Partnership and LLP Accounts — Introduction to Partnership Accounts
Learning Outcomes
- Understand the provisions of the Indian Partnership Act, 1932, Limited Liability Partnership Act, 2008 and Limited Liability Partnership Amendment Act, 2021.
- Understand the features of a partnership firm and the need for a Partnership Deed.
- Understand the points to be covered in a Partnership Deed regarding accounts.
- Learn the technique of maintaining Profit and Loss Appropriation Account.
- Familiarize with the two methods of maintaining Partners' Capital Accounts, namely Fixed Capital Method and Fluctuating Capital Method.
- Note that Capital Account balance as per Fluctuating Capital method is just equal to the sum of the balances of Capital Account and Current Account as per Fixed Capital Method.
- Learn how to arrive at the corrected net profit figure which is to be taken to the Profit and Loss Appropriation Account after rectification of errors.
- Learn that interest on capital and drawings, salaries/commissions are to be shown in the Profit and Loss Appropriation Account and not in the Profit and Loss Account. Also learn that drawings by partners will not appear in the Appropriation Account.
1.1 Introduction: Why Partnership?
- An individual, i.e., a sole proprietor may not be in a position to cope with the financial and managerial demands of the present-day business world.
- As a result, two or more individuals may decide to pool their financial and non-financial resources to carry on a business.
KNOWLEDGE NUGGET
- Partnership: Relation between persons who have agreed to share the profit of a business
- Key Features: Agreement, Business, Sharing of Profit, Mutual Agency
- Minimum Partners: 2
- Maximum Partners: 50 (as per Companies Act, 2013)
1.2 Definition and Features of Partnership
As per Section 4 of the Partnership Act, 1932:
DEFINITION
"Partnership is the relation between persons who have agreed to share the profit of a business carried on by all or any of them acting for all."
Features of a Partnership
- (i) Existence of an agreement: The relation of partnership arises from contract between parties and not from status.
- (ii) Business: A partnership can exist only in business. Section 2(b) of Indian Partnership Act, 1932 states that business includes every trade, occupation and profession.
- (iii) Sharing of profit: The persons concerned must agree to share the profits of the business. Section 4 does not insist upon sharing of losses.
- (iv) Mutual agency: The business is to be carried on by all or any of them acting for all.
- (v) Minor as a partner: A minor can be admitted to share profit only. He cannot be made to share losses.
Number of Partners:
- Minimum Partners: Two
- Maximum Partners: 50 (as per Section 464 of the Companies Act, 2013 read with Rule 10 of Companies (Incorporation) Rules 2014)
1.3 Limited Liability Partnership
- The Indian Partnership Act of 1932 provides for a general form of partnership which has inherent shortcoming of unlimited liability of all partners for business debts.
- With the growth of the Indian economy, a need has been felt for a new corporate form that would provide an alternative to the traditional partnership.
- The Limited Liability Partnership (LLP) is viewed as an alternative corporate business proposal that provides the benefits of limited liability but allows its members the flexibility of organizing their internal structure as a partnership.
LLP — KEY FEATURES
- Separate legal entity — distinct from its partners
- Perpetual succession — changes in partners do not affect existence
- Limited liability — liability limited to agreed contribution
- Body corporate — juristic entity
1.3.1 Definition of LLP
- "Limited liability partnership" means a partnership formed and registered under this Act.
- "Limited liability partnership agreement" means any written agreement between the partners which determines the mutual rights and duties of the partners.
- Small limited liability partnership: Contribution not exceeding ₹25 lakh (or up to ₹5 crore as prescribed) and turnover not exceeding ₹40 lakh (or up to ₹50 crore as prescribed).
1.3.2 Nature of Limited Liability Partnership
- (1) A limited liability partnership is a body corporate formed and incorporated under this Act and is a legal entity separate from that of its partners.
- (2) A limited liability partnership should have perpetual succession.
- (3) Any change in the partners should not affect the existence, rights, or liabilities of the LLP.
1.3.3 Non-applicability of the Indian Partnership Act, 1932
- Save as otherwise provided, the provisions of the Indian Partnership Act, 1932 shall not apply to a limited liability partnership.
1.3.4 Minimum Number of Partners in case of LLP
- Every limited liability partnership shall have at least two partners.
- If the number of partners is reduced below two and the LLP carries on business for more than six months, the only partner shall be personally liable.
1.3.5 Designated Partners
- Every LLP should have at least two designated partners who are individuals and at least one of them should be a resident in India.
- "Resident in India" means a person who has stayed in India for a period of not less than 120 days during the immediately preceding one year.
1.3.6 Liabilities of Designated Partners
- A designated partner should be:
- (a) responsible for the doing of all acts, matters, and things as are required to be done by the LLP in respect of compliance.
- (b) liable to all penalties imposed on the LLP for any contravention of those provisions.
1.3.7 Limitation of Liability of an LLP and its Partners
- An obligation of an LLP arising out of a contract or otherwise, will be solely the obligation of the LLP.
- The Liabilities of an LLP should be met out of the properties of the LLP.
- A partner is not personally liable, directly or indirectly, for an obligation solely by reason of being a partner in the LLP.
- The liability of the LLP and the partners perpetrating fraudulent dealings will be unlimited for all or any of the debts or other liabilities of the LLP.
1.4 Distinction between an Ordinary Partnership Firm and an LLP
| Basis | LLP | Partnership Firm |
|---|---|---|
| Regulating Act | Limited Liability Partnership Act, 2008 | Indian Partnership Act, 1932 |
| Body corporate | It is a body corporate | It is not a body corporate |
| Separate legal entity | Legal entity separate from its members | No separate legal entity |
| Registration | Registration is mandatory | Registration is voluntary |
| Perpetual succession | Death/insolvency of partners does not affect existence | No perpetual succession |
| Liability | Limited to agreed contribution | Unlimited liability |
| Mutual agency | Each partner can bind LLP but not other partners | Each partner can bind firm and other partners |
| Designated partners | At least two designated partners | No such provision |
| Number of Partners | Minimum 2, no maximum limit | Minimum 2, maximum 50 |
1.5 Main Clauses in a Partnership Deed
- The relation between the partners is governed by mutual agreement known as partnership deed.
- It should be comprehensive to avoid disputes later on.
COMMON CLAUSES IN A PARTNERSHIP DEED
- 1. Name of the firm and the partners
- 2. Commencement and duration of business
- 3. Amount of capital to be contributed by each partner
- 4. Amount to be allowed to each partner as drawings
- 5. Rate of interest on capital, drawings, and loan
- 6. Ratio in which profits or losses are to be shared
- 7. Whether a partner will be allowed to draw any salary
- 8. Any variations in the mutual rights and duties of partners
- 9. Method of valuing goodwill
- 10. Procedure by which a partner may retire
- 11. Basis of determination of executors of a deceased partner
- 12. Treatment of losses arising out of insolvency of a partner
- 13. Procedure for settlement of disputes
- 14. Preparation of accounts and their audit
Rules in the Absence of Partnership Deed
DEFAULT RULES (INDIAN PARTNERSHIP ACT, 1932)
- 1. Profits and losses are shared equally
- 2. No interest on capital
- 3. No interest on drawings
- 4. No salary or commission to partners
- 5. Interest on partner's loan @ 6% p.a.
Note: In the absence of an agreement, the interest and salary payable to a partner will be paid only if there is profit.
1.6 Powers of Partners
Implied Powers of Partners (Trading Firm)
- (a) Buying and selling of goods
- (b) Receiving payments on behalf of the firm and giving valid receipt
- (c) Drawing cheques and drawing, accepting and endorsing bills of exchange
- (d) Borrowing money on behalf of the firm
- (e) Engaging servants for the business of the firm
Cases Where Individual Partner Has No Power to Bind the Firm
- (a) Submitting a dispute relating to the firm to arbitration
- (b) Opening a bank account on behalf of the firm in the name of a partner
- (c) Compromise or relinquishment of any claim
- (d) Withdrawal of a suit or proceeding
- (e) Admission of any liability in a suit
- (f) Acquisition of immovable property
- (g) Entering into partnership on behalf of the firm
1.8 Profit and Loss Appropriation
- In a partnership, profit has to be divided between the partners in a certain profit sharing ratio after making necessary adjustments stated in the partnership deed.
- An additional account is prepared called Profit and Loss Appropriation Account.
- Net profit is transferred from the debit side of the Profit and Loss Account to the credit side of the Appropriation Account.
- Adjustments like interest on capital, drawings, loans, salaries, commissions are recorded in this account.
ILLUSTRATION 1
A and B start business on 1st January, 2022, with capitals of ₹30,000 and ₹20,000. According to the Partnership Deed, B is entitled to a salary of ₹500 per month and interest is to be allowed on capitals at 6% per annum. The remaining profits are to be distributed amongst the partners in the ratio of 5:3. During 2022 the firm earned a profit of ₹25,000.
Profit and Loss Appropriation Account for the year ended 31-Dec-22
| Particulars | Amount (₹) | Particulars | Amount (₹) |
|---|---|---|---|
| To B's Capital Account — Salary | 6,000 | By Net Profit | 25,000 |
| To A's Capital Account — Interest | 1,800 | ||
| To B's Capital Account — Interest | 1,200 | ||
| To A's Capital Account (5/8 profit) | 10,000 | ||
| To B's Capital Account (3/8 profit) | 6,000 | ||
| Total | 25,000 | Total | 25,000 |
1.9 Fixed and Fluctuating Capital
- There are two methods of maintaining Partners' Capital Accounts:
- (i) Fixed Capital Method: Initial capital contributions are credited to partners' capital accounts. All subsequent transactions are dealt with through Current Accounts.
- (ii) Fluctuating Capital Method: No current account is maintained. All transactions are passed through Capital Accounts. Capital account balances fluctuate every time.
COMPARISON — FIXED vs FLUCTUATING CAPITAL
| Feature | Fixed Capital Method | Fluctuating Capital Method |
|---|---|---|
| Capital Account | Remains fixed | Fluctuates |
| Current Account | Maintained | Not maintained |
| Interest on Capital | Credited to Current A/c | Credited to Capital A/c |
| Drawings | Debited to Current A/c | Debited to Capital A/c |
| Salary/Profit | Credited to Current A/c | Credited to Capital A/c |
1.9.1 Interest on Capital
- A partner is not entitled to interest on his capital as a matter of right.
- Interest is generally allowed on capitals of the partners at the agreed rate only out of profits.
- In case of loss, no interest is provided.
- In case of insufficient profits, the amount of profit is distributed in the ratio of capital.
INTEREST ON CAPITAL — KEY POINTS
- Calculated on opening balance of capital
- Additional capital → interest for relevant period
- In fixed capital method → credited to Current A/c
- In fluctuating capital method → credited to Capital A/c
- Entry: Profit and Loss Appropriation A/c Dr. To Partners' Capital/Current A/c
1.9.2 Interest on Drawings
- Interest is charged on drawings according to the time that elapses between the taking out of the money and the end of the year.
- Product Method: Amount × Number of months = Product; Total product × Rate × 1/12
INTEREST ON DRAWINGS — FORMULAE
- If dates are not given: Charge interest for 6 months on total drawings
- If drawings are made at the beginning of each month: 6-1/2 months
- If drawings are made at the end of each month: 5-1/2 months
- If drawings are made at the beginning of each quarter: 7.5 months
- If drawings are made at the end of each quarter: 4.5 months
1.9.3 Guarantee of Minimum Profit
- Sometimes, one partner can enjoy the right to have minimum amount of profit in a year.
- If the share of the partner is less than the guaranteed amount, he takes minimum profit.
- The excess is borne by the remaining partners as per the agreement.
- If the question is silent, the burden is borne by the remaining partners in their mutual profit sharing ratio.
Illustration 6
Ram and Rahim start business with capital of ₹50,000 and ₹30,000 on 1st January, 2022. Rahim is entitled to a salary of ₹400 per month. Interest is allowed on capitals and is charged on drawings at 6% per annum. Profits are to be distributed equally. Ram withdrew ₹8,000 and Rahim withdrew ₹10,000. Profit before adjustments came to ₹30,000. Assuming capitals to be fixed, prepare the Profit and Loss Appropriation Account.
SOLUTION
Profit & Loss Appropriation Account for the year ended 31st December, 2022
| Particulars | Amount (₹) | Particulars | Amount (₹) |
|---|---|---|---|
| To Rahim's Current A/c — Salary | 4,800 | By Net Profit | 30,000 |
| To Interest on Capital: | By Interest on Drawings: | ||
| Ram's Current A/c | 3,000 | Ram's Current A/c | 240 |
| Rahim's Current A/c | 1,800 | Rahim's Current A/c | 300 |
| To Profit transferred: | |||
| Ram's Current A/c (1/2) | 10,470 | ||
| Rahim's Current A/c (1/2) | 10,470 | ||
| Total | 30,540 | Total | 30,540 |
Summary
- The Indian Partnership Act defines partnership as "the relationship between persons who have agreed to share the profit of a business carried on by all or any of them acting for all."
- The LLP is a separate legal entity, liable to the full extent of its assets, with the liability of the partners being limited to their agreed contribution.
- In the partnership firm, relations among the partners will be governed by mutual agreement known as Partnership Deed.
- In the absence of an agreement, the interest and salary payable to a partner will be paid only if there is profit.
- During the course of business, a partnership firm will prepare Trading Account and a Profit and Loss Account at the end of every year.
- There are two methods of accounting:
- Fixed Capital Method: Capital accounts remain fixed, current accounts are maintained.
- Fluctuating Capital Method: No current accounts, all transactions pass through capital accounts.
- Interest on capital is calculated for the relevant period for which the amount of capital has been used in the business.
- Subject to contract, interest on capital is to be provided out of profits only.
- Sometimes, one partner can enjoy the right to have minimum amount of profit in a year.
Test Your Knowledge
True and False
- 1. In absence of any agreement partners share profits of the business in the ratio of their capital contribution. False
- 2. Profit sharing ratio and capital contribution ratio need not be same. True
- 3. Every partnership firm must register itself with Registrar of firms. False
- 4. A partner can advance loan to the partnership firm in addition to capital contributed by him. True
- 5. A partner can demand interest on capital even if it is not provided in the partnership deed. False
- 6. If a partner does not take part in day to day business activities of the firm then he is not entitled to any share of profit. False
- 7. Interest should be paid @ 6% p.a. on partners' loan even if it is not provided in the partnership deed. True
- 8. Husband and wife cannot be partners in the same firm. False
- 9. One senior partner is Principal and other partners are his agents. False
- 10. Partners are the agents of the firm and each other. True
Multiple Choice Questions
| 1. If a firm prefers Partners' Capital Accounts to be shown at the amount introduced by the partners as capital in firm then entries for salary, interest, drawings, interest on capital and drawings and profits are made in | (a) Trading Account (b) Profit and Loss Account (c) Partners' Current Account |
| 2. In the absence of any agreement, partners are liable to receive interest on their Loans @ | (a) 12% p.a. (b) 10% p.a. (c) 6% p.a. |
| 3. The relationship between persons who have agreed to share the profit of a business carried on by all or any of them acting for all is known as | (a) Partnership (b) Joint Venture (c) Association of Persons |
| 4. Firm has earned exceptionally high profits from a contract which will not be renewed. In such a case the profit from this contract will not be included in | (a) Profit sharing of the partners. (b) Calculation of the goodwill. (c) Both. |
| 5. In the absence of an agreement, partners are entitled to | (a) Interest on Loan and Advances. (b) Commission. (c) Salary. |
| 6. Partners are supposed to pay interest on drawings only when _____ by the _____ | (a) Provided, Agreement (b) Agreed, Partners (c) Both (a) & (b) above |
| 7. When a partner is given a guarantee by the other partner, loss on such guarantee will be borne by | (a) Partner who gave the guarantee (b) All the other partners. (c) Partnership firm. |
| 8. A, B and C had capitals of ₹50,000; ₹40,000 and ₹30,000 respectively. The firm's reported profit for the year was ₹80,000. As per provisions of the Indian Partnership Act, 1932, find out the share of each partner after taking into account no interest on an advance by A of ₹20,000. | (a) ₹26,267 for Partner B and C & ₹27,466 for partner A. (b) ₹26,667 each partner. (c) ₹33,333 for A, ₹26,667 for B and ₹20,000 for C. |
| 9. X, Y and Z are partners in a firm. Profits before interest on partner's capital was ₹6,000 and X wanted interest on capital @ 20% as his capital contribution was ₹1,00,000 as compared to Y and Z which was ₹75,000 and ₹50,000 respectively. | (a) Profits of ₹6,000 will be distributed equally with no interest on either Capital. (b) X will get the interest of ₹20,000 and the loss of ₹14,000 will be shared equally. (c) All the partners will get interest on capital and the loss of ₹39,000 will be shared equally. |
| 10. X, Y and Z are partners. Profits before interest on partner's capital was ₹6,000 and Y determined interest @ 24% p.a. on his loan of ₹80,000. There was no agreement. Calculate the amount payable. | (a) ₹2,000 to each partner. (b) Loss of ₹4,400 for X and Z & Y will take home ₹14,800. (c) ₹400 for X, ₹5,200 for Y and ₹400 for Z. |
| 11. X, Y and Z are partners. Profits before interest on partner's capital was ₹6,000 and Z demanded minimum profit of ₹5,000 as his financial position was not good. However, there was no written agreement. Profits to be distributed to X, Y and Z will be | (a) Other partners will pay Z the minimum profit and will suffer loss equally. (b) Other partners will pay Z the minimum profit and will suffer loss in capital ratio. (c) ₹2,000 to each of the partners. |
High-Yield Interactive Quiz — Introduction to Partnership Accounts
Q1. In the absence of a Partnership Deed, profits are shared:
Correct Answer: B. In the absence of any agreement, profits and losses are shared equally among partners as per Section 13 of the Indian Partnership Act, 1932.
Q2. In the absence of a Partnership Deed, interest on partner's loan is payable at:
Correct Answer: C. Interest on partner's loan is payable at 6% p.a. even if not provided in the partnership deed.
Q3. The maximum number of partners in a partnership firm is:
Correct Answer: B. As per Section 464 of the Companies Act, 2013 read with Rule 10 of Companies (Incorporation) Rules 2014, the maximum number of partners in a partnership firm is 50.
Q4. Under Fixed Capital Method, interest on capital is credited to:
Correct Answer: B. Under Fixed Capital Method, interest on capital is credited to the Partner's Current Account, not the Capital Account.
Q5. In case of insufficient profits, interest on capital is:
Correct Answer: B. In case of insufficient profits, the amount of profit is distributed in the ratio of capital as partners get profit by way of interest on capital only.
Q6. Which of the following is NOT a feature of a partnership?
Correct Answer: D. A partnership firm does not have a separate legal entity. This is a feature of a company or LLP.
Q7. A minor can be admitted to a partnership:
Correct Answer: B. A minor can be admitted to share profit only. He cannot be made to share losses of the firm.
Q8. The Profit and Loss Appropriation Account is prepared:
Correct Answer: B. The Profit and Loss Appropriation Account is prepared after the Profit and Loss Account. Net profit is transferred from the debit side of P&L to the credit side of Appropriation Account.
Q9. In LLP, the liability of partners is:
Correct Answer: B. In an LLP, the liability of partners is limited to their agreed contribution in the LLP, except in case of willful fraud.
Q10. In the absence of a Partnership Deed, a partner:
Correct Answer: B. In the absence of a Partnership Deed, no salary or commission is payable to any partner.
Q11. Under Fixed Capital Method, drawings are debited to:
Correct Answer: B. Under Fixed Capital Method, drawings are debited to the Partner's Current Account, not the Capital Account.
Q12. The number of designated partners in an LLP must be at least:
Correct Answer: B. Every LLP should have at least two designated partners who are individuals and at least one of them should be a resident in India.