ACCOUNTANCY A LEVEL(FORM SIX) NOTES – PARTNERSHIP ACCOUNTING(1)

PARTNERSHIP ACCOUNTING

A. PARTNERSHIP

WHAT IS IT?

A partnership is a relationship between persons who have agreed to share the profit and loss of the business carried on by all with a profit motive.

Partners

Are persons making an agreement to carry business for a common purpose/intention.

• Individual – these are partners (persons by nature).
• Collectively – This is a firm (legal persons).

MAIN FEATURES OF PARTNERSHIP

1. Two or more persons.
2. There must be an agreement between partners.
3. Lawful business.
4. Profit motive.
5. Principal to agent relationship.
6. Unlimited liabilities.

B. CAPITAL ACCOUNTS

Capital can be contributed:

(a) In kind

Anything equivalent to cash e.g. a house, a car, etc.

TYPES OF CAPITAL ACCOUNTS

There are two types of Capital Account:

(a) Fluctuating Capital Account

• Also known as floating capital account.
• In this system, partners’ capital accounts do not remain intact as their original balance but fluctuate quite frequently.
• The capital account changes with all items concerning partners e.g. interest on drawings, interest on capital, partners’ salaries, commission, drawings, properties brought in, profit and loss distribution.

(b) Fixed Capital Account

Under this system, the original capital invested by the partners remains unaltered unless additional capital is invested or capital itself is withdrawn by mutual agreement.

(c) Partner’s Current Account

It is an account that carries all items concerning partners e.g. interest on capital, interest on drawings, drawings, partners’ salaries and wages, commission to partner.

(d) Profit and Loss Appropriation Account

This is an extension of the usual profit and loss account. It is prepared for adjusting transactions relating to the partnership deed.

Contents

• Interest on partner’s capital.
• Interest on partner’s drawings.
• Interest on partner’s loans.
• Partners’ salaries.
• Partner’s commission.

NOTE

These transactions are treated separately without mixing with general trading transactions.

EXERCISE 1

Amake and Babake started a partnership on 1^st January 2010. Both agreed in the partnership to do the following:

1. To contribute Shs. 100,000 each as capital.
2. To share profit and loss equally.
3. Interest on capital at a rate of 5%.
4. Interest on drawings at a rate of 10%.
5. Partner’s salary Shs. 50,000 per month each.

Transactions for the Month of January 2010:

Required

• Journal Proper to record all the transactions (No narration needed).
• Prepare ledger accounts to record all transactions relating to the month 1/2010.
• Prepare trading profit and loss account and appropriation account for the period in question.
• Show by extracting financial position of the partnership (Amake and Babake).

PROFIT AND LOSS APPROPRIATION ACCOUNT

PROFIT APPORTIONMENT BASIS

We have two bases of apportioning residual profits:

1. Time Basis Apportionment.
2. Profit Analysis Basis.

TIME BASIS APPORTIONMENT

In this method, profit is apportioned evenly between the various periods.

Example

A and B are in partnership sharing profit 3:2 respectively. On 1^st January their capital stood at 500,000 and 400,000 respectively. They admitted C as a new partner on 1^st October 2010, their new profit sharing ratio is 2:2:1. During the year the following transactions took place.

Required:

• Prepare Profit and Loss Appropriation Account on time basis for A and B partnership and ABC partnership. Financial year ended 31^st Dec. 2010.

Workings (W)

Total purchases 1,000,000 x 9/12 = 750,000
Total sales 2,500,000 x 9/12 = 1,875,000
Electricity 100,000 x 9/12 = 75,000
Salaries and wages 200,000 x 9/12 = 150,000
Interest on capital:
A – 600,000 x 10% x 9/12 = 45,000
B – 400,000 x 10% x 9/12 = 30,000
C – 100,000 x 10% x 3/12 = 2,500
Partner’s salaries (A, B & C) total 600,000 x 9/12 = 450,000

A, B & C PROFIT AND LOSS APPROPRIATION ACCOUNT FOR THE PERIOD ENDED 30TH SEPTEMBER 2010

SECOND METHOD; PROFIT ANALYSIS BASIS

In this method, profit is apportioned by using analyzed profit and loss. This requires the use of separate columns in the profit and loss account for the period in question.

a) Gross Profit

Is apportioned between the periods on the basis of turnover.

b) Fixed charges

Fixed charges are apportioned on the basis of time.

c) Variable charges

Variable charges are apportioned on the basis of turnover.

d) Other charges

Other charges with special information given are apportioned according to that given information.

EXERCISE

X and Y are carrying on a business in partnership sharing profit and losses in the ratio of 3:2 but during the year ended 31^st Dec 2007 two other members were admitted namely W and Z on July 1^st and Sept 30^th 2007 respectively. Net sales during the year amounted to shs. 250,000, selling and distribution expenses amount to shs. 12,000.

However, the firm’s sales breakdown were; Tshs.

January 1^st to March 31^st 62,500
April 1^st to June 30^th 93,750
July 1^st to Sept 30^th 31,250
Oct 1^st to Dec 31^st 62,500

The firm normally fixes the Gross profit at 25% above the cost.

Their profits and losses sharing ratios were:

X and Y and W was 2:2:1
X, Y, W and Z was 4:3:2:1

Prepare:

• a) The profit and loss account for the year ended 31^st Dec 2007.
• b) An appropriation account for the year ended Dec 2007.

SOLUTION

W₁; GROSS PROFIT AMOUNT
If the gross profit is 25% above the cost:
Thus sales are at 25%
G.P = 25% x 250,000 = 50,000
W₂; First 6 months G.P; (sales; – 62,500 + 93,750 = 156,250)
6 months G.P = Gross profit x sales for the period
= 50,000 x 156,250 / 250,000 = 31,250.
W₃; Gross profit from July 1^st – 30^th Sept (sales = 31,250)
3 months G.P = 50,000 x 31,250 / 250,000 = 6,250
W₄; Gross profit from October 1^st – Dec 31^st (sales = 62,500)
Last 3 months G.P = 50,000 x 62,500 / 250,000 = 12,500
W₅; Administrative expenses 12,000
a) X 12,000 = 6,000
b) Y 12,000 = 3,000
c) W 12,000 = 3,000
Selling and distribution expenses 25,000
a) For 6 months sales = 156,250
6 months selling and distribution exp.
Total expenses x sale for the period / Total sales
25,000 x 156,250 / 250,000 = 15,625
b) For next 3 months sales = 31,250
3 months selling and distribution exp. = 25,000 x 31,250 / 250,000 = 3,125
c) For the last 3 months sales = 62,500
Last 3 months selling and distribution exp. = 25,000 x 62,500 / 250,000 = 6,250

DR PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 31ST DEC 2007 CR

PROFIT AND LOSS APPROPRIATION A/C FOR THE PERIOD ENDED 31/6/07

ADMISSION OF PARTNERS

• When additional capital or managerial skills or both are required in the course of expansion, it is usual to take new partner(s) into the partnership firm.
• The new partner usually invests additional capital to the firm.
• Admission of a new partner raises the following things:

1. Treatment of Goodwill
2. Revaluation of Assets and liabilities
3. Re-arrangement of old partners’ capital balances after admission
4. Re-arrangement of old partners’ profit sharing ratios

GOODWILL

• Goodwill simply means the good name or the reputation of the business.
• Attraction of more customers depends on goodwill and helps in earning more profit in future.
• Goodwill is an asset.
• New partner gets benefit of the extra asset and old ones lose their shares.
• When a new partner gets some shares in the profit of the firm, he acquires the same rights in the existing assets of the firm and in the extra asset (goodwill).
• If that’s the case, automatically the incoming partner has to compensate the old partners either:

By paying in cash for his share of goodwill.
By allowing the old partners’ capital accounts to be raised rateably.

Method of Valuing Goodwill / Methods of Calculating Goodwill

The goodwill of any business whether sole trader, firm, or company is generally determined by sharing. But it depends upon the following factors:

1. Present earning capacity of the business.
2. Results of the operations of a few previous years.
3. The future prospects of the business.
4. Efficiency of management and employees.
5. Efficiency of advertising machinery and possession of trademarks.

WHEN VALUATION IS NEEDED

(a) On admission of a new partner.
(b) On retirement of a partner.
(c) When changing profit sharing ratios.
(d) On sale of the business.
(e) During amalgamation.
(f) On dissolution.

METHOD OF VALUATION OF GOODWILL

We have four methods of valuation of goodwill:

1. Purchase of Past Profit Method
2. Purchase of Super Profits Method
3. Inferred or Implied Goodwill Method
4. Valuation by Bargaining (Arbitrary Method)

– The value of goodwill is decided by direct bargaining between the buyer and seller.
– For examination purposes, such an amount is usually mentioned.

(a) Purchase of Past Profit Method

In this method, goodwill is valued at an agreed number of years (2-3 years) of an average profit of a given number of past years. Illustration:

Goodwill is valued at two years purchase of the average profits of four years.

• It means average of four years profit multiplied by two.

Goodwill = Average profit x number of years of purchase
= 50,000 x 2 = 100,000
Goodwill = 100,000

B. Purchase of Super Profit Method

Super profit is the difference (excess) between average annual earning (actual) of the business and the expected or normal return on capital invested. If the average annual profit of the business is Shs. 500,000 and the normal earning capacity is 6%, and the capital invested is Shs. 800,000, find super profits.

Super Profit = Average profit (Actual) – Normal return on capital invested.
= 50,000 – (6% x 800,000)
= 50,000 – 48,000
= 2,000

Then super profit is taken as a base in compilation of goodwill.
The goodwill is valued at a certain years of purchase of that super profit.
3 years purchase: 2,000 x 3 = 6,000

C. Inferred or Implied Goodwill Method

When a prospective buyer of a business agrees to pay more than the value of the business taken over, the difference between the purchase price and actual value of the business is known as inferred or implied goodwill.

Example:
If the assets worth 1,000,000 Tshs along with the liabilities of Tshs. 30,000 are taken over by a buyer for Shs. 1,000,000, then the goodwill is:
Goodwill = Purchase Price – Value of the business
= 1,000,000 – (1,000,000 – 30,000)
= 1,000,000 – 970,000
= 30,000

D. Valuation by Bargaining (Arbitrary Valuation)

– The value of goodwill is decided by direct bargaining between the buyer and seller.
– For examination purposes, such an amount is usually mentioned.

ACCOUNTING TREATMENT OF GOODWILL ON ADMISSION

There are two methods in which goodwill can be accounted in the books on admission:

(a) When the goodwill is not appearing in the books.
(b) When the goodwill is already appearing in the books (in the balance sheet).

(c) When goodwill is not appearing in the books.
(d) When new partner pays cash for goodwill, it is always equal to his share in the total goodwill.