Unit 1: Accounting for Partnership Firms – Basic Concepts

According to Section 4 of the Partnership Act 1932, a partnership is defined as “An agreement between two or more persons who have mutually agreed to share profits or losses that will be carried by all or any one of them acting for all”. The individuals who set up the business jointly are called partners, and all the partners collectively are known as the firm.

The following are the important characteristics of a partnership firm:

1. Number of Partners: The minimum number of persons to form a partnership is 2, and the maximum is 50 as per the Companies Rules Act, 2014. Any more than the specified limit makes the partnership illegal.

2. Partnership Deed: A partnership deed is a necessary document that contains all the terms of the partnership and the details about the contribution of each partner towards the firm. It should be in written format as it helps in resolving disputes between partners and acts as evidence at times of legal procedures.

3. Business: One of the important characteristics of business is that it is formed in order to do legal business. So any kind of business that is deemed illegal makes the partnership illegal.

4. Profit/Loss Sharing: Partners are supposed to take profit and loss as per the ratio that was agreed at the time of partnership.

5. Liability: When the firm has unlimited liability, the partners of the firm need to pay from the personal asset if the firm is unable to pay to any concerned third party.

6. Mutual Agency: The firm is an agency and all the partners are its agents. Every partner is an agent and binds other partners by their act, while at the same time is bound by other partners’ actions.

As per the Indian Partnership Act 1932, the following provisions stay relevant when a partnership deed is not present:

1. Sharing of profits and losses: If a partnership deed is absent, then the profit-sharing ratio should be equal among all partners, as per Partnership Act, 1932.

2. Interest on partner’s capital: If the partnership deed is absent, then as per Partnership Act, 1932, the partners are not entitled to interest earned on capital.

3. Interest on partner’s drawings: If the partnership deed is absent, then as per Partnership Act, 1932, no interest shall be charged to the partners in the event of drawing money.

4. Interest on partner’s loan: If the partnership deed is absent, then the partner is eligible for a 6% interest on the loan to the firm.

5. Salary to a partner: In case of the absence of a partnership deed, the partners are not eligible for any salary; any salary whatsoever, if paid, will be as appropriation of profit (in case there is profit).

According to the Partnership Act of 1932, it is not mandatory to have a partnership deed in writing. However, it is a safe option to have it in writing as there are chances that the partners may have conflicts in the future that gives rise to dispute among the partners regarding the operations of the firm. A partnership deed that is documented helps in the proper functioning of the firm and assists in avoiding any kind of disputes that may arise between partners of a firm in future. It also helps resolution of any kind of dispute as a written partnership that is signed by all the partners is suitable for use as an evidence in a court of law.

Whenever a partner withdraws from the firm, any amount, which can be in the form of cash or other forms solely for personal use, is called the drawings. Interest on drawings is referred to the amount that is charged by the firm as interest on the total amount taken as drawings. Interest calculation is dependent on the time and the frequency in which the drawing is made. Here are some situations that can be shown where the calculation is done for interest charged on drawings.

There is a change in profit sharing only when there is an addition of a new partner, retirement or death of a partner or due to a mutually agreed decision among the partners. Some of the factors that need to be taken into account while changing the profit-sharing ratio are: goodwill, accumulated profits and reserves, liabilities and adjustment of capital and profit or loss on the revaluation of the assets, etc.

General reserve is essentially the accumulated profits and profit or loss that is obtained on the revaluation of assets and liabilities, adjustments in capital etc.

If one or more partners decide that it is the right time to change the profit-sharing ratio, then the gaining partner shall gain, and the other will lose; therefore, the gainer should compensate the latter. This results in debiting the gaining partner capital account and crediting the sacrificing partners’ capital account.

Gaining Partner’s Capital A/c Dr.

To Sacrificing Partner’s Capital A/c

(Adjustment entry passed)

Example:

Ram, Shyam, and Mohan are partners in a firm sharing profit and loss in a 3:2:1 ratio. They decide to share profit and loss equally in future. On that date, the books of the firm show ₹ 90,000 as the general reserve, profit due to the revaluation of plant and machinery ₹ 30,000. The following adjustment entry is passed through the capital accounts without affecting the books of accounts.

Here, Mohan gains while Ram loses, so Ram needs to be compensated by Mohan with an amount of ₹ 25,000. The following adjustment entry is passed.

Adjustment Entry: