Unit-III : Concept of Partnership
Definition and Concept
A partnership is a business organization where two or more individuals come together to run a business, share its profits, and bear its risks. It is based on mutual agreement and governed by the provisions of the Indian Partnership Act, 1932.
Definition:
"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."
Key Features of a Partnership:
- Agreement: A partnership is formed through mutual agreement, oral or written.
- Number of Partners: Minimum 2 partners; the maximum is:
10 for banking business.
20 for other businesses.
- Profit Sharing: Profits (and losses) are shared among partners as per their agreement.
- Business: The partnership must carry on lawful business activity.
- Mutual Agency: Both the partners are agents as well as principals for the firm.
- Unlimited Liability: Partners are liable for the debts of the firm.
- Registration: Though it is not necessary, registering a partnership gives legal advantages.
Partnership Deed
A partnership deed is that written agreement by all partners of a partnership firm based on the terms and conditions that may surround their business relationship. A partnership deed acts as a document formalizing the relationship for avoiding disputes and keeping the partnership smooth in operations.
Main Points about Partnership Deed
Legal Recognition:
The Indian Partnership Act, 1932 does not make the partnership deed mandatory but highly recommended.
It shows greater clarity and less misunderstanding among partners.
Contents of a Partnership Deed:
The deed usually consists of:
- Name and address of the firm and its partners.
- Nature of business to be conducted.
- Capital contribution by each partner.
- Profit-sharing ratio among the partners.
- Duties, responsibilities, and liabilities of each partner.
- Provisions for admission, retirement, or expulsion of a partner.
- Procedure for the dissolution of the firm.
- Any other terms mutually agreed upon by the partners.
Advantages:
- Reduces vagueness.
- Gives legal recourse in case of disputes.
- Facilitates effective handling of the partnership.
Registration:
- Although not essential, registration of a partnership deed can offer benefits in terms of law, where it can make a case or sue in courts.
Fixed and Variable Capital Account
Fixed Capital Account
Within a partnership firm, under Fixed Capital Method, the capital brought by partners neither increases nor reduces unless new and permanent capital is added or taken out.
The following two are maintained for a partner:
- Capital Account: Accounts only for fixed capital.
- Current Account: Provides for recording all transactions such as profits, losses, interest on capital, drawings, and salaries.
The capital is thus fixed, not fluctuating with regular business transactions.
Fluctuating Capital Account:
- The Fluctuating Capital Method records all these transactions directly in a single Capital Account for a particular partner.
- The capital balance will fluctuate with increases or decrease because of these transactions.
- No Current Account.
Valuation of Goodwill
Goodwill is an intangible asset that represents the value of a business's reputation, customer relationships, brand recognition, and other non-physical attributes that provide economic benefits. The valuation of goodwill is essential in scenarios such as business acquisitions, mergers, partnerships, or dissolutions.
Importance of Goodwill Valuation
- Business Sales: To ascertain the value of a business available for sale.
- Mergers and Acquisitions: To evaluate the premium paid over the book value of assets.
- Partnership Changes: To calculate compensation during admission, retirement, or death of a partner.
- Legal Requirements: Compliance in cases of insolvency or disputes
Methods of Valuation of Goodwill
- Average Profits Method
Goodwill = Average Profits × Number of Years' Purchase
Here, the past profits average is multiplied by a chosen number of years.
2. Super Profits Method
Goodwill = Super Profits × Number of Years' Purchase
Super Profits = Actual Profits − Normal Profits (calculated using capital employed × normal rate of return).
3.Capitalization Method
(a) Capitalization of Average Profits
Goodwill = Capitalized Value of Business − Net Tangible Assets
Capitalized Value = Average Profits / Normal Rate of Return.
(b) Capitalization of Super Profits
Goodwill = Super Profits / Normal Rate of Return.
4.Annuity Method
Goodwill is calculated by discounting the future super profits as an annuity using a specific discount rate.
Factors Affecting Goodwill
- Location: A prime location can increase goodwill.
- Reputation: Established brand reputation adds value.
- Quality of Products/Services: Higher quality ensures customer loyalty.
- Efficiency of Management: Skilled management increases profitability and goodwill.
- Market Conditions: Favorable market trends enhance goodwill.
Profit Sharing Ratio
The Profit Sharing Ratio is the ratio in which the net profit or loss of a partnership business is divided among the partners according to the terms specified in the partnership deed. If no specific ratio is mentioned in the partnership deed, profits and losses are usually shared equally among all partners.
Admission of Partners
The admission of a partner refers to the bringing into an existing firm of partnership under a new partnership deed as acceptable to all partners in that partnership. It means a change in the partners that calls for readjustments of profit sharing, revaluation of assets and liabilities, and also goodwill settlement.
Important Points:
- New Partnership Deed: In this, terms relating to a new partner could be written under a new partnership deed.
- Goodwill Treatment: The new partner has to pay for the goodwill of the existing partners.
- Capital Adjustment: The new partner brings in capital, which is adjusted according to the requirements of the firm.
- Profit-Sharing Ratio: A new ratio is created that will be used to share the profits and losses of the firm with the new partner.
Profit and Loss adjustment Account
In addition, this Profit and Loss Adjustment Account is usually prepared to rectify any errors, omissions, or discrepancies in the financial statements of any business organization. In many cases, it is used in partnership accounting when a firm is about to go into dissolution or reconstitution.
Definition:
The Profit and Loss Adjustment Account is an account where corrections made on the previous profit or loss figures because of errors, depreciation, outstanding expenses, prepaid expenses, among other financial corrections, are recorded.
Purpose:
- Rectification of past errors.
- To adjust closing balances for expenses and incomes.
- To ensure an accurate profit or loss figure for the financial period.
Steps to Prepare:
- Debit Side:
- Record undercharged expenses.
- Include losses, depreciation, or outstanding expenses.
- Record overcharged expenses.
- Include gains, accrued income, or errors increasing profits.
Balance Sheet
A Balance Sheet is a financial statement that gives an organization's financial position at a given point in time. It states the company's assets, liabilities, and equity and is governed by the basic accounting equation:
Assets = Liabilities + Equity
Preparation Steps for a Balance Sheet:
1. Determine the Reporting Date- Identify the date on which the financial position is to be reported.
2.Classify Accounts
Accounts should be separated into:
- Assets: Resources owned by the company (e.g., Cash, Accounts Receivable, Inventory, Fixed Assets).
- Liabilities: Obligations to outsiders (e.g., Loans, Accounts Payable).
- Equity: Owners' claim after liabilities are deducted (e.g., Share Capital, Retained Earnings).
3. Current and Non-Current Items
- Current Assets and Liabilities: Expected to be used or settled within a year.
- Non-Current Assets and Liabilities: Long-term in nature.
4. Determine Balances
Use trial balance and adjustments to determine the final balances of each account.
5. Arrange in Order
Follow the standard format:
- Assets (Current and Non-Current)
- Liabilities (Current and Non-Current)
- Equity
6. Balance should be ensured
Check that Assets = Liabilities + Equity.
Format of a Balance Sheet:
Horizontal Format
Assets | Liabilities and Equity
-----------------------------------------|----------------------------------
1. Current Assets | 1. Current Liabilities
- Cash - Accounts Payable
Account Receivables - Short-term Loans
- Inventory | 2. Non-Current Liabilities
2. Non-Current Assets | - Long-term Loans
- Property, Plant and Equipment | 3. Equity
- Investments | - Share Capital
| - Retained Earnings
-----------------------------------------|----------------------------------
Total Assets Total Liabilities and Equity
Liabilities Assets
- Current Liabilities - Current Assets
- Non-Current Liabilities - Non-Current Assets
- Equity Total Liabilities = Total Asset
Death and Retirement of Partners
Retirement of a Partner:
The retirement of a partner is when a partner voluntarily retires from the partnership firm. On retirement, the partnership is reconstructed, and the rights, liabilities, and claims of the retiring partner are settled.
Important points:
- Settlement of Dues: The retirement partner is entitled to the share of the assets, goodwill, and profits of the firm.
- Goodwill adjustment: Share of the outgoing partner in the goodwill of the firm is ascertained and distributed among the continuing partners.
- Assets and liabilities are revalued: The assets and liabilities of the firm are revalued to calculate profit or loss distributed among all partners.
- Profit sharing ratio of remaining partners: The profit-sharing ratio of the continuing partners is readjusted.
- Settlement Modes: The retiring partner's dues may be settled in cash, transferred to a loan account, or paid in installments.
Death of a Partner:
The death of a partner results in the dissolution of their relationship with the firm, but the firm may continue if the remaining partners agree. The legal heirs of the deceased partner are entitled to their share in the partnership.
Key points:
Calculation of Share: The share of profits, goodwill, and capital of the deceased partner is calculated up to the date of death.
Revaluation of Assets and Liabilities: Like retirement, assets and liabilities are revalued.
Share of Profit: The share of profit of the deceased partner is calculated based on the time or turnover up to the date of death.
Payment to Legal Heirs: The share of the deceased partner is transferred to legal heirs or as settled in the partnership deed.
Important Terms
Goodwill Revaluation: Share of goodwill in case of retiring or deceased partners.
Reformation of Partnership: Change in partnership terms due to retirement or death.
Executor's Account: It is an account opened to adjust the claims against the deceased partner.
Retirement of a Partner
Definition
A partner retires when one of the partners existing in a partnership firm is willing to opt out of it due to such reasons as aging, ill health, or being interested in his personal business. The partnership carries on with new agreements between the remaining partners.
Important Points:
1. Settlement of Dues:
- The retiring partner is entitled to:
His capital share.
Accumulated profits, reserves or losses.
The revaluation of assets and liabilities.
- Goodwill.
- The amount payable is transferred to the loan account of the retiring partner or paid in cash.
2. Adjustment of Goodwill:
- Goodwill refers to the goodwill of the firm.
- Retiring partner's share of goodwill is adjusted for compensating him
- Gaining ratio of other partners carries the share of goodwill of the retiring partner.
3. Revaluation of Assets and Liabilities: -
- The revaluation account is used to find out how much profit or loss was there due to a change in the value of assets or liabilities.
- The profit or loss is distributed among all the partners, including the retiring partner, at their old profit-sharing ratio.
4. New Profit Sharing Ratio
- After retirement, the remaining partners rectify their profit-sharing ratio
- Gaining Ratio is found out as to which ratio the remaining partners compensate the retiring partner for goodwill.
5. Settlement of Retiring Partner's Account:
- It can be cash, installments, or transfer to the retiring partner's loan account.
- Accounting Entries for Retirement:
To Asset Account (Increase)
To Partner's Capital Account
(Loss on Revaluation)
OR
Partner's Capital Account Dr.
To Revaluation Account
(Profit on Revaluation)
Adjustment of Goodwill:
To Retiring Par's Cap Acc
Settlement of Retiring Partner:
To Cash/Bank/Retiring Par's Loan Acc
Death of a Partner
Introduction:
At the time of the death of a partner, the association he had with the firm ceases to exist. The partnership deed or relevant legal provisions would state who should receive the amount due to the deceased partner and the share due to him.
Important Points
1. Calculation of Share :
- The share of profits, goodwill, and revaluation of assets and liabilities of the deceased partner is calculated.
- It is calculated up to the date of death.
2. Share of Profit:
- Profit share of the deceased partner is due up to the date of death.
- Calculation Methods of Profit:
- Time Basis: Profits vary directly with the time the deceased partner has been in the firm.
- Turnover Basis: Prove is arrived at considering the turnover during the deceased partner's lifetime.
Illustration : If annual profit be ₹ 1,00,000 and the partner dies after three months, then profit share = ₹ 1,00,000 x 3/12 = ₹25,000.
3. Revaluation of Goodwill :
- Goodwill attributable to the deceased partner is calculated and adjusted among the surviving partners in their gaining ratio.
4. Revaluation of Assets and Liabilities :
- Preparing a revaluation account to calculate any change in the value of assets or liabilities.
- The old profit-sharing ratio is followed for the distribution of profit or loss among all partners, including the deceased partner.
5. Settlement with Legal Heirs:
- Capital account of the deceased partner along with his share of profits, goodwill, and revaluation is settled and transferred to his legal heirs.
Accounting Entries on Death:
1. Revaluation of Assets and Liabilities:
To Asset Account (Increase)
To Partner's Capital Account
(Loss on Revaluation)
Partner's Capital Account Dr
To Revaluation Account
(Profit on Revaluation)
2. Share of Profit:
To Deceased Par.'s Cap. Acc.
Adjustment of Goodwill:
Conti. Par. Cap. Acc. Dr.(GR)
To Deceased Par's Cap. Acc.
3.Settlement of Deceased Partner's Dues:
To Legal Heirs Account
To Cash/Bank Account