class 12 notes

Class 12 Accountancy Notes Chapter 2 (Accounting for Partnership : Basic Concepts) – Accountancy-I Book

Philoid

Philoid

— 9 min read

Accountancy-I
Alright class, let's dive into Chapter 2: 'Accounting for Partnership: Basic Concepts'. This chapter lays the foundation for understanding how partnership firms manage their accounts. It's crucial for your exams, so let's break it down systematically.

1. Meaning and Definition of Partnership

  • Context: Partnership arises from the limitations of a sole proprietorship (limited capital, limited managerial skills, limited risk-bearing capacity). It allows individuals to pool resources and expertise.
  • Definition (Section 4 of the Indian Partnership Act, 1932): "Partnership is 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."
  • Persons: Individuals who enter into partnership are individually called 'Partners' and collectively called a 'Firm'. The name under which they carry on business is called the 'Firm Name'.

2. Essential Features/Characteristics of Partnership

  1. Two or More Persons: Minimum 2 partners. Maximum is 50 (as per Rule 10 of the Companies (Miscellaneous) Rules, 2014, effectively overriding the old limit mentioned in the Companies Act).
  2. Agreement: Partnership comes into existence through an agreement (oral or written). A written agreement is called a Partnership Deed.
  3. Business: The agreement must be to carry on some lawful business. Joint ownership of property does not constitute a partnership.
  4. Mutual Agency: This is a crucial test of partnership. Each partner is both an agent and a principal.
    • As an agent, a partner can bind the firm and all other partners by his acts done within the ordinary course of business.
    • As a principal, a partner is bound by the acts of other partners.
    • The business can be carried on by all partners or any one (or more) of them acting for all.
  5. Sharing of Profits: The agreement must be to share the profits (and implicitly, losses) of the business. Sharing profits is essential, but sharing losses is not explicitly mandatory for all partners (e.g., a minor admitted only to benefits). However, for general partners, loss sharing is implied. Note: Sharing profits is prima facie evidence, but not conclusive proof, of partnership (the real test is mutual agency).

3. Partnership Deed

  • Meaning: A written document containing the terms and conditions of the partnership agreement.
  • Importance:
    • Avoids misunderstandings and disputes among partners.
    • Provides clarity on rights, duties, and liabilities.
    • Serves as evidence in court.
  • Typical Contents:
    • Name and address of the firm and its main business.
    • Names and addresses of all partners.
    • Amount of capital contributed by each partner.
    • Accounting period of the firm.
    • Date of commencement of partnership.
    • Rules regarding operation of bank accounts.
    • Profit and loss sharing ratio.
    • Rate of interest on capital (if any).
    • Rate of interest on drawings (if any).
    • Rate of interest on loans advanced by partners to the firm (if different from the statutory 6%).
    • Salaries, commissions, etc., payable to partners (if any).
    • Details of drawings allowed and interest thereon.
    • Rights, duties, and liabilities of each partner.
    • Procedures for admission, retirement, death of a partner.
    • Method of valuation of goodwill and assets on reconstitution.
    • Settlement of accounts on dissolution of the firm.
    • Duration of partnership (if any).
    • Arbitration clause for dispute settlement.

4. Provisions of the Indian Partnership Act, 1932, in the Absence of a Partnership Deed (or if the Deed is Silent on a particular point)

  • Crucial for numerical problems and MCQs. If there is no agreement or the deed is silent:
    1. Profit Sharing Ratio: Profits and losses are shared equally by all partners, irrespective of their capital contribution.
    2. Interest on Capital: No interest on capital is allowed to partners.
    3. Interest on Drawings: No interest is charged on drawings made by partners.
    4. Interest on Loan/Advances by a Partner: If a partner has given a loan or advance to the firm (beyond their capital), they are entitled to interest at the rate of 6% per annum. Note: This interest is a 'charge' against profit, not an 'appropriation'.
    5. Remuneration (Salary, Commission, etc.) to Partners: No salary, commission, or any other remuneration is allowed to any partner for taking part in the business operations.
    6. Admission of a New Partner: Cannot be admitted without the consent of all existing partners.
    7. Participation in Business: Every partner has the right to participate in the conduct of the business.
    8. Access to Books: Every partner has the right to inspect the books of account and take a copy of the same.

5. Special Aspects of Partnership Accounts

  • Accounting is similar to a sole proprietorship, but adjustments are needed for transactions involving partners (capital, drawings, interest, salary, profit distribution).

    (a) Maintenance of Capital Accounts of Partners

    • Transactions like capital introduction, withdrawal, interest on capital, drawings, interest on drawings, salary, commission, share of profit/loss are recorded in the partners' capital accounts.

    • Two methods are followed:

      • i. Fixed Capital Method:

        • Two accounts are maintained for each partner:
          • Capital Account: Records only the initial capital introduced, additional capital introduced, or permanent withdrawal of capital. The balance usually remains 'fixed'.
          • Current Account: Records all other adjustments like interest on capital, drawings, interest on drawings, salary, commission, share of profit/loss. The balance fluctuates.
        • Fixed Capital Accounts always show a credit balance (unless there's a permanent withdrawal exceeding original capital, which is rare). Current Accounts can show a debit or credit balance.

      • ii. Fluctuating Capital Method:

        • Only one account, the Capital Account, is maintained for each partner.
        • All adjustments (capital introduced/withdrawn, interest on capital, drawings, interest on drawings, salary, commission, share of profit/loss) are recorded directly in this account.
        • The balance of this account 'fluctuates' frequently.
        • It generally shows a credit balance, but can show a debit balance.

      • Note: In the absence of specific instructions, the Fluctuating Capital Method should be assumed.

    (b) Distribution of Profit among Partners: Profit and Loss Appropriation Account

    • This is an extension of the Profit and Loss Account.
    • Purpose: To show how the net profit (as per P&L A/c) is distributed or 'appropriated' among the partners.
    • Nature: Nominal Account.
    • Preparation:
      • Starts with Net Profit (credit side) or Net Loss (debit side) transferred from the P&L Account.
      • Debit Side: Shows appropriations like:
        • Interest on Capital
        • Salary to Partners
        • Commission to Partners
        • Transfer to Reserves
        • (Interest on Drawings is shown on the Credit side)
      • Credit Side: Shows:
        • Net Profit b/d (from P&L A/c)
        • Interest on Drawings
      • The balancing figure is the Divisible Profit (or Loss), which is transferred to Partners' Capital/Current Accounts in their profit-sharing ratio.

    (c) Difference between Charge Against Profit and Appropriation of Profit

    • Charge Against Profit: An expense deducted from revenue to determine Net Profit or Net Loss. It is debited to the Profit and Loss Account. It must be paid regardless of whether the firm earns profit or incurs loss. Examples: Rent paid to a partner, Interest on loan by a partner.
    • Appropriation of Profit: Distribution of Net Profit among partners or to reserves. It is debited to the Profit and Loss Appropriation Account. Appropriations are made only if there are sufficient profits. Examples: Interest on capital, Salary to partners, Commission to partners, Transfer to reserve.

    (d) Interest on Capital

    • Allowance: Allowed only if explicitly provided for in the Partnership Deed.
    • Purpose: To compensate partners for contributing capital, especially when capital contributions are unequal but profit sharing is equal (or different).
    • Calculation: Calculated on the opening capital balance (plus additional capital for the period it remained invested, minus withdrawn capital for the period it was withdrawn). Calculated for the relevant period.
    • Accounting Treatment:
      • It's an appropriation of profit (unless specifically stated to be treated as a charge).
      • Debited to P&L Appropriation A/c.
      • Credited to Partners' Capital/Current A/cs.
    • Important Considerations:
      • If Deed is silent: No interest allowed.
      • If Deed provides, but profits are insufficient: Interest is restricted to the amount of available profit, distributed in the ratio of interest claims (or capital ratio if interest rates are same).
      • If Deed provides and treats it as a 'charge': Full interest is allowed irrespective of profit or loss, and debited to P&L Account.

    (e) Interest on Drawings

    • Charging: Charged only if explicitly provided for in the Partnership Deed.
    • Purpose: To discourage excessive drawings by partners.
    • Calculation: Calculated on the amount withdrawn for the period the amount remained withdrawn. Methods:
      • Simple Method: Interest = Amount x Rate x Period
      • Product Method: Interest = Total Product x Rate x (1/12 or 1/365). (Used when drawings are irregular).
      • Average Period Method: Used when fixed amounts are withdrawn at regular intervals. Interest = Total Drawings x Rate x (Average Period / 12).
        • Beginning of every month: Average Period = (12+1)/2 = 6.5 months
        • Middle of every month: Average Period = 12/2 = 6 months
        • End of every month: Average Period = (12-1)/2 = 5.5 months
        • (Similar calculations for quarterly drawings: Beg=7.5, Mid=6, End=4.5 months; Half-yearly: Beg=9, Mid=6, End=3 months - assuming 12 month period).
    • Accounting Treatment:
      • Credited to P&L Appropriation A/c.
      • Debited to Partners' Capital/Current A/cs.

    (f) Salary or Commission to Partners

    • Allowance: Allowed only if provided for in the Partnership Deed.
    • Nature: Appropriation of profit (unless specified as a charge).
    • Commission Calculation: Can be a percentage of Net Profit before charging such commission OR after charging such commission.
      • Before charging: Commission = Net Profit (before commission) x (Rate / 100)
      • After charging: Commission = Net Profit (before commission) x (Rate / (100 + Rate))
    • Accounting Treatment:
      • Debited to P&L Appropriation A/c.
      • Credited to Partners' Capital/Current A/cs.

    (g) Interest on Loan by Partner to the Firm

    • Nature: It is a charge against profit, NOT an appropriation.
    • Rate: As per Deed. If Deed is silent, 6% per annum (as per Partnership Act, 1932).
    • Accounting Treatment:
      • Debited to Profit and Loss Account (not P&L Appropriation A/c).
      • Credited to Partner's Loan Account (or Partner's Capital/Current A/c if specified).

    (h) Rent Paid to a Partner

    • If a partner provides premises to the firm and charges rent.
    • Nature: It is a charge against profit, similar to rent paid to an outsider.
    • Accounting Treatment:
      • Debited to Profit and Loss Account.
      • Credited to Partner's Capital/Current Account (or Rent Payable A/c initially).

6. Guarantee of Profit to a Partner

  • Sometimes, a partner (or partners) may be guaranteed a minimum amount of profit.
  • If the actual share of profit for the guaranteed partner is less than the guaranteed amount, the deficiency is borne by the guaranteeing partner(s) in their agreed ratio (or their profit-sharing ratio if no specific ratio is agreed for bearing the deficiency).
  • Accounting involves calculating the deficiency and adjusting it through the Capital/Current accounts of the guaranteeing and guaranteed partners after the initial distribution of profit.

7. Past Adjustments (Adjustments in Closed Accounts)

  • If errors or omissions (like omission of interest on capital/drawings, salary, wrong profit distribution) are discovered after the final accounts have been prepared and profits distributed, they are rectified in the next year.
  • Rectification is usually done by passing a single Adjustment Journal Entry involving the Partners' Capital/Current Accounts.
  • An Adjustment Table is often prepared to calculate the net effect of the omissions and errors on each partner's account.

Multiple Choice Questions (MCQs)

  1. In the absence of a Partnership Deed, the profits of a firm are divided among the partners:
    a) In the ratio of capital
    b) Equally
    c) In the ratio of time devoted
    d) According to managerial abilities

  2. Interest on capital will be paid to the partners only if provided for in the Partnership Deed, but only out of:
    a) Profits
    b) Reserves
    c) Accumulated Profits
    d) Goodwill

  3. If a partner advances a loan to the firm and the Partnership Deed is silent on the interest rate, the partner is entitled to interest on the loan amount at:
    a) 5% per annum
    b) 6% per annum
    c) 12% per annum
    d) No interest is payable

  4. Which of the following items is NOT dealt with through the Profit and Loss Appropriation Account?
    a) Interest on Capital
    b) Partner's Salary
    c) Interest on Partner's Loan
    d) Partner's Commission

  5. When partners' capital accounts are fixed, where will the drawings made by a partner be recorded?
    a) Debit side of Partner's Capital Account
    b) Credit side of Partner's Capital Account
    c) Debit side of Partner's Current Account
    d) Credit side of Partner's Current Account

  6. A and B are partners sharing profits equally. A withdrew ₹ 2,000 per month at the beginning of every month for 6 months ending 30th Sept 2023. Interest on drawings is charged @ 10% p.a. What is the interest on A's drawings?
    a) ₹ 350
    b) ₹ 300
    c) ₹ 700
    d) ₹ 600
    (Calculation Hint: Total Drawings = 20006 = 12000. Avg Period for 6 months beginning = (6+1)/2 = 3.5 months. Interest = 12000 * 10/100 * 3.5/12)*

  7. Rent paid to a partner is:
    a) An appropriation of profit
    b) A charge against profit
    c) Debited to Partner's Capital Account
    d) Credited to P&L Appropriation Account

  8. The relationship between partners is primarily based on:
    a) Mutual Trust
    b) Capital Contribution
    c) Agreement
    d) Government Registration

  9. If the Partnership Deed provides for interest on capital @ 8% p.a., but the firm incurred a net loss for the year, the interest on capital will be:
    a) Allowed at 8% p.a.
    b) Allowed at 6% p.a.
    c) Not allowed
    d) Allowed only to the extent of loss

  10. Which of the following distinguishes partnership from joint ownership of property?
    a) Sharing of profits
    b) Agreement
    c) Business activity
    d) Mutual Agency

Answers to MCQs:

  1. b) Equally
  2. a) Profits (Generally, unless treated as a charge)
  3. b) 6% per annum
  4. c) Interest on Partner's Loan (It's a charge, debited to P&L A/c)
  5. c) Debit side of Partner's Current Account
  6. a) ₹ 350 (12000 * 10/100 * 3.5/12 = 350)
  7. b) A charge against profit
  8. c) Agreement
  9. c) Not allowed (As it's an appropriation, and there are no profits to appropriate. If it were treated as a charge, it would be allowed, increasing the loss).
  10. d) Mutual Agency (This is the conclusive test)

Remember to thoroughly understand the difference between Fixed and Fluctuating Capital methods, the items appearing in the P&L Appropriation Account, and especially the rules applicable in the absence of a Partnership Deed. These are frequently tested areas. Good luck with your preparation!

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