Learning objectives

••••••••••••
After you have studied this chapter, you should be able to:
• explain what a partnership is and how it differs from a joint venture
• explain the rules relating to the number of partners
• distinguish between limited partners and general partners
• describe the main features of a partnership agreement
• explain what will happen if no agreement exists on how to share profits or losses
• draw up the ledger accounts and financial statements for a partnership

Introduction
••••••••••••
In this chapter, you'll learn about the nature of partnerships and the regulations govern-
ing them. You'll learn that there are two types of partner, limited and general, and about
the difference between them, and about the difference between partnerships that are
limited partnerships and those that are not. Finally, you'll learn how to prepare partner-
ship ledger accounts and how to prepare partnership financial statements.

The need for partnerships

So far we have mainly considered businesses owned by only one person. We've also looked at
joint ventures, which are temporary projects involving two or more parties where they work
together to make a profit and then disband the venture. When a more permanent possibility exists,
two or more people may form themselves into a partnership. This is a long-term commitment to
operate in business together. The people who own a partnership are called partners. They do not
have to be based or work in the same place, though they do in most cases. However, they maintain
one set of accounting records and share the profits and losses.

Activity
32.1 From your general knowledge, can you think of any well-known partnerships
where the partners are located, not just in different cities, but in different
countries? What line of business are they in?

There are various reasons for multiple ownership of a business.

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Activity
32.2 Think about this for a minute and then write down as many reasons as you can
for people wanting to form a partnership.

In addition to the reasons suggested in the answer, there is also the fact that many business
ventures carry financial risk should they fail. When a partnership is formed, the level of risk is
reduced. Firstly, any loss can be shared by all the partners and, secondly, when more than one
person's expertise is involved, the chances of failure are reduced.
There are two types of multiple ownership: partnerships and limited companies. This chapter
deals only with partnerships. Limited companies are the subject of Chapter 36.

Nature of a partnership
A partnership has the following characteristics:
1 It is formed to make profits.
2 It must obey the law as given in the Partnership Act 1890. If there is a limited partner (as
described in Section 32.3 below), it must also comply with the Limited Partnership Act of 1907.
3 Normally there can be a minimum of two partners and a maximum of twenty partners. Excep-
tions are banks, where there cannot be more than ten partners; and there is no maximum for
firms of accountants, solicitors, stock exchange members, surveyors, auctioneers, valuers, estate
agents, land agents, estate managers or insurance brokers.
4 Each partner (except for limited partners, described below) must pay their share of any debts
that the partnership could not pay. If necessary, they could be forced to sell all their private
possessions to pay their share of the debts. This can be said to be unlimited liability.
5 Partners who are not limited partners are known as general partners.

Limited partnerships
Limited partnerships are partnerships containing one or more limited partners. Limited partner-
ships must be registered with the Registrar of Companies. Limited partners are not liable for the
debts as in Section 32.2 (4) above. Limited partners have the following characteristics and restric-
tions on their role in the partnership:
1 Their liability for the debts of the partnership is limited to the capital they have put in. They
can lose that capital, but they cannot be asked for any more money to pay the debts unless they
contravene the regulations relating to their involvement in the partnership (see 2 and 3 below).
2 They are not allowed to take out or receive back any part of their contribution to the partner-
ship during its lifetime.
3 They are not allowed to take part in the management of the partnership or to have the power
to make the partnership take a decision. If they do, they become liable for all the debts and
obligations of the partnership up to the amount taken out or received back or incurred while
they were taking part in the management of the partnership.
4 All the partners cannot be limited partners, so there must be at least one general partner with
unlimited liability.

Activity
32.3 What advantages do you think there might be to general partners in having a
limited partner?

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Limited liability partnerships

This form of partnership was first introduced in 2000. They differ from limited partnerships
(Section 32.3) in that partners are liable only to the extent of their capital invested. Also, all
partners are permitted to take part in the management of the partnership.

Partnership agreements
Agreements in writing are not necessary. However, it is better if a written agreement is drawn up
by a lawyer or an accountant. Where there is a proper written agreement there will be fewer
problems between partners. A written agreement eliminates confusion about what has been
agreed.

Contents of partnership agreements

The written agreement can contain as much, or as little, as the partners want. The law does not
say what it must contain. The usual accounting contents are:
1 the capital to be contributed by each partner;
2 the ratio in which profits (or losses) are to be shared;
3 the rate of interest, if any, to be paid on capital before the profits are shared;
4 the rate of interest, if any, to be charged on partners' drawings;
5 salaries to be paid to partners;
6 arrangements for the admission of new partners;
7 procedures to be carried out when a partner retires or dies.

Activity
32.4 Some partnerships don't bother drawing up a partnership agreement. How do
you think the partners in those partnerships know what rights and responsibili-
ties they have? (You have not been told this yet, but it should be obvious if you
think about it.)

Points 1 to 5 in the list above are considered below. Points 6 and 7 will be taken up in later
chapters.

1 Capital contributions
•••••• • •••• • ••• • •••• • ••• • •••• • •••• • ••• • •
Partners need not contribute equal amounts of capital. What matters is how much capital each
partner agrees to contribute. It is not unusual for partners to increase the amount of capital they
have invested in the partnership.

2 P.rofit (or loss) sharing ratios

•••••••••••••••••••••••••••••••••••••••••••••••••••••
Partners can agree to share profits/losses in any ratio or any way that they may wish. However,
it is often thought by students that profits should be shared in the same ratio as that in which
capital is contributed. For example, suppose the capitals were Allen £40,000 and Beet £20,000.
Some would assume that the partners would share the profits in the ratio of two-thirds to

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one-third, even though the work to be done by each partner is similar. The division of the profits
of the first few years on such a basis might be:

Years 1 2 3 4 5 Total

£ £ £ £ £ £
Net profits 36,000 48,000 60,000 60,000 72,000 276,000
Shared:
Allen 2
/3 24,000 32,000 40,000 40,000 48,000 184,000
1 12,000 16,000 20,000 20,000 24,000 92,000
Beet /3

Overall, Allen would receive £184,000, i.e. £92,000 more than Beet. As the duties of the partners
are the same, in order to treat each partner fairly, the difference between the two shares of profit
should be adequate to compensate Allen for putting extra capital into the firm. It should not be
excessive. It is obvious that £92,000 extra profits is excessive, as Allen only put in an extra
£20,000 as capital.
Consider too the position of capital ratio sharing of profits if one partner puts in £99,000 and
the other puts in £1,000 as capital.
To overcome the difficulty of compensating fairly for the investment of extra capital, the con-
cept of interest on capital was devised.

3 Interest on capital
·····~ ·····························

If the work to be done by each partner is of equal value but the capital contributed is unequal, it
is reasonable to pay interest on the partners' capitals out of partnership profits. This interest is
treated as a deduction prior to the calculation of profits and their distribution among the partners
according to the profit sharing ratio.
The rate of interest is a matter of agreement between the partners. Often it will be based upon
the return which they would have received if they had invested the capital elsewhere.
Taking Allen and Beet's partnership again, but sharing the profits equally after charging 5 per
cent per annum interest on capital, the division of profits would become:

Years 1 2 3 4 5 Total

£ £ £ £ £ £
Net profit 36,000 48,000 60,000 60,000 72,000 276,000
Interest on capitals
A llen 2,000 2,000 2,000 2,000 2,000 10,000
Beet 1,000 1,000 1,000 1,000 1,000 5,000
Remainder shared:
Allen 1
/2 16,500 22,500 28,500 28,500 34,500 130,500
Beet 1
/2 16,500 22,500 28,500 28,500 34,500 130,500

Summary Allen Beet

£ £
Interest on capital 10,000 5,000
Ba lance of profits 130,500 130,500
140,500 135,500

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Allen has thus received £5,000 more than Beet, this being adequate return (in the partners' estima-
tion) for having invested an extra £20,000 in the partnership for five years.

4 Interest on drawings
••••••••••••••••••••••••••••••••••••••
It is obviously in the best interests of the partnership if cash is withdrawn from it by the partners
in accordance with the two basic principles of (a) as little as possible, and (b) as late as possible.
The more cash that is left in the partnership, the more expansion can be financed, the greater the
economies of having ample cash to take advantage of bargains and of not missing cash discounts
because cash is not available, and so on.
To deter the partners from taking out cash unnecessarily the concept can be used of charging
the partners interest on each withdrawal, calculated from the date of withdrawal to the end of the
financial year. The amount charged to them helps to swell the profits divisible between the part-
ners. The rate of interest should be sufficient to achieve this without being too harsh.
Suppose that Allen and Beet have decided to charge interest on drawings at 5 per cent per
annum, and that their year end was 31 December. The following drawings are made:

Allen
Drawings Interest

£ £
1 January 2,000 £2,000 x 5% x 12 months = 100
1 March 4,800 £4,800 x 5% x 10 months = 200
1 May 2,400 £2,400 x 5% x 8 months --
80
1 July 4,800 £4,800 x 5% x 6 months = 120
1 October 1,600 £1,600 x 5% x 3 months --
20
Interest charged to Allen = 520

Beet
Drawings Interest

£ £
1 January 1,200 £1,200 X 5 o/o X 12 months = 60
1 August 9,600 £9,600 X 5 o/o X 5 months = 200
1 December 4,800 £4,800 X 5o/o X 1 months --
20
Interest charged to Beet = 280

5 Partnership salaries
•••• • •••••••••••••••••••••••••••••••
One partner may have more responsibility or tasks than the others. As a reward for this, rather
than change the profit and loss sharing ratio, the partner may have a partnership salary which
is deducted before sharing the balance of profits.

Performance-related payments to partners

Partners may agree that commission or performance-related bonuses be payable to some or all of
the partners linked to their individual performance. As with salaries, these would be deducted
before sharing the balance of profits.

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An example of the distribution of profits

Taylor and Clarke have been in partnership for one year sharing profits and losses in the ratio of
3 2
Taylor / 5 , Clarke / 5 . They are entitled to 5 per cent per annum interest on capitals, Taylor having
£20,000 capital and Clarke £60,000. Clarke is to have a salary of £15,000. They charge interest
on drawings, Taylor being charged £500 and Clarke £1,000. The net profit, before any distribu-
tions to the partners, amounted to £50,000 for the year ended 31 December 2020.
The way in which the net profit is distributed among the partners can be shown as:

£ £ £
Net profit 50,000
Add Charged for interest on drawings:
Taylor 500
Clarke 1,000
1,500
51,500
Less Salary: Clarke 15,000
Interest on cap ital:
Taylor 1,000
Clarke 3,000
4,000
(19,000)
Balance of profits 32,500
Shared:
Taylor 3/ 5 19,500
Clarke 2/ 5 13,000
32,500
The £50,000 net profits have therefore been shared:
Taylor Clarke
£ £
Balance of profits 19,500 13,000
Interest on capital 1,000 3,000
Sa lary 15,000
20,500 31,000
Less Interest on drawings (500) (1,000)
20,000 30,000

£50,000

The financial statements

If the sales, inventory and expenses of a partnership were exactly the same as those of a sole
trader, then the income statement would be identical with that prepared for the sole trader.
However, a partnership would have an extra section at the end of the income statement. This
section is called the profit and loss appropriation account, and it is in this account that the dis-
tribution of profits is shown. The heading to the income statement for a partnership does not
normally include the words 'appropriation account'. It is purely an accounting custom not to
include it in the heading. (Sometimes examiners ask for it to be included in the heading, in which
case, you need to do so! )
The profit and loss appropriation account of Taylor and Clarke from the details given
would be:

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Taylor and Clarke

Income Statement for the year ending 31 December 2020

(Trading Account section -same as for sole proprietor)

(Profit and Loss Account section -same as for sole proprietor)
Profit and Loss Appropriation Account

£ £ £
Net profit (from the Profit and Loss Account section) 50,000
Interest on drawings:
Taylor 500
Clarke 1,000
1,500
51,500
Less: Sa lary: Clarke 15,000
Interest on capitals
Taylor 1,000
Clarke 3,000
4,000 (19,000)
32,500
Ba lance of profits shared:
3 19,500
Taylor /5

Clarke 2
/5 13,000
32,500

Fixed and fluctuating capital accounts

There are two choices open to partnerships: fixed capital accounts plus current accounts, and
fluctuating capital accounts.

1 Fixed capital accounts plus current accounts

•••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••
The capital account for each partner remains year by year at the figure of capital put into the
partnership by the partners. The profits, interest on capital and the salaries to which the partner
may be entitled are then credited to a separate current account for the partner, and the drawings
and the interest on drawings are debited to it. The balance of the current account at the end of
each financial year will then represent the amount of undrawn (or withdrawn) profits. A credit
balance will be undrawn profits, while a debit balance will be drawings in excess of the profits to
which the partner was entitled.
For Taylor and Clarke, capital and current accounts, assuming drawings of £15,000 for Taylor
and £26,000 for Clarke will be:

Taylor- Capital

2020 £
Jan 1 Bank 20,000

Clarke - Capital

2020 £
Jan 1 Bank 60,000

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Taylor- Current Account

2020 £ 2020 £
Dec 31 Cash: Drawings 15,000 Dec 31 Profit and loss
31 Profit and loss appro- appropriation account:
priation account: Interest on capita l 1,000
Interest on drawings 500 Share of profits 19,500
31 Balance c/d 5,000
20,500 20,500
2021
Jan 1 Ba lance b/d 5,000

Clarke - Current Account

2020 £ 2020 £
Dec 31 Cash: Drawings 26,000 Dec 31 Profit and loss
31 Profit and loss appropriation account:
appropriation account: Salary
Interest on drawings 1,000 Interest on capital 3,000
31 Balance c/d 4,000 Share of profits 13,000
31l000 31l000
2021
Jan 1 Balance b/d 4,000

Notice that the salary of Clarke was not paid to him, it was merely credited to his current account.
If instead it was paid in addition to his drawings, the £15,000 cash paid would have been debited
to the current account, changing the £4,000 credit balance into a £11,000 debit balance.
Note also that the drawings have been posted to the current accounts at the end of the year. The
amounts withdrawn which add up to these amounts were initially recorded in the Cash Book. Only
the totals for the year are posted to the current account, rather than each individual withdrawal.
-Examiners often ask for the capital accounts and current accounts to be shown in columnar form
rather than as T-accounts. For Taylor and Clarke, these would appear as follows:

Capital Accounts
Taylor Clarke Taylor Clarke

£ £ 2020 £ £
Jan 1 Bank 20,000 60,000

Current Accounts
Taylor Clarke Taylor Clarke

2020 £ £ 2020 £ £
Dec 31 Cash: Drawings 15,000 26,000 Dec 31 Salary 19,500 15,000
31 Interest on 500 1,000 31 Interest on 1,000 3,000
drawings capital
31 Ba lances c/d 5,000 4,000 31 Share of profits 13,000
20,500 31,000 20,500 31,000
2021
Jan 1 Balances b/d 5,000 4,000

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2 Fluctuating capital accounts

· ·· ··· · ·· ·· ··· · ··· ·· ·· ·· ·· ·· ·· ·· ·· ·~ ·· ·· ·· ·· ·· ·· ·· ·

The distribution of profits would be credited to the capital account, and the drawings and interest
on drawings debited. Therefore, the balance on the capital account will change each year, i.e. it
will fluctuate.
If fluctuating capital accounts had been kept for Taylor and Clarke they would have appeared:

Taylor- Capital

2020 £ 2020 £
Dec 31 Cash: Drawings 15,000 Jan 1 Bank 20,000
31 Profit and loss Dec 31 Profit and loss
appropriat ion account: appropriation account:
Interest on drawings 500 Interest on capita l 1,000
31 Ba lance dd 25,000 Share of profits 19,500
40l500 40l500
2021
Jan 1 Ba lance b/d 25,000

Clarke - Capital

2020 £ 2020 £
Dec 31 Cash: Drawings 26,000 Jan 1 Bank 60,000
31 Profit and loss appro- Dec 31 Profit and loss appro-
priation account: priation account:
Interest on 1,000 Salary 15,000
drawings Interest on capita l 3,000
31 Ba lance dd 64,000 Share of profit 13,000
91l000 91l000
2021
Jan 1 Ba lance b/d 64,000

Fixed capital accounts preferred

The keeping of fixed capital accounts plus current accounts is considered preferable to fluctuating
capital accounts. When partners are taking out greater amounts than the share of the profits that
they are entitled to, this is shown up by a debit balance on the current account and so acts as a
•
warn1ng.

Where no partnership agreement exists

As mentioned in the answer to Activity 32.4, where no partnership agreement exists, express or
implied, Section 24 of the Partnership Act 1890 governs the situation. The accounting content of
this section states:
(a ) Profits and losses are to be shared equally.
(b) There is to be no interest allowed on capital.
(c) No interest is to be charged on drawings.
(d) Salaries are not allowed.
(e) Partners who put a sum of money into a partnership in excess of the capital they have agreed
to subscribe are entitled to interest at the rate of 5 per cent per annum on such an advance.
Section 24 applies where there is no agreement. There may be an agreement not by a partner-
ship deed but in a letter, or it may be implied by conduct, for instance when a partner signs a
balance sheet which shows profits shared in some other ratio than equally. Where a dispute arises

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as to whether an agreement exists or not, and this cannot be resolved by the partners, only the
courts are competent to decide.

The balance sheet

For the partnership, the capital part of the balance sheet will appear in this form:

Taylor and Clarke

Balance Sheet as at 31 December 2020 (extract)

£ £
Capita l accounts Taylor 20,000
Clarke 60,000
80,000
Current accounts Taylor Clarke
£ £ £ £
Sa lary 15,000
Interest on capital 1,000 3,000
Share of profits 19,500 13,000
20,500 31,000
Less Drawings 15,000 26,000
Interest on drawings 500 1,000
(15,500) (27,000)
5,000 4,000
9,000

If one of the current accounts had finished in debit, for instance if the current account of Clarke
had finished up as £400 debit, the figure of £400 would appear in brackets and the balances would
appear net in the totals column:

Taylor Clarke

£ £ £
Closing ba lance 5,000 (400) 4,600

If the net figure turned out to be a debit figure then this would be deducted from the total of the
capital accounts.

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