WELCOME CHAPTER1 ACCOUNTING FOR PARTNERSHIP BASIC CONCEPTS INTRODUCTION

WELCOME

CHAPTER-1 ACCOUNTING FOR PARTNERSHIP BASIC CONCEPTS

INTRODUCTION You have already learnt the accounting procedure for sole trading concerns. Limitations of sole proprietorship 1. Limited financial resources 2. Limited managerial ability 3. Limited scope of expansion 4. Unlimited liability The need of partnership arose due to the limitations of sole proprietorship.

Definition As per section 4 of the Indian Partnership Act 1932, Partnership is the relationship between persons who have agreed to share the profits of a business carried on by all any of them acting for all. *Persons who enter into the partnership are individually called partners and collectively called a firm.

Features 1. Agreement/Deed The basis upon which the partnership is constituted is an agreement , between the partners. The agreement should be for carrying on a lawful business. The agreement may be in oral or written form. 2. Two or more persons A minimum of two persons are required to form a partnership. The maximum number of persons in a partnership is limited to 10, in case of banking business and 20 if it is carrying on any other business.

3. Business The agreement should be for carrying on some business. Business include every trade, occupation or profession. The business must be legal. 4. Sharing of profits The objectives of partnership must be to earn profits and must be distributed among partners in an agreed ratio. In case of losses too are shared in the agreed ratio. 5. Business carried on by all or any of them acting for all. Each partner can participate in the conduct of business and act for the firm, as well as each partner is bound by the acts of

other partners. Thus a partner is both an agent and the principal. ie. , he is an agent when he makes the other partners liable for his acts. He is the principal when the other partners make him liable for their acts. This is based on mutual agency principle. Partnership Deed A written agreement which contains the terms and conditions of partnership is called Partnership deed. Contents of the Deed *Name of the firm *Name and address of all partners *Nature and place of the firm *Date of commencement of partnership. *Duration of partnership

*Amount of capital contributed or to be contributed by each partner. etc………………… Rules applicable in the absence of partnership deed 1. No interest on capital 2. No interest on drawings 3. No salary 4. No commission 5. Equal share in profits 6. 6% interest on loan taken from a partner.

Proforma of capital account Dr. Cr. Particulars a a m m a a Particulars m m a a a m m m a m Drawings X X Balance b/d X X Interest on drawings X X Cash X X Share of loss X X Salary X X Commission X X Interest on loan given to Firm X X Interest on capital X X Share of profit X X X

• A partner’s capital account normally shows credit balance. • However it can show a debit balance under certain circumstances, like excessive withdrawal etc………. . There are two methods of maintaining capital accounts of partners. (in partnership) 1. Fixed Capital Method 2. Fluctuating Capital Method

Fixed Capital Method Fluctuating Capital Method In the fixed capital method all adjustments like salary, commission, interest on capital, profit etc are shown in current account. In the fluctuating capiltal method, all adjustment like salary, commission, interest on capital etc. . are show in the capital a/c itself. In the fixed capital method there are two account to be prepared for each partner. Capital a/c & Current a/c In the fluctuating capital method, there is only one a/c ie, capital a/c for each partner The balance of fixed capital a/c does not change in general circumstances. The balance of fluctuating capital a/c keep on changing from time to time. Capital a/c normally shows credit balance while current a/c can show a credit or debit balance. Fluctuating capital a/c normally shows a credit balance.

ILLUSTRATION 1 Arun and Balu entered into a partnersip business on 1 st April 1998. They have contributed capital of Rs. 50000 and Rs. 60000 respectively. They decided to share profits and lossess equally. According to the deed interest on capital is allowed at 6% per annum and Balu was entitled to get a salary of Rs. 8000 per annum. During the year Balu withdrew Rs. 6000 and Arun withdrew Rs. 4000. Netprofit of the business after providing interest on capital and salary to Balu amounted to Rs. 16000. Show the capital accounts of the partners. 1. When capitals are fixed 2. When capitals are flictuating

1. When capitals are fixed Dr Capital a/c particulars Arun Balu Balance c/d 50000 60000 Cr. Particulars Arun Balu cash 50000 60000 Balance b/d

Current a/c Dr. particulars Arun Balu particulars Cr. Arun Balu Drawings 4000 6000 Share of profit 8000 800 0 Interest on capital 3000 360 0 Salary Balance c/d 7000 1360 0 1100 0 1960 0 800 0 1100 196 0 00 Balance b/d 7000 136 00

2. Fluctuating capital method Dr. Capital a/c particulars Arun Bal u Drawings 4000 600 Cash 0 Balance c/d Cr. particulars Arun Balu 5000 0 6000 0 Share of profit 8000 Interest on capital 3000 3600 Salary ------- 8000 6100 0 7960 0 5700 0 7360 0 5700 736 0 00 6100 796 0 00 Balance b/d

Profit and loss Appropriation a/c Profit and loss appropriation a/c is an extension of profit and loss account. It is prepared to show net profit is distributed among the partners. Proforma of Profit and loss appropriation a/c Cr. Dr. Particulars Am Interest on capital XXX Netprofit b/d XXX Salary XXX Interest on drawings XXX Commission XXX Loss XXX Reserve XXX Profit XXXX

ILLUSTRATION 2 On 1 st January 2000 ‘R’ and ‘S’ entered into a partnership contributing Rs. 40000 and 30000 respectively, and sharing profit and losses in the ratio of 3: 2. R is to be allowed a salary of Rs. 6000 per year. Interest on capital is to be allowed at 6% per annum. During the year R withdrew Rs. 3000 and S Rs. 4000. Interst on the same being Rs. 150 and Rs. 240 respectively. The profit of the year before the above mentioned adjustments was Rs. 12500. Pass the necessary entries relating to the appropriation of profit and prepare the profit and loss appropriation a/c and partner’s capital a/c.

Dr. P&L appropriation a/c Cr. Am Particulars R’s salary 6000 Net profit b/d 12500 Interest on capital (2400+1800) 4200 Interest on drawings 150+240 390 Capital a/c R-1614 S-1076 2690 12890

Interest on drawings Case 1 When drawings of a fixed amount are made in the beginning of every month, interest will be charged on the whole amount for 6 ½ months. Interest on drawings = total drawings X rate of interest X 61/2 12 100 Example A & B are partners in a firm. B withdrew Rs. 5000 per month(in the beginning of the month). Calculate his interest on drawings for the preparations of final a/c, if it is charged @ 10%.

Total drawings = 5000 X 12 = 60000 Interest on drawings = total drawings X rate of interest X 6 ½ 12 100 = 60000 X 10 X 6 ½ 100 12 =3250 Case 2 When drawings of a fixed amount are made at the end of the every month. Interest on drawings = total drawings X rate of interest X 5 ½ 100 12

Example A partner makes a drawings of Rs. 1000 per month ( at the end of the every month ). Under the partnership deed interest is to be charged at 15% per annum. Calculate his interest on drawings. Total drawings=1000 X 12 = 12000 Interest on drawings = total drawings X rate of interest X 5 ½ 100 12 = 12000 X 15 X 5 ½ 100 12 =825

Case 3 When drawings are made in the middle of every month. Interest on drawings = total drawings X rate of interest X 6 ½ 100 12 Example A partner make a drawings of Rs. 1000 per month. Under the partnership deed interest is to be charged @ 15% per annum. Calculate his interest on drawings. Interest on drawings = total drawings x rate of interest x 6 ½ 12 100 Product method ( In the case- different amounts withdrawn on different dates)

Date Amount Period product January 31 3600 11 39600 March 31 2400 9 21600 June 30 4800 6 28800 August 31 1200 4 4800 October 30 6000 2 12000 Total 106800 Interest on drawings = Total of product X 1/12 X 5/100 = 445

Goodwill can be defined as “ the present value of a firm’s anticipated excess earnings” or as “ the capitalised value attached to the differential profit capacity of a business. *Goodwill is an intangible asset Factors determining Goodwill. 1. Conduct of business Goodwill of a business to a large extend, is attached with the quality of the goods it deals with and services it provides. Higher the quality more will be the goodwill or viceversa. 2. Location The location of a business firm is another factor affecting goodwill. Easy and convenient locations will attract more customers

Which eventually add to the goodwill of the firm. 3. Efficiency of the business If the management of the business is highly efficient , it will be able to maintain cost efficiency and productivity which will enhance profitability of the business and there by it’s goodwill. 4. Market condition Monopoly in the market restricts competition and helps the firm to earn higher profits which enhances it’s goodwill. 5. Special previlages The firm that enjoys special previlages like import license , uninterrupted supply of electricity, attractive trade marks etc………. brings goodwill to the firm.

Need for the valuation of goodwill 1. Change in the profit sharing ratio amongst the existing partners. 2. Admission of a new partner 3. Retirement of a partner 4. Death of a partner 5. Dissolution of a firm involves sale of business as a going concerns. 6. Amalgamation of firms. Methods of valuation of goodwill 1. Average profit method Under this method the value of goodwill is calculated at an agreed number of years purchase of the average profits for the past few years. At the time of the sale of an established business , the purchaser has to pay an extra amount for the value of

goodwill. This amount is equal to the profits he is likely to receive for the first few years. The goodwill , there for , should be calculated by multiplying the past average profits by the number of years during which the anticipated profits are expected to accrue. Example The profits of a firm for the last six years are given. The partnership agreement provides the valuation of goodwill at 3 years purchase prince of the average profits of the last 6 years. Calculate the value goodwill. The profits of the firm were : -

Year Profits 1992 60000 1993 40000 1994 50000 1995 55000 1996 45000 1997 50000 Calculate the goodwill under average profits method ? ---------------------Goodwill = Average profits X no. of years purchased Average profit = Total profit No. of years = 60000+40000+55000+45000+50000 6

= 300000 6 = 50000 ====== Goodwill= Average profit x No. of years purchased = 50000 X 3 =150000 ======

2. Weighted average profit method Weighted average method is the modified version of simple average profit method for computing goodwill. Under this method each year profit is multiplied by the respective number of weights , based on the principle of earnings in the immediate past and earnings in the distant past. Example The profits of a firm for the last 5 years ending 31 st March were as follows : Year Profits Weight 1999 18000 1 2000 2 2001 30000 3 2002 24000 4 2003 18000 5

Calculate the value of goodwill on the basis of 3 year purchased of weighted average profit. ---------------------------Weighted average profit = Total of products for profits Total of weight Year Profits Weight Product(profit x weight) 1999 18000 1 18000 22000 2 44000 2001 30000 3 90000 2002 24000 4 96000 2003 18000 5 90000 ----------15 338000 Weighted average profit = Total of products for profits Total of weight

= 338000 15 = 22533 ====== Goodwill = Weighted average profit x number of years = 22533 x 3 = 67599 ====== 3. Super profit method Under super profit method , goodwill is calculated at a certain number of years purchase of the super profits of the business. Super profits means excess of actual profits over normal profit.

Example The average profit of the firm for the last 5 years 20000 and the capital invested in 130000. The normal profits for the similar line of business is 10%. Calculate the amount of goodwill if it is 2 years purchase of super profit. ----------------------Normal profit = 10% of capital invested. ie ; = Normal profit = 130000 x 10 100 = 13000 ===== Average profit = 20000 Super profit = Average profit - normal profit = 20000 – 13000 =7000 ====

Goodwill = Super profit x Number of years purchased = 7000 x 2 = 14000 ===== 3. Capitalization method Under this method the goodwill can be calculated in two ways. 1. By capitalizing the average profits. 2. By capitalizing the super profits. Capitalizing the average profit Here , expected future maintainable profits are estimate after providing for reasonable managerial remuneration. These expected future profits are capitalized on the basis of normal rate of return to find out the total value of business.

Example A business has earned average profits of Rs. 80000 during the last few years and the normal rate of return in similar type of business is 10%. Find out the value of goodwill by capitalization method , given that the assets of the firm amount to Rs. 600000 and liabilities to Rs. 100000. ---------------------Capital of the firm = 600000 – 100000 = 500000 ====== Average profit = 80000 Normal rate of return = 10 100 80000 x 100 = 800000 10 ====== Goodwill = capitalized value – net asset = 800000 - 500000 = 300000

Capitalization of super profit Super profit are capitalized under this method. Example Calculate goodwill if : 1. The goodwill of a firm is estimated at three years purchase of the average profits of the last 5 years which are as follows: Year Profits 1999 10000 2000 15000 2001 5000 2002 5000(loss) 2003 8000 2. If the firms total capital employed is Rs. 100000 and the normal rate of return is 6%, the average profit for the last 5 years is Rs. 15000 and goodwill is estimated at 3 years purchase of super profits.

Remuneration given to partner was Rs. 2000 /-. 3. Rama Bothers earn a net profit of Rs. 25000 with a capital of Rs. 200000. The normal rate of return in the business is 10%. Use capitalization of super profits method to value of the goodwill ------------------------ 1. Average profit = (10000+15000+8000 – 5000)/5 = 33000/5 = 6600 Goodwill = 6600 x 3 = 19800 2. Average profit = 15000 Remuneration to the partners =2000 Average actual profit =15000 – 2000= 13000 Normal profit = 100000 x 6/100 = 6000 Super profit = 13000 - 6000 = 7000 Goodwill=70000 x 3 = 21000

Normal profit = 200000 x 10/100 = 20000 Super profit= Average profit – normal profit = 25000 – 20000 = 5000 Goodwill = Super profit x 100/Normal rate of return =5000 x 100/10 =50000 ===== 4. Present value of super profit Here goodwill is estimated as the present value of the future super profits. This method is based on the principal of determining the present value of future cash flow. Example A firm has forecasted it’s future profit for five years as follows. 1 st year - 100000 2 nd year - 120000 3 rd year - 80000 4 th year - 110000 5 th year - 130000

The total assets of the firms are Rs. 1000000 and outside liabilities are Rs. 300000. The present value factor at 10% are as follows. Year 1 2 Present value factor 0. 9091 0. 8264 3 4 5 0. 7513 0. 6830 0. 6209 Calculate value of goodwill. -----------------------------------Year 1 2 3 4 5 Profit 100000 120000 80000 110000 130000 Normal profit 70000 70000 Super profit 30000 50000 10000 40000 60000 Super profit x pvf 27273 41320 7513 27320 37254

Goodwill = 27273+41320+7513+27320+37254 = 140680 ====== Past adjustments After closing the accounts of the firm , it may come to light that certain items were omitted or left out by mistake. In such a case necessary adjustment are carried out in the partners capital accounts. Profit and loss adjustment a/c is used for this purpose. we can also prepare a statement of adjustment to find out the net difference and pass a direct journal entry in the capital accounts.

Example The net profit of X , Y , and Z for the year ended March 31 st 2006 was Rs. 60000 and the same was distributed among them in their agreed ratio of 3: 1: 1. It was subsequently discovered that the under mentioned transactions were not recorded in the books: 1. Interest on the capital at the rate 5% per annum. 2. Interest on drawings amounting to X Rs. 700 , Y Rs. 500 and Z Rs. 300 3. Partners salary : X-Rs. 1000 , Y-Rs. 1500 per annum The capital a/c of partners were fixed as X Rs. 100000 , Y Rs. 80000 and Z Rs. 60000. Record the adjustment entry? --------------------------------

Adjusted Profit and loss appropriation a/c Particulars Interest on capital X 5000 Y 4000 Z 3000 Salary X 1000 Y 1500 Profit transferred to capital a/c X-28200 Y-9400 Z-9400 Am Particulars Am Net profit b/d 60000 12000 2500 Interest on drawings X-700 Y-500 Z-300 1500 47000 61500 ======

Statement showing adjustment Particulars X Y Z Amount which should have been credited 28200 9400 1500 ------ 4000 ------14900 3000 ------12400 500 ------- 300 ------- 14400 12000 ------2400 12100 12000 -------100 Amount which should have been credited to the capital a/c Salary – 1000 Interest on capital --5000 ------34200 Less, Amount which should have been debited Interest on drawings 700 ------Amount actually reserved Amount actually credited 33500 36000 ------2500

X’s capital a/c. Dr. 2500 Y a/c Z a/c 2400 100 --------------------------------------------

CREATED BY : 1. DIVYA RAJ (Group member) 2. JINCY SUSAN SKARIA ( Group member) 3. JUBY SUSAN JAMES (Group member) 4. JULIE JOSE (Group member) 5. MEENU. H (Group leader )

THANK YOU…. .