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AUDIT OF
PARTNERSHIP FIRM
INDIA SILICATE
WORKS
DEFINATION OF PARTNERSHIP :
Indian Partnership Act, 1932,,,,,,
"Partnership" is 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.
Persons who have entered into partnership with one another are called individually "partners"
and collectively a "firm", and the name under which their business is carried on is called the
"firm name".
persons
There should be at least two persons to form a partnership or partnership firm.
Restrictions on the number of persons
The maximum number of members that can exist in partnership is 10 in case of a
firm carrying on banking business and 20 in case of any other business.
This restriction is placed by the companies act and not the partnership act.
Companies Act, 1956 show
There should be a business carried on by the partnership and that too with an
intention to make and share profits of that business.
Therefore we can say
reciprocal
In his/her role as a partner, a person acts both as a principal as well as an agent.
A partner is an agent of the firm for the acts that the he/she does on behalf of the
firm, whereby he/she can bind the other partners for such acts. The other partners
would be in the position of a principal for such acts.
With regard to the acts of the other partners, he/she will be in the position of a
principal (since he as a partner is bound by the acts of the other partners on behalf of
the firm)
Where a partner cannot be made responsible for the acts of one or more other
partners we cannot say they together form a partnership. This mutual agency is what
really decides whether there is a partnership or not.
Thus it is said the "Mutual Agency" is the real test of partnership.
TYPES OF PARTNERSHIP :
ACTIVE/ACTUAL PARTNERSHIP
In this type of partnership the partners are actively involved in the business and business
relations and other aspects of the partnership firms.
DORMANT/SLEEPING PARTNERSHIP
In a dormant or a sleeping partnership, the partner will lend his name to the business but neither
interested in the business nor the profit sharing from the business.
NOMINAL PARTNERSHIP
These type of partners are known to the outsiders only. They will not actually involve in the
business.
SUB PARTNERSHIP
If a partner wants to share his profits to others he can enter into the partnership with others
stating the profit sharing levels or ratio. This is sometime referred to as parnership marketing.
Partnership is a form of business organisation. A business and its ownership are independent
entities. The idea that the actual business and the form of organisation that is owning it are
different would help you in creating an understanding on the difference in accounting for
partnership firms and other forms of business organizations.
The same business may be owned by a
sole proprietor,
partnership firm,
co-operative society,
Ascertaining the profit or loss is a task related to the business. The process of profit
ascertainment (final accounting) for a business would be more or less the same whatever may be
the form of business organisation that is owning the business.
What's different?
How the profit made is dealt with in distributing it among ownership is an idea related to the
form of business organisation. The way the profits made by an organisation are shared is what is
different from organisation to organisation.
reserve
set aside
In a partnership firm, the act of distributing profits among the partners is identified as
Appropriation of profits.
Factors of Production and Returns
In economic terms, the four basic factors of production are Land, Labour, Capital and
Organisation. Each of these factors would be compensated by sharing a part of the income
earned. What a factor gets as its share is what is called the return for the factor.
Thus profit earned by the partnership firm can be said to be the returns earned by the
Organisation.
In case of a sole proprietary concern, there is only a single person who contributes the capital of
the organisation (the sole proprietor) and as such all the organisation's returns belong to the
owner. For this reason the net profit is generally transferred to the Capital a/c in total.
In case of a partnership firm there would be two or more persons contributing the capital of the
organisation and as such the organisation's returns have to be equitably distributed among them.
Organisation - Partnership Firm
Land, Labour and Capital are factors of production which we see or feel.
Organisation is an intangible factor that combines these three factors to achieve the intended
objective. Organisation in one way can be understood as, the efforts made by those who have
contributed capital in conducting the affairs of the organisation to achieve its objectives. These
efforts may take many different forms.
What constitutes Organisation in a Partnership Firm
In a partnership firm partners contribute capital. They also make contributions to the organisation
in many other forms. All the contributions other than capital that partners contribute to the firm
constitute the factor we call Organisation.
Partners contribution to the firm takes many different forms which may be tangible or intangible.
Some of them are
Time
Partners spend their time and efforts in working for the firm by looking after the day to
day affairs of the firm. This contribution may be full time, part time or intermittent.
Business Relations
Partners through their personal contacts in the society bring in customers which may
result in more sales.
Intelligence
Partners use their intelligence and abilities in various situations like in solving problems
faced by the firm, tiding over tough situations, overcoming competitions etc.
We do not consider the Capital contributed by the partners as a part of the factor organisation,
since Capital itself is considered a distinct factor.
Varied Contributions of Partners towards the Organisation
Since no two beings can be having with the same capabilities, the contributions made by the
partners for the factor called organisation varies from partner to partner. Each partner contributes
according to his/her abilities and possibilities.
are having more or less the same contacts outside through which sales are generated,
have all withdrawn the same amounts of money for their personal uses (drawings)
PUBLIC RELATIONS/CONTACTS
C has greater contacts in the outside world, a lot of customers are C's contacts. Now, the
contribution of C towards the sales of the firm through his contacts is greater than that of A and
B. Therefore, it would not be appropriate to share the profits equally among them.
Compensate by paying Commission to Partner.
Compensate C for providing more customers to the business by paying commission on sales. The
commission paid to C for sales made to customers who are his contacts would be compensation
for his greater contribution.
Profit equal to the total "Commission to Partners" to all the partners who have made a
contribution in this respect is set aside and is distributed to them in proportion to the value of
their contributions as agreed upon between partners.
Rest of the profits can be shared equally if all other contributions are equal.
Drawings
The Drawings of A, B and C are respectively, 2,000, 15,000 and 5,000 respectively.
Assume that drawings are being recorded using the 'Drawings a/c' which is the general
convention. Therefore, the Capital a/c balances are not affected by drawings made by partners.
The net capital contribution at any time can be obtained by setting off the Capital a/c and
Drawings a/c balances.
The net capital account balances of the partners are not in proportion to their capital account
balances. Therefore paying interest on capital based on capital account balances would be unjust.
Remedy - charge Interest on Drawings.
Greater the drawings greater the interest payable by the partners. This would compensate the
unevenness in drawings made by the partners.
Remunerating Organisation = distributing Profits
As can be seen, Interest on Capital, Salary to Partners, Commission to Partners, etc., are all paid
out of profits made and as such form appropriations of profits. All these appropriations are
intended to ensure an equitable distribution of profits among the partners based on their
contributions for the firm.
All the contributions other than capital together are identified as 'organisation' and it is rightly
said that remuneration for organisation is profit.
Distribution of Profits among Partners
Partners profit sharing ratio
A:B:C
1:1:1
The only conclusion that can be drawn straight away reading the postings would be that there is a
transfer to or from the Profit and Loss a/c.
Charge Against Profits Vs. Appropriation of Profits
Classification of Debits to Profit and Loss account
If we consider a single profit and loss account in use, we can classify all the debits being made to
the account into two as
Charge on/against Profits
encumbrance
A charge can be interpreted as a debit to the profit and loss account which represent an
expenditure or loss. A charge will result in reduction of profits. All expenses and losses
are a charge against profits.
Salaries, Wages, Rent, Depreciation, Loss on Sale of Assets etc., are all charges against
profits.
Appropriation of Profit
reserve
set aside
Profit appropriated is profit set aside for being used in the future for some purpose
specified or unspecified. It is not for the purpose of an expenditure that has already been
committed or incurred. For this reason, appropriation of profits does not result in a
reduction of profits.
Creation of reserves is an example of profit appropriation.
Duration of Partnership
The ratio in which the profits and losses are to be shared among partners
Name of the Bank/Banks where the business banking accounts should be maintained
and the person/persons who are vested with the power to operate the accounts.
The person/persons responsible for accounting for the business transactions and the
place where the books of accounts are to be kept generally.
Everything that is relevant to the relationship between the partners forms part of the agreement.
Even aspects relating to Arbitration (in case of disputes among themselves) etc., will be part of
the agreement.
Role of Partnership Deed in Accounting
Any and every aspect relating to the partnership may be included in the "Partnership Deed". This
deed forms the basis of any transaction involving the partners. Even accounting for partnership
firms is a function that is to be carried on in accordance with the provisions in the "Partnership
Deed".
Salary to be paid to partners, profits to be shared among partners, interest on capital, interest on
drawings, etc., are all to be decided based on the agreement between the partners (i.e. based on
the partnership deed).
Thus in accounting for transactions involving these, compliance with what is agreed upon should
be ensured.
Interest on Drawings
No specific mention is made about drawings in the act. Therefore, it is assumed that the
provisions that are applicable for Capital would also be applicable for Drawings.
In the absence of an agreement between the partners, a partner is not entitled to pay any interest
on Drawings.
If there is an agreement between the partners then interest is to be charged at the rates agreed
upon.
Interest on Partners Loans or Advances
In the absence of an agreement between the partners, a partner is entitled to receive interest at the
rate of 6% p.a. on any payment or advance made beyond the amount of Capital he has to
contribute.
If there is an agreement between the partners then interest is to be paid at the rates agreed upon, .
The profit sharing ratio may be expressed in a number of different forms. Whatever may be the
form in which the ratio is expressed it can always be converted to a form convenient to us for
being used in problem solving.
Simple Ratio
May, Day and Way are partners sharing profits in the in the ratio 1 : 3 : 4.
Simple Ratio [Fractions represent shares]
Where the shares are represented by fractional numbers, one should always check to see if the
sum of the fractional parts representing shares add up to 1.
Interest on Capital
Interest on Capital is to be paid
The balance in Capital account unless where it is maintained under Fixed Capital Method, keeps
fluctuating on account of a number of reasons, thus making it difficult to assess the amount of
capital employed in the business. There would be a change on account of appropriations made at
the end of the accounting period like salary to partners, commission to partners, etc. Even during
the course of the accounting period, the balances may change on account of additional capital
introduced, capital withdrawn, etc.,
In the absence of appropriate information, it is a convention that interest is paid on the opening
balances in Capital Accounts on the assumption that it has been employed for the full length of
the accounting period and all other changes to the capital account have been done towards the
end of the accounting period.
In problem solving we will come across these situations.
Where the Drawings a/c balances at the end of the accounting period are known and there
is no information relating to the time of drawing, interest is calculated on the closing
balance.
Salary to Partners
Salary is to be paid to partners only if it is specifically agreed upon.
If there is no mention in the partnership agreement then no salary need be paid.
Commission to Partners
Commission is to be paid to partners only if it is specifically agreed upon.
If there is no mention in the partnership agreement then no commission need be paid.
Expressing Commission
Commission payable to partners may be expressed in a number of different ways. It may be
Specified amount
What method is employed for expressing and calculating commission is dependent on the reason
for which the commission is being offered and the agreement between the partners.
There are two ways commission as a % of a value can be expressed. How it is expressed decides
how the commission is calculated mathematically.
Consider Commission being calculated as a % of Net Profit as an example.
waver
Since the capital account balances changes (fluctuates) with the regular transactions relating to
capital, the Capitals accounts maintained under this method are known as "Fluctuating Capital
Accounts".
Fixed Capital Accounts
Purpose
Profits (revenue) increase capital. By profits we mean all the appropriations of profits that find
their way into the capital account, like interest on capital, salary to partner, commission to
partner, share of profits. Capital also increases when additional capital is brought in by the
partner which is a Capital natured transaction.
Under the fluctuating capital account system, since we use only a single capital account, it gets
affected by transactions of both capital and revenue nature.
If the organisation intends to obtain the information relating to the Capital account balance on
account of Capital natured transactions and Revenue Natured transactions separately, a separate
Capital accounts needs to be maintained to record the revenue natured transactions.
The basic purpose of accounting is derivation of information. The more information we need, the
more accounting heads we need to maintain.
In both cases any specific agreement between partners has to be considered in arriving at the
balances and calculation of interests. Say if they agree to consider only the balance at the end for
calculating interest, only that balance would be considered even if the partners have brought in
additional capital or withdrawn capital during the accounting period.
In contributing these assets or services to the firm, the partners personally incur an opportunity
cost/loss which they will consider before employing them for the firm.
where the partner is investing capital he/she would be thinking of the earnings they might
get if that capital is employed elsewhere;
where he/she is employing his/her time as a working partner, he/she would be thinking of
his/her earning if he/she employs the same time elsewhere.
Each and every contribution of the partner has an opportunity cost loss attached to it unless they
are sitting idle.
Where a partner is very much sure that he can employ what he/she is contributing to the
firm elsewhere in a more profitable manner, why should he/she invest them for the firm,
unless there is some sort of assurance for the returns they get by contributing to the firm?
When a person is getting into a partnership agreement, he/she will be conscious of his/her
own abilities as well as the limitations of his/her other partners. Moreover, he/she would
be measuring his/her opportunity cost/loss in becoming a partner.
In the context of a particular guarantee, one or more partners can be given the guarantee. Since,
there should be at least one partner who is giving the guarantee, not all the partners can be the
guaranteed.
All Partners Cannot be the Guarantors
In the context of a particular guarantee, one or more partners can give the guarantee. Since, there
should be at least one partner who is being guaranteed, not all the partners can be the guarantors.
There should be at least one who is giving and one who is guaranteed, thus eliminating the
chance of all the partners being either guarantors or the guaranteed in such cases.
A Partner can be a guarantor and a guaranteed
One or more partners can be both the guarantor and guaranteed at the same time. A partner may
guarantee one or more other partners and at the same time get a guarantee from one or more
other partners
Guarantee to Partners
Guarantee to One Partner
A, B and C are partners in a firm sharing profits and losses in the ratio 5 : 3 : 2. They now decide
to admit Mr. M as a partner giving him 110th share and taking among
themselves 510th,310thand110th respectively. Mr. M was willing to join as a partner only if he is
guaranteed that his annual share of profits would be not less than 20,000.
Effect of the Guarantee
If Mr. M is to get his guaranteed annual share, the firm would have to make an annual profit of at
least 2,00,000 ( 110th of 2,00,000 = 20,000). If the profit is lesser, then the existing partners
should forego their share to ensure that Mr. M gets his guaranteed share of profits. If the profit is
more than 2,00,000, the guarantee does not affect the share of other partners.
The guarantee may be given by one or more partners.
Shortfall
The difference between the amount guaranteed and the amount that a guaranteed partner would
get if the guarantee is not brought into force, is what we call the shortfall.
The terms of guarantee enable us to understand what constitutes the guaranteed amount and
thereby calculate the guaranteed amount and the shortfall that has to be made good if any.
Who bears the shortfall and in what proportion?
Who bears the burden of shortfall is dependent on who has given the guarantee.
Where there is only one partner who has given the guarantee, the total burden inevitably has to
be borne by that partner only.
Where two are more partners have given the guarantee or the firm has given the guarantee, the
proportion in which the burden of shortfall is borne by the partners is dependent on the
agreement between them. In problem solving, where there is no mention of the proportion, we
assume that they share the burden in proportion to the profit sharing ratio inter se between them.
REFERENCES:
(1) http://www.futureaccountant.com/partnership-accounts/study-notes/#.Vg649NKqqkr.