Chapter 1- Partnership [FAR160] PDF

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Partnership AccountsCHAPTER 1: PARTNERSHIP ACCOUNTS1 IntroductionThere are various types of business. One of those kinds is a partnership. Partnership is a business owned by two or more people who agree on the distribution of profits and/or losses and on the extent to which each will be liable for t...

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Chapter 1 Partnership Accounts CHAPTER 1: PARTNERSHIP ACCOUNTS 1.0

Introduction There are various types of business. One of those kinds is a partnership. Partnership is a business owned by two or more people who agree on the distribution of profits and/or losses and on the extent to which each will be liable for the debts of one another. There are many advantages of partnership, for example: a) Partnerships are relatively easy to establish. b) With more than one owner, the ability to raise funds may be increased, both because two or more partners may be able to contribute more funds and because their borrowing capacity may be greater. c) Every partner has enough time in managing their business operations due to contribution of time from other partners. d) A partnership may benefit from the combination of complementary skills of two or more people. There is a wider pool of knowledge, skills and contacts. e) Partnerships can be cost-effective as each partner may be having specialization in certain areas in their business. f) Partnerships provide moral support and more ideas for the goodness of the business.

However, partnership also has its own disadvantages as compared to other types of business, for example: a) Every partner is jointly and individually liable for the actions of the other partners. b) Profits and losses must be shared among partners. The problem is on how we value each other’s time and skills spent on the business operations. c) Every partner can give any ideas for the improvement of the business. Since decisions are shared, disagreements can occur. d) The partnership may have a limited life; it may end upon the withdrawal or death of a partner. e) Every partner must consult other partners and negotiate more as they cannot make decisions by themselves. They must be more flexible and open minded. f) A major disadvantage of a partnership is unlimited liability. General partners are liable without limit for all debts contracted and errors made by the partnership.

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Chapter 1 Partnership Accounts 1.1

Characteristics of Partnership Partnership Act 1961 was defined partnership as the relationship which exists between persons carrying on a business in common view to make profits. Basically, there are three main types of partnerships. They are: a) General Partner In general partnerships, two or more partners, jointly and severally, share all profits and losses, management authority, and risk for the business. b) Limited Liability Partner In a limited liability partnership, the partners have an option either to participate in management or not. This partner has a limited liability up to the capital invested in the business if there any claims from the creditors. The creditors cannot take any personal wealth of this partner as a settlement of the debt. c) Sleeping Partner In sleeping partner, this partner is not actively participating in the management. They are only contributing the capital and share profits and losses. However, they are also liable for the partnership debts.

1.2

The Partnership Agreement An agreement must be set up by partners before they are running the business. This can be done through either written or oral agreement. But, normally, the agreement will be written since they want to avoid any misunderstanding or disagreements that could arise among partners later. This agreement should comprise of: i) Name of partners and name of the business. ii) Capital contributed by each partner. iii) Profit sharing ratio among partners. iv) Salary paid to partners, if any. v) Interest on capital that paid to partners, if any. vi) Interest on drawings that paid to partners, if any.

1.3

The Partnership Act 1961 If the partnership does not set up any agreement among members, then they must follow the Partnership Act 1961. According to this act: i) The profits and losses will be shared equally among partners regardless the amount of capital contributed by every partner. ii) Partners are not entitled for the salary. iii) Partners will not receive any interest on capital and interest on drawings. iv) Partners will receive only 8% interest on advances made to the business. v) Every partner should take part in the management and can access to the partnership books anytime. vi) Business decisions must be agreed by all members.

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Chapter 1 Partnership Accounts 1.4

Accounting for Partnership The business must maintain various books. In partnership, the recordkeeping is not too different from sole trader. This business still has to record the transactions in ledgers and journals but the different is the recording items in capital account and a few accounts must be created for this business-like current account for every partner and the appropriation account (show the profits allocated for every partner). There are two types of capital account; they are fixed capital account and fluctuating capital account. i. Fixed capital account The capital that contributed by partners will remain fixed over the life of the business. For that purpose, the business must maintain two accounts separately; they are capital account and current account. However, all items that related to partners’ income such interest on drawings, interest on capital, share of profits and losses etc will be entered into Current Account. The capital account will only be affected when there are additional capital and drawings made by partners. ii. Fluctuating capital account The capital account will not be fixed, and it is always fluctuating since all the entries that related to drawings, interest on drawings, interest on capital, share of profits and losses etc are recorded in the capital account. Format of Partner Capital a/c: Partner’s capital a/c Particulars Balance b/d Add: Goodwill (OPSR) Revaluation profit Realization profit

Partner A

Partner B

xx xx

xx xx

Less: Goodwill (NPSR) Revaluation loss Realization loss

xx xx

xx xx

Balance c/d

xx

xx

Besides capital account, the business also must maintain the Current account. The entries under the Current account are all items like drawings, interest on drawings, interest on capital, share of profits and losses etc. Given below is the format of current account:

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Chapter 1 Partnership Accounts Partner’s current a/c Particulars Balance b/d Add: Interest on capital Salary (Accrued) Interest on loan Share of profit Less: Drawings Interest on drawings Share of loss Balance c/d

Partner A xxx xx xx xx xx (xx) (xx) (xx)

Partner B xxx xx xx xx xx (xx) (xx) (xx)

xxx

xxx

1.4.1

Interest on Capital The interest will be given to the partners due to the contribution of capital to the business. This is also a method to encourage partners in contributing more capital in the partnership. The amount will be entered into the Current account as well as the Appropriation account.

1.4.2

Interest on drawings The interest will be charged to the partners because of the drawings made by them. This amount will be considered as an expense to the partners. The amount will be entered into the Current account and the Appropriation account.

1.4.3

Interest on loan (advances) The interest is given to the partners who gave loans to the business. But, the treatment for loan received can be divided into two; either it can be treated as a loan from insiders (partner) or outsiders (other bankers). If it is treated as a loan from insiders (partner), amount of interest will be recorded in the Appropriation Account while if not, it will be recorded in the Statement of Comprehensive Income. This amount is considered as an income to the partners. The amount will be entered into the Current account and the Appropriation account.

1.5 The Appropriation Account Given below is the format of the Appropriation Account: Appropriation Account for the year ended …… RM Net profit (from profit and loss account) Interest on drawings: - Partner A - Partner B - Partner C

RM xxx

xx xx xx xx

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Chapter 1 Partnership Accounts Less: Salaries: - Partner A - Partner B - Partner C

xx xx xx xx

Interest on capital: - Partner A - Partner B - Partner C

xx xx xx xx

Interest on loan: - Partner A - Partner B - Partner C

xx xx xx xx xxx

Current account – share of profit/loss - Partner A - Partner B - Partner C

xx xx xx xxx

1.6

Minimum Guaranteed Profit One of the partners may eligible for minimum guaranteed profit. It is the minimum profit that the partner will get in a year. If there any deficiency, it will be borne by other partners based on profit sharing ratio. Example: Caca, Cici and Cucu are partners in partnership. Based on their agreement, Cici is having a minimum guaranteed profit of RM15,000. Their profit-sharing ratio is 2:2:1 respectively. The deficiency will be borne by Caca and Cucu. Assume the distributable profit are: a) RM60,000 b) RM30,000 Suggested solution: Distributable profit = RM60,000

Caca Cici Cucu

Apportionment of profit (without minimum guaranteed profit 60,000 x 2/5 = 24,000 60,000 x 2/5 = 24,000 60,000 x 1/5 = 12,000

Apportionment of profit (with minimum guaranteed profit) 60,000 x 2/5 = 24,000 60,000 x 2/5 = 24,000 60,000 x 1/5 = 12,000

Cici will receive RM24,000 of her share. This amount is already exceeded the minimum profit.

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Chapter 1 Partnership Accounts Distributable profit = RM30,000

Caca

Apportionment of profit (without minimum guaranteed profit 30,000 x 2/5 = 12,000

Cici

30,000 x 2/5 = 12,000

Cucu

30,000 x 1/5 = 6,000

Apportionment of profit (with minimum guaranteed profit) 30,000 x 2/5 = 12,000 – (3,000 x 2/3) = 10,000 30,000 x 2/5 = 12,000 + 3,000 =15,000 30,000 x 1/5 = 6,000 – (3,000 x 1/3) = 5,000

Cici is guaranteed a minimum profit of RM15,000. Any deficiency is bear by Caca and Cucu. 1.7

Dissolution of Partnership A partnership business can be dissolved due to one of the following factors: i. ii. iii. iv. v.

One of the partners become incapable to performing the business One of the partners become bankrupt or die Disagreement between partners The business is no longer profitable or not relevant to the market Restriction in business operation due to change in law and regulation.

Upon dissolution of partnership business, all the asset must be disposed or sell, and all the liabilities should be settled off. Any profit or loss exist during the dissolution must be distributed among the partners according to the partnership agreement and the Partnership Act, 1961. 1.7.1 Garner Vs Murray Rule When a partner is insolvent and has a debit balance in his capital account, thus, in this situation the Garner Vs Murray can be applied. Garner Vs Murray in 1904 stated that ‘the others partner who are solvent have to bear the deficiency according to their last agreed capital amount’’. The meaning of last agreed capital amount is the amount capital balance in Statement of Financial Position and not based on the profit-sharing ratio. Therefore, Garner Vs Murray rule only can be applied: ! ! !

Upon dissolution When there are at least 3 partners The partner has a debit balance in capital account and become insolvent.

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Chapter 1 Partnership Accounts COMPREHENSIVE QUESTION Jani, Lee and Ton are in partnership, preparing accounts to 31 December each year. Their partnership agreement states that: 1. The partners are entitled to 5% per annum interest on their opening capital accounts. No interest is allowed (or charged) on current account balances. 2. Interest is charged on the partners' drawings at 7% per annum. Their drawings during the year to 31 December 2019 were as follows:

Jani Lee Ton

1 June 2019 RM10,000 RM12,000 RM3,000

1 November 2010 RM30,000 RM20,000 RM3,000

3. Partners' annual salaries are Lee RM6,000 and Ton RM 12,000. As at 31 December 2019, the partners only received salaries up to October 2019. 4. Remaining profits and losses are shared between Jani, Lee and Ton in the ratio 5:4:1. Ton is guaranteed a minimum profit of RM10,000 per year. If the profits are insufficient, the deficiency should be borne by the other two partners according to their profit-sharing ratio. The partners' capital and current account balances as at 1 January 2019 are as follows: Capital a/c Current a/c RM RM Jani 50,000 16,320 Cr Lee 30,000 1,110 Cr Ton 10,000 (590) Dr The capital account balances remained unchanged during the year to 31 December 2019. 5. In addition to the above capital, Jani has advanced a further RM 15,000 on 1 July 2019. This transaction has not been recorded and to be treated as Appropriation item. 6. The partnership's net profit for the year to 31 December 2019 is RM81,961. Required: a)

Prepare an appropriation account for the year ended 31 December 2019. (8 marks)

b)

Prepare the partners' current accounts (in columnar form) for the year to 31 December 2019. (6 marks)

c)

Explain why it is generally thought preferable to maintain fixed capital accounts, rather than fluctuating capital account for each partner. (2 marks)

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Chapter 1 Partnership Accounts SUGGESTED SOLUTION a. Jani, Lee and Ton Appropriation Account for the year ended 31 December 2019 Net Profit for the year Add: Interest on drawings Jani (7% x 10,000 x 7/12) + (7% x 30,000 x 2/12) Lee (7% x 12,000 x 7/12) + (7% x 20,000 x 2/12) Ton (7% x 3,000 x 7/12) + (7% x 3,000 x 2/12)

81,961 758 723 158 1,639 83,600

Less: Interest on capital Jani (5% x 50,000) Lee (7% x 30,000) Ton (7% x 10,000)

2,500 1,500 500 (4,500)

Less: Salaries Lee Ton

6,000 12,000 (18,000)

Less: Interest on loan Jani (8% x 15,000 x 6/12)

(600) 60,500

Share of profit Jani (5/10 x 60,500) = 30,250 - (5/9 x 3,950) Lee (4/10 x 60,500) = 24,200 - (4/9 x 3,950) Ton (1/10 x 60,500) = 6,050 + 3,950

28,056 22,444 10,000 60,500

b. Jani Balance b/d Drawings IOD Balance c/d

40,000 758 6,718

47,476

Partner current account Lee Ton 590 Balance b/d 32,000 6,000 IOC 723 158 Salaries 5,752 IOL Profit sharing Balance c/d 32,723 12,500

Jani 16,320 2,500 600 28,056 47,476

Lee 1,110 1,500 1,000

Ton 500 2,000

22,444 10,000 6,669 32,723 12,500

c. It can show the actual amount of capital of capital contributed by each partner and It will ensure that the amount of drawings made by partners do not exceeds their capital

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Chapter 1 Partnership Accounts CHANGES IN A PARTNERSHIP (BEFORE ACCOUNTING PERIOD) 2.0

Introduction For the partnership business, it could happen a leaving by partners like retirement, death of a partner or change in profit sharing ratio. Sometimes, a new partner will be introduced in a business. Those situations are called as changes in a partnership. Whenever it is happened, the business must be dissolved, and the remaining partners will make a new agreement. In other words, the old book of accounts will be closed and the new one will be opened. There are two types of changes; they are changes that happened at the end or begin of accounting period or changes that happened during the accounting period. Besides that, partners are also required to: a) Revalue the partnership assets. b) Calculate the amount of goodwill.

2.1

Changes at the year-end or begin These changes happened at the year-end or begin. The important things are the business must revalue the assets and calculate the amount of goodwill. Whenever it is happened, the remaining balance in the Capital and Current account must be paid to the leaving partner. The amount remains could be paid by cash, bank or sometimes that partner willing to treat it as a loan to the business.

2.2

Revaluation account Whenever changes happened, the partnership must be dissolved. Besides that, the business also must revalue their assets up to the fair value. This is the fair treatment for the remaining partners since we want to know the actual value of assets when the changes happened. The comparison between the fair value and the carrying value of the assets will be made in order to get the net worth of their share of the net assets. Normally, there are differences between both values. That differences also actually referring to the profit or loss on revaluation. If the amount of fair value is higher than carrying value then there is a profit on revaluation, whereas if the carrying value of an asset is higher that the fair value, then it is a loss on revaluation. The comparison of both values will be recorded in a temporary account namely Revaluation account. The purpose of this account is to know whether the business will get the profits or losses on revaluation. Amount of profits or losses will be transferred to the Capital account. Example: Alif, Ba and Ta are partners in a firm. They are operating the services business. Profits and losses are to be shared in the ratio of 3:2:1 respectively. Unfortunately, Alif died in an accident. The assets of the partnership were: RM 19,000

Building at carrying value

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Chapter 1 Partnership Accounts Motor vehicle Trade receivables

35,000 12,000

Upon Alif’s death, the assets of the partnership are revalued up to the fair values as follows: RM Building 25,000 Motor vehicle 32,000 Trade receivables 11,000 Required: Prepare the revaluation account.

Suggested solution: Particulars

Revaluation a/c Debit

Increase in Building Decrease in Motor vehicles Decrease in Trade receivables

Balance

6,000 3,000 1,000

Share of profit Partner capital a/c Alif 1,000 Ba 667 Ta 333

2.3

Credit

2,000

(2,000)

Goodwill Goodwill is an intangible asset. Its existence due to various reasons such as location of the business’s premises, good products or services, top management and workers’ relationship etc. It is also considered as the value of the business. That value normally will be based on the selling price of the business. For that purposes, the amount of goodwill must be assessed same as the revaluation of assets whenever changes happened. However, according to MFRS 138 (Intangible assets), the amount of goodwill will not be maintaining in the statement of financial position. There are two methods on how to calculate the amount of goodwill. They are accounting profit and super profit method.

1.3.1 Methods of Determining Goodwill i. Accounting Profit Under this method, it will use the average annual profit of the business for the past number of years. The amount of goodwill will be determined based on the number of years’ purchase of the net profit that calculated before.

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Chapter 1 Partnership Accounts

Example There are three partners in a partnership. They are Aminah, Bakar and Chong. Chong has retired due to his health. Upon his retirement, the amount of goodwill will be taken as equal three years’ purchase of the average annual profit for the last five years. RM 2007 30,500 2008 42,000 2009 39,000 2010 50,000 2011 52,000 Required: Calculate the amount of goodwill. Suggested solution 1. Find the amount of average annual profit. Average annual profit = 30,500 + 42,000 + 39,000 + 50,000 + 52,000 5 years = RM42,700. 2.

Find the amount of goodwill RM42,700 x 3 years = RM128,100

ii. Super Profit Method The amount...