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01 ACCOUNTING FOR PARTNERSHIP FIRMS –

FUNDAMENTALS

Learning Objectives
I. Definition & Features of Partnership
II. Partnership Deed & Its Contents and Rules
III. Limited Liability Partnership (LLP) and its Nature
IV. Maintenance of Capital Accounts of Partners Under
Fixed & Fluctuating Capital Methods
V. Distribution of Profit among Partners
VI. Profit and Loss Appropriation Account
VII. Interest on Drawings
VIII. Past Adjustments
IX. Guarantee of Profit to a Partner

Definition of Partnership
• Section 4 of the Indian Partnership Act 1932 defines partnership as the ‘relation between persons
who have agreed to share the profits of a business carried on by all or any of them acting for all’.

Partners, Firm and Firm Name

• Persons who have entered into partnership with one another are individually called ‘partners’ and
collectively called ‘firm’.
• The name under which the business is carried is called the ‘firm name’.
• A partnership firm has no separate legal entity, apart from the partners constituting it.

Features of Partnership
1) Two or More Persons: In order to form partnership, there should be at least two persons. By virtue of
Section 464 of the Companies Act 2013, the Central Government is empowered to prescribe maximum
number of partners in a firm, but the number of partners cannot be more than 100. The Central
government has prescribed the maximum number of partners in a firm to be 50.
2) Agreement: Partnership is the result of an agreement between two or more persons to do business
and share its profits and losses. Agreement can be oral or written, but in order to avoid disputes, it is
preferred that the partners have a written agreement.
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3) Business: The agreement should be to carry on some business. Mere co-ownership of a property does
not amount to partnership. For example, if Rohit and Sachin jointly purchase a plot of land, they
become the joint owners of the property and not the partners. But if they are in the business of
purchase and sale of land for the purpose of making profit, they will be called partners.

4) Mutual Agency: The business of a partnership may be carried on by all the partners or any of them
acting for all. Each partner carrying on the business is the principal as well as the agent for all the other
partners. He can bind other partners by his acts and also is bound by the acts of other partners with
regard to the business of the firm.

5) Sharing of Profit: Another important element of partnership is that the agreement between partners
must be to share profits and losses of a business. The sharing of loss is implied. If some persons join
hands for the purpose of some charitable activity, it will not be termed as partnership.

6) Liability of Partners: Each partner is liable jointly with all the other partners and also severally to the
third party for all the acts of the firm done while he is a partner. The liability of a partner for acts of the
firm is also unlimited. This implies that his private assets can also be used for paying off the firm’s debts.

Partnership Deed
• The document containing the terms and conditions of partnership is known as Partnership deed.
• It can be oral or written. The clauses of partnership deed can be altered with the consent of all the
partners. The deed should be properly drafted and prepared as per the provisions of the ‘Stamp
Act’ and preferably registered with the Registrar of Firms. It is also called as ‘Articles of Partnership’.

Contents of Partnership Deed

• Names and Addresses of the firm and its main business.
• Names and Addresses of all partners.
• The amount of capital to be contributed by each partner.
• The accounting period of the firm.
• The date of commencement of partnership.
• Rules regarding operation of Bank Accounts.
• Profit and loss sharing ratio.
• Rate of interest on capital, loan, drawings, etc.
• Mode of auditor’s appointment, if any.
• Salaries, commission, etc., if payable to any partner.
• The rights, duties and liabilities of each partner.
• Treatment of loss arising out of insolvency of one or more partners.
• Settlement of accounts on dissolution of the firm.
• Method of settlement of disputes among the partners.
• Rules to be followed in case of admission, retirement, death of a partner; and
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• Any other matter relating to the conduct of business.

Rules applicable in the Absence of Partnership deed

1) Profit Sharing Ratio: If the partnership deed is silent about the profit-sharing ratio, the profits and
losses of the firm are to be shared equally by partners, irrespective of their capital contribution in
the firm.

2) Interest on Capital: No interest on capital is payable if the partnership deed is silent on the issue.

3) Interest on Drawings: No interest is to be charged on the drawings made by the partners, if there
is no mention in the deed.

4) Interest on Loan: If any partner has advanced loan to the firm for the purpose of business, he/she
shall be entitled to get an interest on the loan amount at the rate of 6 per cent per annum.

5) Remuneration for Firm’s Work: No partner is entitled to get salary or other remuneration for
taking part in the conduct of the business of the firm unless there is a provision for the same in the
Partnership Deed.

Apart from the above, the Indian Partnership Act specifies that subject to contract between the
partners

1) If a partner derives any profit for himself /herself from any transaction of the firm or from the use of
the property or business connection of the firm or the firm name, he/she shall account for the
profit and pay it to the firm.
2) If a partner carries on any business of the same nature as and competing with that of the firm,
he/she shall account for and pay to the firm all profit made by him/her in that business.

Rights of a Partner
• Every partner has the right to share profits or losses with other partners in the agreed ratio.
• Every partner has the right to take part in the conduct of the business.
• Every partner has the right to be consulted in the matters related to partnership business.
• Every partner has the right to inspect and have a copy of the books of accounts.
• Every partner has a right to disallow the admission of a new partner.
• Every partner is the joint owner of the partnership property.
• Every partner has a right to retire from the firm after giving proper notice.

Limited Liability Partnership (LLP)

• The Limited Liability Partnerships (LLPs) in India came into existence with the enactment of ‘Limited
Liability Partnership Act, 2008’ which lay down the law for the formation and regulation of Limited
Liability Partnerships.
• Definition: ‘Limited Liability Partnership’ means a partnership formed and registered under this Act.
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Nature of Limited Liability Partnership (LLP)

1) A LLP is a body corporate formed and incorporated under this act.
2) It is a legal entity separate from that of its partners.
3) A LLP shall have perpetual succession.
4) Any change in the partners of an LLP shall not affect the existence, rights or liabilities of the LLP.
5) Indian Partnership Act, 1932 shall not apply to a LLP.

Distinction Between an Ordinary Partnership Firm and an LLP

Basis of Distinction Partnership Firm LLP’s

Applicable Law Indian Partnership Act, 1932. The Limited Liability Partnership Act,
2008.
Registration Optional Compulsory with Registrar of
Companies
Creation Created by an Agreement Created by Law
Body Corporate Body Corporate cannot become a Body Corporate can become its partner.
partner.
Separate Legal Entity It is not a separate legal entity. It is a separate legal entity.

Perpetual Succession Partnerships do not have It has perpetual succession, and

perpetual succession. individual partners may come and go.
Number of Partners Minimum 2 and Maximum 50 Minimum 2 but no maximum limit.
Ownership of Assets Firm cannot own any assets. The The LLP as an independent entity can
partners own the assets of the own assets.
firm.

Special Aspects of Partnership Accounts

Accounting treatment for partnership firm is similar to that of a sole proprietorship business with the
exception of the following aspects:
• Maintenance of Partners’ Capital Accounts.
• Distribution of Profit and Loss among the partners.
• Adjustments for Wrong Appropriation of Profits in the Past.
• Reconstitution of the Partnership Firm; and
• Dissolution of Partnership Firm.
The first three aspects mentioned above have been taken up in the following sections of this chapter. The
remaining aspects have been covered in the subsequent chapters.
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Maintenance of Capital Accounts of Partners

There are two methods by which the capital accounts of partners can be maintained. These are:
1) Fixed capital method
2) Fluctuating capital method

Fixed Capital Method

• Under the fixed capital method, the capitals of the partners shall remain fixed unless additional
capital is introduced, or a part of the capital is withdrawn as per the agreement among the partners.
• All items like share of profit or loss, interest on capital, drawings, interest on drawings, etc. are
recorded in a separate accounts, called Partner’s Current Account.
• The partners’ capital accounts will always show a credit balance, which shall remain the same (fixed)
year after year unless there is any addition or withdrawal of capital.
• The partners’ current account on the other hand, may show a debit or a credit balance. Thus, under
this method, two accounts are maintained for each partner viz., capital account and current
account, while the partners’ capital accounts shall always appear on the liabilities side in the
balance sheet, the partners’ current account’s balance shall be shown on the liabilities side, if they
have credit balance and on the assets side, if they have debit balance.

Proforma of Capital Accounts (When the Capitals are fixed)

Dr. Cr.

Particulars A B C Particulars A B C
₹ ₹ ₹ ₹ ₹ ₹
To Cash/Bank A/c (Drawings xxx xxx xxx By Balance b/d xxx xxx xxx
against Capital) (Opening Balance)
To Balance c/d (Closing xxx xxx xxx By Cash/Bank A/c xxx xxx xxx
Balance) (Additional Capital)
xxx xxx xxx xxx xxx xxx

Proforma of Current Accounts

Dr. Cr.
Particulars A B C Particulars A B C
₹ ₹ ₹ ₹ ₹ ₹
To Balance b/d xxx xxx xxx By Balance b/d xxx xxx xxx
(In case of debit opening (In case of credit opening
Balance) Balance)
To Drawings (Drawings xxx xxx xxx By Interest on Capital xxx xxx xxx
against Profit) By Partner’s Salary
To Interest on Drawings xxx xxx xxx By Partner’s Commission xxx xxx xxx
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To P & L A/c (share of loss, xxx xxx xxx By P & L Appropriation A/c xxx xxx xxx
in case of loss) (share of profit, in case of
To Balance c/d xxx xxx xxx profit) xxx xxx xxx
xxx xxx xxx xxx xxx xxx

Fluctuating Capital Method

• Under the fluctuating capital method, only one account, i.e. capital account, is maintained for each
partner.
• All the adjustments such as share of profit and loss, interest on capital, drawings, interest on
drawings, salary or commission to partners, etc. are recorded directly in the capital accounts of the
partners. This makes the balance in the capital account to fluctuate from time to time.
• That’s the reason why this method is called fluctuating capital method.
Proforma of Capital Accounts
(When the Capitals are fluctuating)

Dr. Cr.
Particulars A B C Particulars A B C
₹ ₹ ₹ ₹ ₹ ₹
To Cash/Bank A/c xxx xxx xxx By Balance b/d (Opening xxx xxx xxx
(Drawings against Capital) Balance)
To Drawings (Drawings xxx xxx xxx By Cash/Bank A/c (Additional xxx xxx xxx
against Profit) Capital)
To Interest on Drawings xxx xxx xxx By Interest on Capital xxx xxx xxx
To P & L A/c (share of loss, xxx xxx xxx By Partner’s Salary xxx xxx xxx
in case of loss) By Partner’s Commission xxx xxx xxx
To Balance c/d (Closing xxx xxx xxx By P & L Appropriation A/c xxx xxx xxx
Balance) (share of profit, in case of
profit)
xxx xxx xxx xxx xxx xxx
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Distinction between Capital Account and Current Account

Basis of Distinction Capital Account Current Account

When prepared It is prepared both in case of Fluctuating It is prepared only in case of

Capital Method as well as Fixed Capital Fixed Capital Method.
Method.
Balance When Capital Account is prepared on Current Account may show a
Fixed Capital Method, it will show only Credit or a debit balance.
credit balance. In Fluctuating Capital
Method, it may show a Credit or a debit
balance.
Nature When Capital Account is prepared on Current Account Changes with
Fixed Capital Method, it generally every transaction.
remains unchanged from year to year. In
Fluctuating Capital Method, it changes
with every transaction.

Distribution of Profit among Partners

• The profits and losses of the firm are distributed among the partners in an agreed ratio.
• For this purpose, it is customary to prepare a Profit and Loss Appropriation Account of the firm and
ascertain the final figure of profit and loss to be distributed among the partners, in their profit-
sharing ratio.
Profit and Loss Appropriation Account
• Profit and Loss Appropriation Account is merely an extension of the Profit and Loss Account of the
firm. It shows how the profits are appropriated or distributed among the partners.
• All adjustments in respect of partner’s salary, partner’s commission, interest on capital, interest on
drawings, etc. are made through this account.

The Journal Entries regarding Profit and Loss Appropriation Account are as follows:
1) For transfer of balance of Profit and Loss Account
• Profit and Loss A/c Dr.
To Profit and Loss Appropriation A/c
(Net Profit transferred)

2) For Interest on Capital

a) For allowing Interest on capital
• Interest on Capital A/c Dr.
To Partner’s Capital/Current A/c
(Being interest on capital allowed @ ...... % p.a.)
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1) For transferring Interest on Capital to P/L Appropriation A/c

• Profit and Loss Appropriation A/c Dr.
To Interest on Capital A/c
(Being interest on capital transferred to P/L Appropriation A/c)

3) For Salary or Commission payable to a partner

a) For allowing Salary or Commission to a partner
• Partners Salary/Commission A/c Dr.
To Partner’s Capital/Current A/c
(Being salary/commission payable to a partner)
b) For transferring Partner’s Salary/Commission to Profit and Loss Appropriation A/c
• Profit and Loss Appropriation A/c Dr.
To Partner’s Salary/Commission A/c
(Being salary/commission transferred to P/L Appropriation A/c)

4) For transfer of Reserves

• Profit and Loss Appropriation A/c Dr.
To Reserve A/c
(Amount transferred to reserve)

5) For Interest on Drawings

a) For charging interest on a partner’s drawings
• Partner’s Capital/Current A/c Dr.
To Interest on Drawings A/c
(Being interest on drawings charged @ ….. % p.a.)
b) For transferring interest on drawings to Profit and Loss Appropriation A/c
• Interest on Drawings A/c Dr.
To Profit and Loss Appropriation A/c
(Being interest on drawings transferred to P&L Appropriation A/c)

6) For transfer to Profit

• Profit and Loss Appropriation A/c Dr.
To Partners Capital/Current A/cs
(Being profits distributed among partners)
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Profit and Loss Appropriation Account

for the year ended …….
Dr. Cr.
Particulars ₹ Particulars ₹
To Salaries of Partners xxx By Profit & Loss A/c xxx
To Commission to Partners xxx (Net Profit transferred from
To Interest on Partner’s Capitals: P & L A/c)
A xxx By Interest on Drawings:
B xxx xxx A xxx
To Reserve A/c xxx B xxx xxx
To Profit Transferred to:
A’s Capital/Current A/c xxx
B’s Capital/Current A/c xxx xxx
xxx xxx

Distinction between Profit & Loss Account and Profit & Loss Appropriation Account

Basis of Distinction Profit and Loss Account Profit and Loss Appropriation Account

Stage of Preparation It is prepared after the Trading Account It is prepared after the Profit and Loss
and hence starts with the gross profit Account and hence starts with the net
disclosed by Trading Account. profit disclosed by Profit and Loss
Account.
Objective It is prepared to ascertain net profit or It is prepared to show appropriation i.e.
net loss. distribution of net profit of the year
among the partners.
Opening/closing This account has neither opening This account may have opening as well
Balance balance nor closing balance. as closing balances.
Charge or Expenses debited to this account are Expenses debited to this account are
Appropriation charge against profits. appropriation of profits.
Partnership This account is not prepared on the This account is prepared on the basis of
Agreement basis of partnership agreement, except partnership agreement.
for interest on loan from partners.
Matching Principle Matching Principle (i.e., matching of Matching Principle is not followed
revenue against expenses) is followed while preparing this account.
while preparing this account.
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Distinction between Charge Against Profit and Appropriation out of Profit

Basis of Distinction Charge Against Profit Appropriation out of Profit

Nature It indicates expenses to be It indicates distribution of net profit

deducted from profits while to various heads.
calculating net profit or loss.
Recording It is debited to Profit and Loss It is debited to Profit and Loss
Account. Appropriation Account.
Necessary or not It is necessary to make changes Appropriation are made only when
against profits even if there is loss. there is profit.
Example Interest on partner’s loan and rent Interest on capital, partner’s salary
paid to a partner. etc.

Example 1: Shiv and Hari entered into partnership on 1st April 2022, contributing ₹ 5,00,000 and ₹ 2,00,000
respectively. Hari also introduced ₹ 1,00,000 as additional capital on 1st July 2022. They agreed to share
profits and losses in the ratio of 3: 2. Following information is provided regarding the partnership:
i) Shiv and Hari, each are allowed a salary of ₹ 5,000 per quarter.
ii) Interest is to be allowed on Capitals @ 8% p.a. and charged on drawings at 10% р.а.

Drawings of Shiv and Hari during the year were ₹ 12,000 and ₹ 10,000 respectively. Profit as at 31st March,
2023 before the above mentioned adjustments was ₹ 1,96,000.
Prepare:
i) Profit and Loss Appropriation A/c, and
ii) Partner’s Capital A/cs.

PROFIT AND LOSS APPROPRIATION ACCOUNT

For the year ended 31st March 2023

Dr. Cr.

Particulars ₹ Particulars ₹
To Partner’s Salary: By Profit & Loss A/c 1,96,000
Shiv 20,000 By Interest on Drawings: (note 2)
Hari 20,000 40,000 Shiv 600
Hari 500 1,100
To interest on Capitals: (note 1)
Shiv 40,000
Hari 22,000 62,000

To Profit transferred to:

Shiv’s Capital A/c 57,060
Hari’s Capital A/c 38,040 95,100
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1,97,100 1,97,100

Dr. PARTNER’S CAPITAL ACCOUNTS Cr.

Date Particulars Shiv Hari Date Particulars Shiv Hari
2023 ₹ ₹ 2022 ₹ ₹
March 31 To Drawings 12,000 10,000 April 1 By Bank 5,00,000 2,00,000
March 31 To Interest on July 1 By Bank ----- 1,00,000
Drawings 600 500 2023
March 31 To Balance March 31 By Salary 20,000 20,000
c/d 6,04,460 3,69,540 March 31 By Interest on
Capitals 40,000 22,000
March 31 By Profit &
Loss
Appropriation
A/c 57,060 38,040
6,17,060 3,80,040 6,17,060 3,80,040

Note 1 : Calculation of Interest on Capitals ₹

Shiv On ₹ 5,00,000 at 8% for 1 year 40,000

Hari On ₹ 2,00,000 at 8% for 1 year 16,000

On ₹ 1,00,000 at 8% for 9 months 6,000
22,000
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Interest on Shiv’s drawings = 12,000 x 100 x 12 = ₹ 600
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Interest on Hari’s drawings = 10,000 x 100 x 12 = ₹ 500

Interest on Capital
• No interest is allowed on partners’ capitals unless it is expressly agreed among the partners. When
the deed specifically provides for it, interest on capital is credited to the partners at the agreed rate.
• Interest on capital is generally provided for in two situations: (i) when the partners contribute
unequal amounts of capitals but share profits equally, and (ii) where the capital contribution is same
but profit sharing is unequal.

Example 2: Rakshit and Malik are partners in a firm sharing profits and losses in the ratio of 4: 1. On 1st
April 2021, their capitals were ₹ 1,20,000 and ₹ 80,000 respectively. On 1st December 2021, they decided
that the total capital of the firm should be ₹ 3,00,000 to be contributed by them in the ratio of 2: 1.
According to the partnership deed, interest on capital is allowed to the partners @6% p.a. Calculate
interest on capital to be allowed for the year ending 31st March 2022.