HEXCO · Polytechnic · NC Accountancy

Business Accounting 2: Partnership Financial Statements

Learning Outcome 3 of 6

Free HEXCO NC Accountancy notes on Partnership Financial Statements, learning outcome 3 of 6 in Business Accounting 2. Correction of errors, control accounts, partnerships, incomplete records, manufacturing accounts and ratio analysis. Semester 2, module 310/22/M06.

Here we learn what a partnership is, its objectives, advantages and disadvantages, how it differs from a sole trader, and how to prepare its statement of profit or loss, appropriation account, partners' capital and current accounts, and statement of financial position.

When two or more people run a business together, the accounts follow the same rules as for a sole trader, except that the profit and the capital must be divided fairly between the partners.

3.1 Meaning and Objectives of Partnerships

Many small and professional businesses, such as law firms, accounting practices and family businesses, are run as partnerships.

Understanding their nature explains why their accounts include extra statements and accounts.

Definition of a Partnership

A partnership is the relationship between two or more persons who carry on a business together with a view to making a profit, each contributing money, property, skill or labour.

The terms are usually set out in a written partnership agreement (deed), which covers capital contributions, profit-sharing ratios, salaries, interest on capital and drawings, and what happens when a partner leaves.

Objectives of Partnerships

People form partnerships to raise more capital than one person could, to combine skills and experience, to share the workload and responsibility, to share risks and losses, to earn profits for all partners, and to continue the business through the contributions of several people rather than one.

Partnerships and Sole Traders Compared

The table compares the two forms of business.

Sole trader	Partnership
Ownership One owner.	Ownership Two or more partners.
Capital Limited to what one person can raise.	Capital Contributed by several partners, so usually more.
Decisions Made quickly by the owner alone.	Decisions Shared, which brings more ideas but can be slower and cause disagreement.
Profit All profit belongs to the owner.	Profit Shared in the agreed profit-sharing ratio.
Accounts One capital account, drawings deducted from it.	Accounts An appropriation account, and capital and current accounts for each partner.

Advantages and Disadvantages of Partnerships

The advantages are more capital, shared skills and workload, shared losses, easy and cheap to form, privacy since accounts need not be published, and more continuity than a sole trader.

The disadvantages are unlimited liability in an ordinary partnership, so partners may lose personal property for the firm's debts; joint liability for the actions of other partners; disagreements between partners; profits shared among several people; and instability, because the death or withdrawal of a partner may end the partnership.

Rules Where There is No Agreement

Where the partners have not agreed on these matters, accounting textbooks, following the rules in the UK Partnership Act 1890, apply these rules: profits and losses are shared equally, no interest is allowed on capital, no interest is charged on drawings, no partner is paid a salary, and interest is paid on a partner's loan to the firm at a stated rate. Learners should follow any specific rule given in the question, because the agreement always takes priority.

3.2 Measuring the Performance of a Partnership

A partnership's statement of profit or loss is prepared exactly like a sole trader's, ending with the profit for the year.

That profit is then divided between the partners in an appropriation account.

Partnership Revenue and Expenses

Revenue includes sales less returns, and other income such as discount received, rent received and commission received. Expenses include cost of sales, wages of employees, rent, electricity, depreciation and bad debts. Interest on a partner's loan is an expense charged in the statement of profit or loss, because it is a return on borrowed money. However, partners' salaries, interest on capital and drawings are not expenses: they are appropriations of profit, shown in the appropriation account.

Statement of Profit or Loss

Tafadzwa and Nyasha are in partnership. Their statement of profit or loss for the year is shown in summary below.

The Appropriation Account

The partnership agreement provides: interest on capital at 5% (capitals: Tafadzwa $40,000, Nyasha $30,000); a salary for Nyasha of $6,000; interest on drawings of $300 for Tafadzwa and $200 for Nyasha; and the remaining profit shared 3:2. Interest on drawings is added to the profit, because partners pay it to the firm; salaries and interest on capital are deducted; and the balance is shared.

Working: interest on capital is 5% × 40,000 = $2,000 for Tafadzwa and 5% × 30,000 = $1,500 for Nyasha. The residual profit is 30,000 + 500 - 6,000 - 3,500 = $21,000, shared 3:2, so Tafadzwa gets 21,000 × 3/5 = $12,600 and Nyasha 21,000 × 2/5 = $8,400.

Statement of Changes in Equity

The statement of changes in equity shows how each partner's share of the business changed during the year: opening capital and current account balances, plus capital introduced, interest on capital, salaries and share of profit, less drawings and interest on drawings, giving the closing balances. In partnership accounts at this level, this information is usually shown through the partners' current accounts and capital accounts, which are explained next.

3.3 Measuring the Financial Position of a Partnership

The statement of financial position of a partnership shows the same assets and liabilities as a sole trader's.

The difference is in the equity section, which shows each partner's capital and current account.

Fixed and Fluctuating Capitals

Under fixed capitals, each partner's capital account stays at the agreed amount and changes only when capital is introduced or withdrawn by agreement, while all the yearly items, such as salary, interest and profit share (credits) and drawings (debits), go to a separate current account. Under fluctuating capitals, there is no current account, so all these items go straight to the capital account, which therefore changes every year. Fixed capitals are more common, because they keep the agreed capital clear.

Partners' Current Accounts in Columnar Form

Current accounts are usually shown side by side in columnar form, with one money column per partner. At the start of the year, Tafadzwa's current account had a credit balance of $1,500, while Nyasha's had a debit balance of $800, because Nyasha had drawn more than her share in earlier years. Drawings for the year were Tafadzwa $10,000 and Nyasha $9,000.

Partners' Capital Accounts in Columnar Form

With fixed capitals, the capital accounts simply show the agreed balances. If capitals were fluctuating, the items in the current accounts above would be entered here instead, and the closing capitals would be Tafadzwa 40,000 + 5,800 = $45,800 and Nyasha 30,000 + 5,900 = $35,900.

Partnership Assets, Liabilities and Capital

Assets are the resources the firm controls, such as premises, equipment, vehicles, inventory, receivables and bank. Liabilities are amounts the firm owes, such as trade payables, accruals, bank loans and loans from partners, which are shown as non-current liabilities, not as capital. Capital is the partners' investment, shown through their capital and current accounts, with each current account balance shown separately; a debit balance on a current account is deducted.

Statement of Financial Position

The statement of financial position of Tafadzwa and Nyasha is shown below. The net assets of $81,700 equal the total of the capital and current accounts.