Working in partnership

A key difference is derived from the basic definitions of ‘sole trader’ and ‘partnership’. A ‘sole trader’ is precisely that – someone who trades on their own. Therefore, there is only one owner of the business, and all of the profit earned by the business belongs to the owner. Consequently, the profit and loss account is closed off by the transfer of profit to the owner’s capital account.

The format in which a sole trader’s profit and loss account is typically presented may mean that candidates are not always aware of the need for this transfer. Candidates should remember that the profit and loss account is part of the double entry system, with the relevant ledger account balances being written off to the profit and loss account. The resulting balance (of profit or loss for the period) is then transferred to the owner’s capital account. If the result for the period is a profit, the double entry will be:

Dr Profit and loss account
Cr Capital

This maintains the accounting equation, and reflects the fact that capital is increased by the profit for the period.

On the other hand, a partnership is defined as ‘the relationship... between persons carrying on a business in common with a view of profit.’ This definition is taken from the UK Partnership Act of 1890. It is also relevant to the international papers (but candidates preparing for international papers should replace references to ‘profit and loss account’ in this article with ‘income statement’). This means that in a partnership there is more than one owner, and the profit is shared between the owners.

In a partnership, it is the residual profit which is divided between the partners in the profit and loss sharing ratio. The residual profit is the amount of profit remaining after taking into account the fact that the partners will be entitled to a proportion of the profit under the terms of the partnership agreement. These proportions are the ‘appropriations of profit’. They will arise because of a variety of factors. For example, the partners may have differing degrees of involvement, or may bring specific skills to the business.

However, these reasons are rarely an issue in exam questions. It is more likely that exam questions will require candidates to calculate and account for appropriations of profit according to the terms of the partnership agreement. A key point to remember is that as in a sole trader’s accounts, any amounts actually paid to the owners (whether in cash or in kind) should be treated as drawings.

If a partner is entitled to a salary, it is dealt with as part of the appropriation of profit. It is not an expense of the business, and should not be charged to the profit and loss account in order to calculate profit. Only salaries paid to employees of the business are charged to the profit and loss account.

Partners’ capital and current accounts
While it is normally the case that all appropriations of profit are taken to a current account, it is important to be clear about whether the question requires this approach. If so, this may be referred to by stating that the partnership maintains fixed capital accounts. This means that each partner will have a capital account and a current account. The capital account will record the initial introduction of capital, and will normally only be adjusted if the partner introduces additional capital. The current account will record the appropriations of profit and drawings. If the partnership maintains floating capital accounts, there will be no current account, and appropriations of profit and drawings will be recorded in the capital account.

Appropriations of profit
Partnership accounts require the use of a profit and loss appropriation account. This is the account to which profit is transferred from the profit and loss account. The amounts due to each partner in respect of salaries, interest on capital, interest on drawings and residual profit are then transferred from this account to the current account.

It should be noted that while salaries and interest on capital will reduce the amount of residual profit to be shared between the partners, interest on drawings will increase the residual profit.

Drawings
As noted above, any amounts paid to the partners should be treated as drawings, and will be recorded as a debit balance on the partnership trial balance. The correct treatment to prepare the final accounts is to credit the drawings account and debit the current account.

Example
Alex, Bob and Carl are in partnership, sharing profits and losses in the ratio 4:3:3 respectively. The partnership maintains fixed capital accounts. Alex is entitled to a salary of £13,000 per annum. The partnership agreement also provides for the partners to receive interest on capital at 6% per annum, and to pay interest on drawings at a rate of 9% per annum. For the purposes of the interest calculations, all drawings are assumed to have been made on the first day of the financial year.

At 1 July 2002 the balances on the partners’ capital and current accounts were:

On 1 January 2003, Carl introduced a further £100,000 of capital and increased his involvement in the business. It was agreed that he should be paid a salary of £10,000 per annum from that date. During the year, the partners withdrew £18,000 each.

The profit for the year to 30 June 2003 has been calculated to be £128,900. You should note that this includes deductions for the partners’ salaries.

Required
Show the profit and loss appropriation account and the partners’ current accounts.

Solution to example Working 1 Correct net profit Reported net profit     £128,900 add: Partners’ salaries:       (year to 30 June) Alex £13,000   (6 months 1 January to 30 June) Carl £5,000 £18,000 Correct net profit     £146,900 Working 2 Interest on capital Alex £325,000 x 6% p.a. for full year =   £19,500 Bob £200,000 x 6% p.a. for full year =   £12,000 Carl £100,000 x 6% p.a. for 6 months = £3,000     £200,000 x 6% p.a. for 6 months = £6,000 £9,000       £40,500 Working 3 Interest on drawings £18,000 x 9% = £1,620 each = total £4,860 Working 4 Residual profit   Correct net profit   £146,900 less: Salaries £18,000     Interest on capital £40,500 £58,500       £88,400 add: Interest on drawings   £4,860       £93,260 Working 5 Share of residual profit Alex 4 parts out of 4+3+3 = 40% = £37,304 Bob 3 parts out of 4+3+3 = 30% = £27,978 Carl 3 parts out of 4+3+3 = 30% = £27,978       £93,260

Ronnie Patton is Examiner for Paper B1