatment of goodwill on death or withdrawal of a partner?

Same things applies as shown above for both ways.

Things to bear in mind to score well in this topic:

1) For goodwill to be opened, you only apportion using OLD ratio. Whilst for goodwill not to be opened, remember to apportion using both ratio.

2) When preparing for balance sheet, do make sure to include goodwill account in intangible asset (if goodwill account is to be opened).

3) Remember the formats well.

Partnership Account – Capital and Current Account (also Fixed Capital or Fluctuating Capital Account)

This topic gets a little bit complicated to explain and I am aware that different teachers seem to have different approaches in teaching Capital and Current Account in partnership account. Some would encourage the opening of both capital and current account just because students will make less mistakes and more presentable answers but some would encourage throwing everything into Capital Account (don’t ask me why) but I have a feeling that it saves more time and you don’t have to open a current account.

As for now, I will try to explain opening both accounts instead of opening capital account alone (Fixed Capital Account).

Capital account works the same way as Sole Proprietorship account. For example, if Allen invests $10,000 and Ben invests $20,000 into AB Business, then you will have the following double entries:

Partnership Capital AC DE

So then that’s it. You wouldn’t be require to do anything to Capital Account anymore.

As for Current Account, since you will not be doing anything to the Capital Account, most entries will be posted to current account as shown below.

Partnership Account - Current Account So now it’s time to know how to do everything in Capital Account (Fluctuating Capital Account.) Referring to the diagram below, I have drawn both Allen Capital Account and Profit And Loss Appropriation account (in a T-account format). With these two accounts, you will now be able to see the link. If you see it carefully (remember double entry?) Try matching up interest on capital from Allen Capital Account to Profit And Loss Appropriation Account and try to match the rest of them! You will probably smile later.

Note: You can also match the current account above to the profit and loss appropriation account since it’s double entry kind of thing.

One thing to note is: You might not be able to see drawings in the profit and loss appropriation account because drawing is not an expenses, it is a direct cash withdrawal (it has a personal relationship to the partner but not the business operations) so it will not appear in your Profit and Loss account. To reiterate, anything that has no relationship to the business operations such as drawing and goodwill, will only affect the Balance Sheet accounts.

Introduction to Partnership Account

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.)

Advantages:

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.

Partnership Account - Profit Sharing Ratio

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.

Partnership Appropriation Account

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.