ACCOUNTING FOR PARTNERSHIP

BASIC CONCEPTS

A business can be organised in the

LEARNING OBJECTIVES form of a sole proprietorship, a
After studying this chapter you will be partnership firm or a company.
able to : Earlier, you have studied how to
l Define partnership and list its essential prepare Profit and Loss Account and
features;
Balance Sheet of a sole proprietor.
l Explain the meaning and list the
contents of partnership deed; If one man was intelligent enough
l Recognise the relevant provisions of the and commanded all the resources
Indian Partnership Act 1932, as that he needed and also the
applicable to accounting in the absence
necessary power to do everything,
of any provision to the contrary in the
partnership agreement; he would have carried on his
l Prepare partners' capital account under business as an individual. Alas, this
fixed and fluctuating capital method; is not true in life. Every man needs
l Distribute profit or loss among the help from others and this is true in
partners and prepare profit and loss
appropriation account;
business which requires huge
l Explain how guarantee of a minimum resources for the ongoing expansion
amount of profit to a partner is treated programmes. Therefore, one of the
in the books of accounts; inevitable ways is to for m
l Carry out past adjustments; partnership by joining hands with
l Explain the meaning of goodwill and
person(s) who can complement the
methods of its evaluation;
l Describe the accounting implications efforts by bringing in the necessary
of change in profit sharing ratio; and intellectual as well as financial
l Explain 'joint life policy' in relation to capital. This chapter is devoted to
partnership accounts. the basic aspects of partnership
accounting dealing with the
 2 ACCOUNTANCY

preparation of Profit and Loss Account and Balance Sheet of a partnership firm.
Although the basic accounting procedure is similar in all cases, there are certain
special features in the accounts of a partnership firm. In the case of a partnership
firm, for example, the special features relate to the distribution of profits, the
maintenance of capital accounts and the adjustments required when the firm is
reconstituted. In this chapter, we shall study the nature of partnership and
discuss the basic aspects of partnership accounts like preparation of capital
accounts, distribution of profits amongst partners and change in the profit-
sharing ratio of the existing partners along with preparation of Profit and Loss
Account and Balance Sheet of the partnership firm.

1.1 Nature of Partnership

The sole proprietorship has its limitations such as limited capital, limited
managerial ability and limited risk-bearing capacity. Hence, when a business
expands or when it is to be set up on a scale, which needs more capital and
involves more risk, two or more persons join hands to run it. They agree to
share the capital, the management, the risk and profits of the business. Such
mutual economic relationship based on a written or an oral agreement amongst
these persons is termed as 'partnership'. The persons who have entered into
partnership are individually known as 'partners' and collectively as 'firm'.
The Indian Partnership Act, 1932 defines partnership as "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". Based on this definition, the essential
features of partnership are as follows:
1. Two or more persons : To form a partnership, there must be at least two
persons. There is, however, a limit on the maximum number of persons
who constitute a partnership firm. It should not exceed 10 if the firm is
carrying on a banking business and 20 if it is engaged in any other business.
2. Agreement between the partners : A partnership is created by an agreement.
It is neither created by operation of law as in the case of Hindu Undivided
Family nor by status. The agreement forms the basis of economic
relationship amongst the partners. The agreement can be written or oral.
3. Business : The agreement should be for carrying on some legal business. A
joint ownership of some property by itself does not constitute partnership.
However, the joint ownership of the property may be used for forming the
partnership in order to pursue the business objectives for which the
partnership is formed.
ACCOUNTING FOR PARTNERSHIP — BASIC CONCEPTS 3

4. Sharing of profits : The agreement should be to share the profits of the

business. If some persons join hands to carry on some charitable activity,
it will not be termed as partnership. Of course, the ratio in which the
partners will share the profits is determined by the agreement or in the
absence of the agreement; it is shared equally amongst the partners.
5. Business carried on by all or any of them acting for all : The firm's business
may be carried on by all the partners or any one of them acting for all. This
means that partnership is based on the concept of mutual agency
relationship. A partner is both an agent (he can, by his acts, bind the other
partners) and a principal (he is bound by the acts of other partners). The
implication of this is that partner binds others and others bind him in the
same way. Further implication of this is that each partner is entitled to
participate in the conduct of business affairs and act for and on behalf of
the firm.

1.2 Partnership Deed

1.2.1 Meaning
A partnership is formed by an agreement. This agreement may be written or
oral. Though the law does not expressly require that there should be an
agreement in writing but the absence of a written agreement may be a source
of trouble in managing the affairs of the partnership firm. Therefore, a
partnership deed should be written, assented and signed by all the partners.

1.2.2 Contents of Partnership Deed

The partnership deed usually contains the following particulars:
l Name of the firm;
l Names and addresses of all partners;
l Nature and place of the business;
l Date of commencement of partnership;
l Duration of partnership, if any;
l Amount of capital contributed or to be contributed by each partner;
l Rules regarding operation of bank accounts;
l Ratio in which profits are to be shared;
l Interest, if any, on partners' capital and drawings;
 4 ACCOUNTANCY

l Interest on loan by the partners(s) to the firm;

l Salaries, commissions, etc. if payable to any partner(s);
l The safe custody of the books of accounts and other documents of
the firm;
l Mode of auditor's appointment, if any;
l Rules to be followed in case of admission, retirement, death, of a partner;
l Settlement of accounts on dissolution of the firm; and
l Mode of settlement of disputes among the partners.

1.2.3 Provisions Affecting Accounting Treatment

Normally, a partnership deed covers all matters relating to the mutual
relationship amongst the partners. But if the deed is silent on certain matters
or in the absence of any deed or an express agreement, the relevant provisions
of the Partnership Act shall become applicable. It is, therefore, necessary to
know the provisions of the Act, which have a direct bearing on the accounting
treatment of certain items. These are as follows:
1. Profit Sharing : The partners shall share the profits of the firm equally
irrespective of their capital contribution.
2. Interest on Capital : No interest is allowed to partners on the capital
contributed by them. Where, however, the agreement provides for interest
on capital, such interest is payable only out of the profits of the business.
In other words, if there are losses, interest on capital will not be allowed
even if the agreement so provides.
3. Interest on Loan : If any partner, apart from his share of capital, advances
money to the firm as a loan, he is entitled to interest on such amount at the
rate of 6 per cent per annum. Such interest shall be paid even out of the
assets of the firm. This means that interest on loan shall be paid even if
there are losses. Implying, thereby, that it is a charge against the revenues.
4. Interest on Drawings : No interest will be charged on drawings made by
the partners.
5. Remuneration to Partners : No partner is entitled to any salary or
commission for participating in the business of the firm.
It should be remembered that the above rules are applicable only in the
absence of any provision to the contrary in the partnership agreement.
ACCOUNTING FOR PARTNERSHIP — BASIC CONCEPTS 5

1.3 Special Aspects of Partnership Accounts

Following are the specific issues that require special attention in case of
partnership accounts:
l Maintenance of capital accounts of partners;
l Ascertainment and allocation of profit and losses ;
l Adjustment for wrong allocation of profits and losses ;
l Allocation of profits involving minimum guaranteed profit to a partner;
l Reconstitution of the partnership firm; and
l Dissolution of the firm.
The first four aspects are discussed in this chapter and the last two are dealt
with in the following chapters.

1.3.1 Partners' Capital Accounts

In case of partnership firm, the transactions relating to partners are recorded in
their respective capital accounts. Normally, each partner's capital account is
prepared separately. But these accounts can also be shown in a tabular form as
shown later in this chapter.
There are two methods by which the capital accounts of partners can be
maintained. These are:
l Fluctuating Capital Method; and
l Fixed Capital Method.

1.3.1.1 Fluctuating Capital Method

Under the fluctuating capital method, only one account viz., the capital account
for each partner, is maintained. It records all items affecting partner's account
like interest on capital, drawings, interest on drawings, salary, commission,
and share of profit or loss in the capital account itself. As a result of these, the
balance in the capital account keeps on fluctuating.
The items that usually appear on the debit and the credit side of the
Partners' capital account are :
l Credit Side
1. Capital introduced or the opening balance;
2. Additions to capital made during the year, if any;
 6 ACCOUNTANCY

3. Interest on capital, if any;

4. Salary to the partners, if any;
5. Commission and bonus to the partners;
6. Share of profit.
l Debit Side
1. Drawings made during the year, if any;
2. Interest on drawings, if any;
3. Share of loss, if any;
4. Withdrawal of capital, if any;
5. Closing Balance.
Thus, the capital account of a partner will appear as follows:
Partners' Capital Account
Dr. Cr.
Date Particulars J.F. Amount Date Particulars J.F. Amount
(Rs.) (Rs.)

Drawings *** Opening balance * * *

Interest on *** Addition to capital * * *
drawings Interest on capital * * *
Share of loss *** Salary * * *
Withdrawal of *** Commission/Bonus * * *
capital Share of profit * * *
Closing balance ***
Total *** Total ***

Format under fluctuating method

Note : A Partners' Capital Account usually shows a credit balance. It can, however, show a
debit balance under certain circumstances, such as over withdrawal or insolvency of the partner.

1.3.1.2 Fixed Capital Method

Under the fixed capital method, the capitals of the partners shall remain fixed
unless some additional capital is introduced or some amount of capital is
withdrawn by an agreement among the partners. Hence, all items like interest
on capital, drawings, interest on drawings, salary, commission, and share of
profit or loss are not to be shown in the capital accounts. For all these
transactions, a separate account called 'Partner's Current Account' is opened.
Thus, under fixed capital method, two accounts are maintained for each partner
viz., (i) Capital Account, and (ii) Current Account. It may be noted that the
capital account will continue to show the same balance from year to year
unless some amount of capital is introduced or withdrawn, while the balance
of current account will fluctuate from year to year.
ACCOUNTING FOR PARTNERSHIP — BASIC CONCEPTS 7

Under the fixed capital account method, the capital account and the current
account would appear as shown below:
Partners' Capital Account
Dr. Cr.
Date Particulars J.F. Amount Date Particulars J.F. Amount
(Rs.) (Rs.)
Withdrawal **** Opening balance ****
of capital Addition to capital ****
Closing balance ****

Total **** Total ****

Format under fixed capital method

Partners' Current
Dr. Cr.

Date Particulars J.F. Amount Date Particulars J.F. Amount

(Rs.) (Rs.)
Opening balance* *** * Opening balance* * * * *
Drawings *** * Interest on capital * * * *
Interest on *** * Salary * * * *
drawings *** * Commission/Bonus * * * *
Share of loss *** * Share of profit * * * *
Closing balance* *** * Closing balance* * * * *
Total **** Total ****

Format of Current Account

* In Partners' Current Account, opening balance and closing balance may appear on either
side, i.e. debit or credit.

Illustration 1 (Fixed and Fluctuating Capital Account)

Amit and Sumit commenced business as partners on April 1, 2000. Amit
contributed Rs. 40,000 and Sumit Rs. 25,000 as their share of capital. The
partners decided to share their profits in the ratio of 2:1. Amit was entitled to
a salary of Rs. 6,000 p.a. Interest on capital was to be provided @ 6% p.a. The
drawings of Amit and Sumit for the year ending March 31, 2001were
Rs. 4,000 and Rs. 8,000, respectively. The profits of the firm after providing
Amit's salary and interest on capital were Rs. 12,000.
Draw up the Capital Accounts of the partners:
(i) When capitals are fluctuating, and
(ii) When capitals are fixed.
 8 ACCOUNTANCY

Solution
(i) When capitals are fluctuating

Books of Amit and Sumit

Amit's Capital Account

Dr. Cr.
Date Particulars J.F. Amount Date Particulars J.F. Amount
(Rs.) (Rs.)

Drawings 4,000 Cash 40,000

Balance c/f 52,400 Salary 6,000
Interest on Capital 2,400
Profit and Loss
Appropriation A/c. 8,000
(Share of profit 2/3
of Rs. 12,000)

Total 56,400 Total 56,400

Sumit's Capital Account

Dr. Cr.
Date Particulars J.F. Amount Date Particulars J.F. Amount
(Rs.) (Rs.)
Drawings 8,000 Cash 25,000
Balance c/f 22,500 Interest on Capital 1,500
Profit and Loss 4,000
Appropriation A/c
(Share of profit 1/3
of Rs.12,000)
Total 30,500 Total 30,500

(ii) When capitals are fixed.

Books of Amit and Sumit
Amit's Capital Account

Dr. Cr.
Date Particulars J.F. Amount Date Particulars J.F. Amount
(Rs.) (Rs.)
Balance c/f 40,000 Cash 40,000

Total 40,000 Total 40,000

ACCOUNTING FOR PARTNERSHIP — BASIC CONCEPTS 9

Amit's Current Account

Dr. Cr.
Date Particulars J.F. Amount Date Particulars J.F. Amount
(Rs.) (Rs.)

Drawings 4,000 Salary 6,000

Balance c/f 12,400 Interest on Capital 2,400
Profit and Loss 8,000
Appropriation
(Share of profit 2/3
of Rs. 12,000)
Total 16,400 Total 16,400

Sumit's Capital Account

Dr. Cr.
Date Particulars J.F. Amount Date Particulars J.F. Amount
(Rs.) (Rs.)

Balance c/f 25,000 Cash 25,000

Sumit's Current Account

Dr. Cr.
Date Particulars J.F. Amount Date Particulars J.F. Amount
(Rs.) (Rs.)
Drawings 8,000 Interest on Capital 1,500
Profit and Loss 4,000
Appropriation
(Share of profit 1/3
of Rs. 12,000)
Balance c/f 2,500
Total 8,000 Total 8,000

1.3.2 Distribution of Profit

In case of partnership firm, the net profit (after charging the interest on capital,
partners' salary and commission and after taking into account the interest on
drawings) is to be shared by all the partners in the agreed profit sharing ratio.
As stated earlier, in the absence of any specific agreement to this effect, the
profit is to be distributed equally among the various partners.
 10 ACCOUNTANCY

1.3.2.1 Profit and Loss Appropriation Account

As stated above, the net profit as shown by the profit and loss account of a
partnership firm needs certain adjustments with regard to interest on capitals,
interest on drawings, salary, commission to the partners, if provided, under
the agreement. For this purpose, 'Profit and Loss Appropriation Account' may
be prepared. This is merely an extension of the profit and loss account and is
prepared to show how net profit is to be distributed among the partners. This
account is credited with net profit and interest on drawings, and debited with
interest on capitals, salary or commission to partners. If, however, the profit
and loss appropriation account shows a net loss, it will be shown on the debit
side of the profit and loss appropriation account. After these adjustments
have been made, the Profit and Loss Appropriation Account will show the
amount of profit or loss, which shall be distributed among the partners in the
agreed profit sharing ratio.

For preparing the profit and loss appropriation account, the following journal
entries have to be recorded for various items:

1. For Interest on Capital

(i) For Crediting Interest on Capital to Capital/Current Account :

Interest on Capital a/c Dr.
Partners' Capital/Current a/c

(ii) For transferring Interest on Capital to Profit and Loss Appropriation Account:
Profit and Loss Appropriation a/c Dr.
Interest on Capital a/c

2. For Interest on Drawings

(i) Interest on Drawings is a gain to the firm and is charged to Partner's Capital/Current
Account
Partners Capital/Current a/c Dr.
Interest on Drawings a/c

(ii) For transferring Interest on Drawings to Profit and Loss Appropriation Account, the
following entry is to be recorded:

Interest on Drawings a/c Dr.

Profit and Loss Appropriation a/c
ACCOUNTING FOR PARTNERSHIP — BASIC CONCEPTS 11

3. Partner's Salary

(i) Salary allowed to a partner is a gain of the individual partner and charge against
the profits of the firm as per partnership agreement. For this following entry is recorded:

Salary to Partner a/c Dr.

Partner Capital/Current a/c

(ii) For charging salary allowed to a partner:

Profit and Loss Appropriation a/c Dr.

Salary to partner a/c

4. Partner's Commission
(i) Commission is an expense for the firm and a gain to the partner. For this, following
entry is made:
Commission to partner a/c Dr.
Partner's capital/current a/c

(ii) Commission paid to a partner is charged to Profit and Loss Appropriation account by
recording the following entry:
Profit and Loss Appropriation a/c Dr.
Commission to partners a/c

5. For Transfer to Reserve:

Profit and Loss Appropriation a/c Dr.
Reserve

6. For share of Profit or Loss on Appropriation

If Profit:
Profit and Loss Appropriation a/c Dr.
Partner's Capital/Current a/c

If Loss:
Partner's Capital/Current a/c Dr.
Profit and Loss Appropriation a/c
 12 ACCOUNTANCY

The Profit and Loss Appropriation Account will appear as follows:

Profit and Loss Appropriation Account

Dr. Cr.
Date Particulars J.F. Amount Date Particulars J.F. Amount
(Rs.) (Rs.)

Net Loss as per ** Net profit as per .....

Profit and Loss A/c Profit and Loss A/c
(if loss) (if profit)
Interest on Capital Interest on drawings
A ×× A ××
B ×× ** B ×× ×××
Partner's Salary ...... Capital A/cs Share
Partner's ...... of loss (if loss)
Commission A ××
Reserve (transfer) ...... B ×× ×××
Capital A/cs - ......
Share of profit
(if profit)
A ××
B ×× ***

Total ......... Total .........

Proforma of Profit and Loss Appropriation Account

Illustration 2 (Preparation of Profit and Loss Account and Balance Sheet)

Aakriti and Akash are partners sharing profits in the proportion of 3:2. The
undermentioned trial balance was extracted from their books on December
31, 2000.
Trial Balance as on December 31, 2000

Rs. Rs.

Aakriti's Capital 65,000

Akash's Capital 40,000
Aakriti's Drawings 4,000
Akash's Drawings 3,000
Goodwill 10,000
Plant and Machinery 40,000
Office Furniture 5,000
Purchases 85,000
Sales 1,60,000
Total c/f 1,47,000 2,65,000
ACCOUNTING FOR PARTNERSHIP — BASIC CONCEPTS 13

Total b/f 1,47,000 2,65,000

Sundry Debtors 40,500

Sundry Creditors 14,510
Returns Inwards and Outwards 1,500 2,500
Rent 3,750
Postage and Telegrams 500
Advertising Expenditure 9,000
Opening stock 11,500
Cash in hand 16,000
Wages 14,000
Telephone Charges 500
Salaries to staff 12,250
Printing and Stationery 750
Commission 5,000
Travelling Expenses 2,000
Carriage Inwards 5,800
Motor Van 20,860
Bills payable 8,900

Total 2,90,910 2,90,910

You are required to prepare the Profit and Loss Account for the year ended
December 31, 2000 and Balance Sheet as at that date. The following
adjustments are to be made:
1. The value of stock on December 31, 2000 was Rs. 12,500.
2. Write off Rs. 250 from office furniture; 10% on plant and machinery
and 20% on motor van.
3. Create a provision of 5% on the sundry debtors for bad debts.
4. Write off 1/5th of the advertising expenses.
5. Partners are entitled to interest on capital @ 5% p.a. and Akash is
entitled to a salary of Rs. 1,800 p.a.
 14 ACCOUNTANCY

Solution
Books of Akriti and Akash
Profit and Loss Account for the year ended December 31, 2000.

Dr. Cr.
Particulars Amount Particulars Amount
(Rs.) (Rs.)
Opening Stock 11,500 Sales 1,60,000
Purchases 85,000 Less : Returns 1,500 1,58,500
Less: Returns 2,500 82,500
Wages 14,000
Carriage Inwards 5,800
Gross Profit c/f 57,200 Closing Stock 12,500
1,71,000 1,71,000
Salaries to staff 12,250 Gross Profit b/f 57,200
Rent 3,750
Postage and Telegram 500
Advertising Exp. written off 1,800
Telephone Charges 500
Printing and Stationery 750
Commission 5,000
Travelling Expense 2,000
Depreciation
Plant 4,000
Furniture 250
Motor Van 4,172 8,422
Provision for Bad Debts 2,025
Salary to Akash 1,800
Interest on capital :
Aakriti 3,250
Akash 2,000 5,250
Net Profit Transferred to
Capital a/c:
Aakriti 7,892
Akash 5,261 13,153

Total 57,200 Total 57,200

ACCOUNTING FOR PARTNERSHIP — BASIC CONCEPTS 15

Balance Sheet as at December 31, 2000

Liabilities Amount Assets Amount

(Rs.) (Rs.)

Aakriti's Capital 65,000 Goodwill 10,000

Less:Drawings 4,000 Plant and Machinery 40,000
61,000 Less: Depreciation 4,000 36,000
Add: Interest on Capital 3,250
Net profits 7,892 72,142 Office Furniture 5,000
Less: Depreciation 250 4,750
Akash's Capital 40,000
Less: Drawings 3,000 Motor Vans 20,860
37,000 Less: Depreciation 4,172 16,688
Add: Interest on Capital 2,000
Salary 1,800 Sundry Debtors 40,500
Net profits 5,261 46,061 Less: Provision 2,025 38,475
Sundry Creditors 14,510 Cash on hand 16,000
Bills Payable 8,900 Advertising exp. 9,000
Less: Written-off (1/5) 1,800 7,200
Stock on hand 12,500
Total 1,41,613 Total 1,41,613

Illustration 3 (Distribution of profit)

Ajit, Choudhary and Vishal set up a partnership firm on January 1, 2001.
They contributed Rs. 50,000, Rs. 40,000 and Rs. 30,000 respectively as
their capitals and decided to share profits in the ratio of 3:2:1. The partnership
deed provided that Ajit is to be paid a salary of Rs. 1,000 p.m. and Choudhary
a commission of Rs. 5,000. It also provided that interest on capital be allowed
@ 6% p.a. The drawings for the year were: Ajit Rs. 6,000, Choudhary Rs.
4,000 and Vishal Rs. 2,000. Interest on drawings Rs. 270 on Ajit's drawings,
Rs. 180 on Choudhary's drawings and Rs. 90 on Vishal's drawings. The net
amount of profit as per the profit and loss account for the year ended 2001 was
Rs. 35,660.
You are required to record the necessary journal entries relating to
appropriation of profit and prepare the profit and loss appropriation account
and the partners' capital accounts.
 16 ACCOUNTANCY

Solution
Books of Ajit, Chaudhary and Vishal
Journal

Date Particulars L.F. Debit Credit

Amount Amount
2001 (Rs.) (Rs.)

End of Profit and Loss a/c Dr. 35,660

the year Profit and Loss Appropriation a/c 35,600
(Transfer of Profit to Profit and Loss
Appropriation Account)
Ajit's Salary a/c Dr. 12,000
Ajit's Capital a/c 12,000
(Amount of Ajit's Salary)
Profit and Loss Appropriation a/c Dr. 12,000
Ajit's Salary a/c 12,000
(Transfer of Ajit's Salary to
Profit and Loss Appropriation Account)
Choudhary's Commission a/c Dr. 5,000
Choudhary's Capital a/c 5,000
(Amount of Choudhary's Commission)
Profit and Loss Appropriation a/c Dr. 5,000
Choudhary's Commission a/c 5,000
(Transfer of Choudhary's Commission
to Profit and Loss Appropriation Account)
Interest on Capital a/c Dr. 7,200
Ajit's Capital a/c 3,000
Choudhary's Capital a/c 2,400
Vishal's Capital a/c 1,800
(Amount of interest on capital)
Profit and Loss Appropriation a/c Dr. 7,200
Interest on Capital a/c 7,200
(Transfer of Interest on Capital to
Profit and Loss Appropriation Account)
Ajit's Capital a/c Dr. 270
Choudhary's Capital a/c 180
Vishal's Capital a/c 90
Interest on Drawings a/c 540
(Amount of interest on drawings)
Interest On Drawings a/c Dr. 540
Profit and Loss Appropriation a/c 540
(Transfer of Interest on drawings to
Profit and Loss Appropriation Account)
ACCOUNTING FOR PARTNERSHIP — BASIC CONCEPTS 17

Profit and Loss Appropriation a/c Dr. 12,000

Ajit's Capital a/c 6,000
Choudhary's Capital a/c 4,000
Vishal's Capital a/c 2,000
(Amount of profit on appropriation)

Profit and Loss Appropriation Account for the year ended December 31,2001
Dr. Cr.
Particulars Amount Particulars Amount
(Rs.) (Rs.)
Ajit's Salary 12,000 Net profit as per profit 35,660
Choudhary's Commission 5,000 and loss account
Interest on Capital: Interest on Drawings :
Ajit's Capital 3,000 Ajit's Capital 270
Choudhary's Capital 2,400 Choudhary's capital 180
Vishal's Capital 1,800 7,200 Vishal's Capital 90 540
Capital Accounts -
Share of Profit:
Ajit's Capital 6,000
Choudhary's Capital 4,000
Vishal's Capital 2,000 12,000
Total 36,200 Total 36,200

Ajit's Capital Account

Dr. Cr.
Date Particulars J.F. Amount Date Particulars J.F. Amount
2001 (Rs.) 2001 (Rs.)
Drawings 6,000 Cash 50,000
Interest on Drawings 270 Salary 12,000
Balance c/f 64,730 Interest on Capital 3,000
Profit and Loss
Appropriation
(Share of profit) 6,000
Total 71,000 Total 71,000
 18 ACCOUNTANCY

Choudhary's Capital Account

Dr. Cr.
Date Particulars J.F. Amount Date Particulars J.F. Amount
2001 (Rs.) 2001 (Rs.)
Drawings 4,000 Cash 40,000
Interest on Drawings 180 Commission 5,000
Balance c/f 47,220 Interest on Capital 2,400
Profit and Loss
Appropriation
(Share of profit) 4,000

Total 51,400 Total 51,400

Vishal's Capital Account

Dr. Cr.

Date Particulars J.F. Amount Date Particulars J.F. Amount

2001 (Rs.) 2001 (Rs.)
Drawings 2,000 Cash 30,000
Interest on Drawing 90 Interest on Capital 1,800
Balance c/f 31,710 Profit and Loss
Appropriation
(Share of profit) 2,000

Total 33,800 Total 33,800

Illustration 4 (Distribution of profit)

Pawan and Purna are partners in a firm sharing profits in the ratio of 3:2. The
balance in their capital and current accounts as on January1, 1998 were
as under :
Pawan Purna
(Rs.) (Rs.)
Capital Account 30,000 20,000
Current Account (Cr.) 10,000 8,000
The partnership deed provided that Pawan is to be paid salary @ Rs. 500 p.m.
whereas Purna is to get commission of Rs. 4,000 for the year.
Interest on capital is to be allowed @ 6% p.a. The drawings of Pawan and
Purna for the year were Rs. 3,000 and Rs. 1,000, respectively. Interest on
ACCOUNTING FOR PARTNERSHIP — BASIC CONCEPTS 19

drawings for Pawan and Purna works out at Rs. 75 and Rs. 25, respectively.
The net profit of the firm before making these adjustments was Rs. 24,900.
Prepare the Profit and Loss Appropriation Account and the partners' capital
and current accounts.
Solution

Books of Pawan and Purna

Profit and Loss Appropriation Account for the year ended Dec. 31,1998

Dr. Cr.
Particulars Amount Particulars Amount
(Rs.) (Rs.)
Pawan's Salary 6,000 Net profit as per Profit and 24,900
Purna's Commission 4,000 Loss account
Interest on Capital: Interest on drawings :
Pawan's current 1,800 Pawan's current a/c 75
Purna's current 1,200 3,000 Purna's current a/c 25 100
Capital accounts
(Share of Profit):
Pawan's current 7,200
Purna's current 4,800 12,000

Total 25,000 Total 25,000

Partners' Capital Account

Dr. Cr.
Date Particulars J. Pawan Purna Date Particulars J. Pawan Purna
1998 F. Rs. Rs. 1998 F. Rs. Rs.

Balance c/f 30,000 20,000 Balance b/f 30,000 20,000

Partners' Current Account

Dr. Cr.
Date Particulars J.F. Pawan Purna Date Particulars J.F. Pawan Purna
1998 Rs. Rs. 1998 Rs. Rs.
Drawings 3,000 1,000 Balance b/f 10,000 8,000
Interest on 75 25 Salary 6,000 --
Drawing Commission -- 4,000
Balance c/f 21,925 16,975 Interest on 1,800 1,200
Capital
Share of profit 7,200 4,800
Total 25,000 18,000 Total 25,000 18,000
 20 ACCOUNTANCY

1.3.3 Calculation of Interest on Capital

If the partnership agreement specifically provides for the payment of the interest
on the capital contributed by the partners, the same has to be allowed. Interest
to be allowed on capital is to be calculated with respect to the time, rate and
amount. Generally, following points are to be borne in mind while calculating
the interest on capital:

1. Normally, interest on the opening balance at the beginning of the year is

allowed for the whole accounting year.
2. If additional capital is invested during the year, interest for the relevant
period is calculated.
3. If part of the capital is withdrawn during the year, interest on the part of
the capital that was invested for the whole year, interest is calculated for
the whole year and it is added with the amount of interest that is calculated
on the remaining capital that was invested for the relevant period. For
example, Anmol has Rs. 30,000 as balance in his capital account at the
beginning of the year. In the middle of the year he withdrew Rs.10,000
from his capital. He is entitled for interest @ 10% p.a.
In this case, interest will be calculated in the following manner:
(20,000 × 10/100) + (10,000 × 10/100 × 1/2) = Rs. 2,500;

Alternatively, we can calculate interest on capital with respect to the

amount remained invested for the relevant period. In the above example,
the interest may also be calculated as follows:
(30,000 × 10/100 × 1/2) + (20,000 × 10/100 × 1/2) = Rs. 2,500.

Illustration 5 (Interest on Capital)

Mansoor and Reshma are partners in a firm. Their capital accounts showed
the balance on Jan 1, 2000 as Rs. 20,000 and Rs. 15,000 respectively.During
the year, Mansoor introduced additional capital of Rs.10,000 on May 1,
2000 and Reshma brought in further capital of Rs.15,000 on July 1, 2000.
Reshma withdrew Rs. 5,000 from her capital on October 1, 2000. Interest
is allowed @ 6% p.a. on the capitals. Calculate the interest to be paid on
the capital.
ACCOUNTING FOR PARTNERSHIP — BASIC CONCEPTS 21

Solution
Statement showing calculation of interest

Particulars Mansoor Reshma

Rs. Rs.

1. Interest on capital balance on

Jan 1, 2000:
Mansoor – (20,000×6/100) 1,200
Reshma – (15,000×6/100) 900
2. Add interest on additional capital:
Mansoor – (10,000×6/100×8/12) 400
Reshma – (15,000×6/100×6/12) 450
3. Less: Interest on capital withdrawn
by Reshma (5000×3/12×6/100) (75)

Total Interest Payable 1,600 1,275

1.3.4 Calculation of Interest on Drawings

Interest on drawings is to be charged from the partners, if the same has been
specifically provided in the partnership deed. Interest on drawings is to be
calculated with reference to the time period for which the money was withdrawn.
Following may be the possibilities requiring the different calculations of
interest when:
(1) Amount, rate of interest and date of withdrawal is given:
Suppose, Johnson is a partner who withdrew Rs. 20,000 on October 1,
2002. Interest on drawings is charged @ 10% per annum. The calculation
of interest will be as follows:

10 3
Rs. 20,000 × × = Rs. 500
100 12

(2) Amount and rate of interest are given but date of withdrawal is not specified:
Suppose, Ahmed is a partner who withdraws Rs. 20,000 and interest on
drawings is charged @ 10% per annum. The calculation of interest will be
as follows:
10 6
Rs. 20,000 × × = Rs. 1,000
100 12
 22 ACCOUNTANCY

Here, it is noted that in the absence of any particular date of withdrawal,

it is assumed that withdrawals are made evenly throughout the year. Hence,
interest is charged for the average of the period of the year, i.e., six months.
(3) Fixed amount is withdrawn every month:
In this case, there may be three possibilities and accordingly the interest for
that period will be charged:
a) If amount is withdrawn during the month (implicitly assumed to be in
the middle of month), interest is calculated for six months;
b) If the withdrawal is made in the beginning of the month, interest is
calculated for 6½ months (six and a half months), and
c) If withdrawal is made at the end of the month, interest is calculated
for 5 ½ months (five and a half months).
(4) If amount is withdrawn at each quarter:
(a) If amount is withdrawn in the beginning of each quarter, in this case
the interest is calculated on total drawings for a period of seven and
a half months, and
(b) If amount is withdrawn at the end of each quarter, the amount of
interest is calculated on total drawings for a period of four and a half
months.
(5) Different amounts are withdrawn at different intervals:
In this case, the sum of the product of amount withdrawn and the time is
calculated and then the rate of interest is applied for a period of one month.
For example, Sonu withdraws Rs. 1,000 on March 1; Rs. 2,000 on 30th
June; Rs. 1,000 on 1st November and Rs. 2,000 on 31st December. Interest
on drawings is charged at 10% per annum. In this case, interest on
drawings will be calculated as follows :
Statement of Calculation of Interest on Drawings

(1) (2) (3) (4) (5)

Date Amount(Rs.) Time Period Product Interest*(Rs.)
(2×3)
March 1 1000 10 Months 10,000 10,000 × 10/100 × 1/12 = 83.33
June 30 2000 6 Months 12,000 12,000 × 10/100 × 1/12 = 100
Nov.1 1000 2 Months 2,000 2,000 × 10/100 × 1/12 = 16.67
Dec.31 2000 0 0 0
Total 24,000 200*

* Instead of this cumbersome calculation, the same result can be obtained by calculating the Interest
on the sum of product for a period of one month = Rs. 24,000 × 10/100 × 1/12 = Rs. 200
ACCOUNTING FOR PARTNERSHIP — BASIC CONCEPTS 23

Illustration 6 (Interest on Drawings)

Rajesh is a partner in a firm. He withdrew the following amounts during the year
2000 :
Rs.
January 31 6,000
March 31 4,000
June 30 8,000
September 30 3,000
October 31 5,000
The interest on drawings is to be charged @ 6% p.a. Assuming the accounting
year closes on December 31each year, interest on drawings to be debited to Rajesh
shall be worked out as follows :
1 2 3 4
Date Amount(Rs.) Period Months Product(Rs.)
(2×3)
Jan 31 6,000 11 66,000
March 31 4,000 9 36,000
June 30 8,000 6 48,000
Sept 30 3,000 3 9,000
Oct 31 5,000 2 10,000
Total 26,000 1,69,000

Interest on drawings for one month on the sum of products :

Rate of interest 1
× sum of products ×
100 12
= 6/100 × Rs. 1,69,000 × 1/12
= Rs. 845
Alternatively, interest can be calculated separately for each amount for the
period involved and then totalled. In that case also, we shall arrive at the same
amount of interest.

Illustration 7 (Interest on drawings)

Amit and Sonu are partners sharing profits equally. Amit withdrew Rs. 1,000
p.m. regularly on the first day of every month for personal expenses. If interest
 24 ACCOUNTANCY

on drawings is to be charged @ 5% p.a., calculate the interest on the drawings of

Amit.

Solution

Calculation of Interest on Drawings

(1) (2) (3) (4)

Date Amount of drawings(Rs.) Period for which money has Product(Rs.)
2001 been used (2 × 3)
Jan 1 1,000 12 12,000
Feb 1 1,000 11 11,000
Mar 1 1,000 10 10,000
Apr 1 1,000 9 9,000
May 1 1,000 8 8,000
June 1 1,000 7 7,000
July 1 1,000 6 6,000
Aug 1 1,000 5 5,000
Sept 1 1,000 4 4,000
Oct 1 1,000 3 3,000
Nov 1 1,000 2 2,000
Dec 1 1,000 1 1,000
Total 12,000 78,000

Interest on Drawings = Rate of Interest/100 × 1/12 × Sum of the product

= 5/100 × 1/12 × 78,000
= Rs. 325
It may be noted that when a fixed amount is drawn at regular intervals,
the interest on drawings can also be calculated on the basis of the average
period. The calculation of the average period depends upon the fact whether
the fixed amount is withdrawn on the first day of every month or the last day
of every month.
If the fixed amount is withdrawn on the first day of every month, the
average period will be calculated with the help of following formula :
Average period = (Total period in months + 1)/2
If the fixed amount is withdrawn on the last day of every month, the average
period will be calculated by the following formula :
Average period = (Total period in months – 1)/2
ACCOUNTING FOR PARTNERSHIP — BASIC CONCEPTS 25

In illustration 6, the partners withdrew a fixed amount on the first day of

every month. Hence, the interest on drawings can also be calculated by applying
the average period formula.
Average period = (Total period in months + 1)/2
= (12 +1)/2 = 6.5 Months
Interest on drawings for 6.5 months @ 5% p.a.

5 13 1
= 12000 × × ×
100 2 12
= Rs. 325

Illustration 8 (Interest on Drawings)

Maneesh and Mohan are partners in a firm. The partnership deed provided
that interest on drawings will be charged @ 6% p.a.. During the year ended,
December 31, 2002, Maneesh withdrew Rs.5,000 in the beginning of each
quarter and Mohan withdrew Rs. 5,000 at the end of each quarter. Calculate
interest on the partners' drawings.

Solution
Maneesh's total drawings = Rs.5,000 × 4 = Rs.20,000
Mohan's total drawings = Rs.5,000 × 4 = Rs.20,000

Interest on Maneesh's Drawings :

12 + 3
Number of months for which interest will be charged = = 7.5 months
2

6 15 1
Interest = Rs. 20,000 × × × = Rs. 750
100 2 12

Interest on Mohan's drawings :

12 − 3
Number of months for which interest will be charged = = 4.5 months
2

6 9 1
Interest = Rs. 20,000 × × × = Rs. 450
100 2 12
 26 ACCOUNTANCY

1.4 Guarantee of Profit to a Partner

Guarantee is an assurance that a partner will not get as his share of profit less
than the guaranteed amount. There may be two situations :
(a) Guarantee to one partner by (others) the firm,
(b) Guarantee to a partner by another partner individually.
(a) Guarantee to one partner by (others) the firm
Sometimes, a partner is guaranteed a minimum amount by way of his
share in the profits of the firm. Such a guarantee may be given to an
existing partner or to a new partner at the time of admission. Such
guaranteed amount shall be paid to partner when his share of profit, as
calculated, according to his profit sharing ratio is less than the guaranteed
amount. The deficiency of such guaranteed amount will be borne by the
other partner's in their profit sharing or agreed ratio as the case may be.
Example, Soni and Mita are partners and they decide to admit Mary into
the partnership firm. The profit sharing ratio is agreed as 3:2:1 with a
guaranteed amount of Rs. 5,000 to Mary. For the year ended 2001, the
business earns a profit of Rs. 24,000. Mary's share works out to Rs. 4,000
(1/6 of Rs. 24,000). This is Rs. 1,000 less than the guaranteed amount of
Rs. 5,000. Hence, Mary will get Rs. 4,000 as her share of the profit in the
profit sharing ratio and the deficiency of Rs.1,000 (i.e. the amount by
which Rs. 4,000 falls short of the guaranteed amount) shall be transferred
to the credit of Mary by transfer from Soni and Mita in their profit sharing
ratio, i.e. 3:2.

Illustration 9 (Guarantee of Profit)

Mouse, Keyboard and Monitor are partners. They admit Printer as a partner
with a guarantee that his share of profits shall not be less than Rs. 20,000 p.a.
Profits are to be shared in the proportion of 4:3:3:2. The total profits for the
year ended 2002 were Rs. 96,000. Prepare the profit and loss appropriation
account showing the division of the profits for the year.
ACCOUNTING FOR PARTNERSHIP — BASIC CONCEPTS 27

Solution
Books of Mouse, Key Board and Monitor
Profit and Loss Appropriation Account
for the year ended........2002
Dr. Cr.
Particulars Amount Particulars Amount
(Rs.) (Rs.)
Mouse 30,400 Net Profits 96,000
Keyboard 22,800
Monitor 22,800
Printer 20,000

Total 96,000 Total 96,000

Notes to Solution :
Printer's share = Rs. 96,000 × 2/12 = Rs. 16,000.
Since Printer has been guaranteed a minimum amount of Rs. 20,000, therefore, he
will given Rs. 20,000 and remaining amount i.e., Rs. 20,000 – Rs.16,000 = Rs. 4,000
will be borne by Mouse, Keyboard and Monitor in the ratio of 4:3:3.

Mouse's share = Rs. 96,000 × 4/12 = Rs. 32,000

Less :
contribution to Printer (Rs. 4,000 × 4/10) = Rs. 1,600 Rs. 30,400
Keyboard's share = Rs. 96,000 × 3/12 = Rs. 24,000
Less:
contribution to Printer (Rs. 4,000 × 3/10) = Rs. 1,200 Rs. 22,800
Monitor's share = Rs. 96,000 × 3/12 = Rs. 24,000
Less:
contribution to Printer (Rs. 4,000 × 3/10) = Rs. 1,200 Rs. 22,800
(b) Guarantee to a partner by another partner individually
The guarantee to an existing or incoming partner may be given by all the
old partners or any of them in their new profit sharing ratio or an agreed
basis. In illustration 9, all the three partners have agreed to guarantee
Printer for the minimum share of profit. Hence, these three divided the
Printer's share in the ratio of 4:3:3. Suppose Mouse alone agrees to
guarantee Printer then profit distribution will be as follows :
Mouse's share Rs. 96,000 × 4/12 = Rs. 32,000
Less : Printer's share Rs. 4,000
Final share of Mouse Rs. 28,000
In other words Keyboard and Monitor will get full share, i.e. Rs.24,000 each.
 28 ACCOUNTANCY

Illustration 10 (Guarantee of Profit)

Kim and Lal are partners in a firm sharing profit in the ratio of 2:1. They decide to
admit Mohit with 1/4th share in profits with a guaranteed amount of Rs.
25,000. Kim undertook to meet the liability arising out of the guaranteed amount
to Mohit. The profit sharing ratio between Kim, Lal and Mohit will be 2:1:1. The
firm earned profit of Rs. 76,000 for the year ended March 31, 2001.
You are required to prepare Profit and Loss Appropriation Account and
show the distribution of profit amongst the partners.

Solution
The Profit and Loss Appropriation Account will be prepared as follows :
The Profit and Loss Appropriation Account
for the year ended March 31, 2001
Dr. Cr.
Particulars Amount Particulars Amount
(Rs.) (Rs.)
Share of Profit Net Profit as per profit 76,000
Kim and loss account
(2/4 of 76,000) 38,000
Less: Mohit's
deficiency
(2/3 of 9,000) 6,000 32,000
Lal
(1/4 of 76,000) 19,000
Mohit
(1/4 of 76,000) 19,000
Add: deficiency
borne by Kim 6,000 25,000
Total 76,000 Total 76,000

Notes to the Solution :

The minimum guaranteed amount to Mohit is Rs. 25,000 whereas, his share of profit as
per the profit sharing ratio works out to be Rs. 19,000 only. Hence, there is a shortfall of
Rs 6,000. This amount will be borne by Kim.

1.3.4 Past Adjustments

Sometimes, after the final accounts have been prepared and the partners'
capital account are closed, it is found that certain items have been omitted by
ACCOUNTING FOR PARTNERSHIP — BASIC CONCEPTS 29

mistake or have been wrongly treated. Such omissions and commissions usually
relate to the interest on capital, interest on drawings, salary to partners, etc.
In such a situation, necessary adjustments have to be made in the partners'
capital account through an account called Profit and Loss Adjustment Account.
The following procedure may be helpful in recording necessary adjustments :
1. If, interest on capital is one of the items of omissions, then first ascertain
the partners' capital at the beginning. This can be done by deducting
partners' share of current year's profit from their capitals at the end and
adding their drawings thereto.
2. Work out the amounts of omitted items that are to be credited to partners'
capital accounts such as interest on capital, salaries to partners, etc. The
following journal entry for the adjustment is recorded :
Profit and Loss Adjustment a/c Dr.
Partners' Capital a/c (individually)
3. Work out the amounts of omitted items which are to be debited to Partners'
Capital Accounts such as interest on drawings and record the following
adjustment entry are recorded :
Partners' Capital (individually) a/c Dr.
Profit and Loss Adjustment a/c
4. Work out the balance of the Profit and Loss Adjustment Account. The
credit balance of the Profit and Loss Adjustment Account reflects the profit
and the debit balance, the loss. This is to be distributed among the partners.
5. The balance of the Profit and Loss Adjustment Account as worked out in
point 4 above be transferred to the partners' capital accounts in their
profit sharing ratio. Thus, the Profit and Loss Adjustment Account will
stand closed. It will involve the following journal entry :
If it is a credit balance (profit)
Profit and Loss Adjustment a/c Dr.
Partners' Capital (individually) a/c
If it is a debit balance (loss)
Partners' Capital (individually) a/c Dr.
Profit and Loss Adjustment a/c
The adjustment can also be made directly in the Partners' Capital Accounts
without preparing a Profit and Loss Adjustment Account. In such a situation,
 30 ACCOUNTANCY

we shall prepare a statement to find out the net effect of omissions and
commissions and then to debit the capital account of the partner who had been
credited in excess and credit the capital account of the partner who had been
debited in excess.

Illustration 11 (Past adjustments)

Asha and Bony are partners in a firm sharing profits equally. Their capital
accounts as on December 31, 2000 showed balances of Rs. 60,000 and
Rs. 50,000 respectively. After taking into account the profits of the year
2000, which amounted to Rs 20,000, it was subsequently found that the
following items have been left out while preparing the final account of the
year ended 2000.
(i) The partners were entitled to interest on capitals @ 6% p.a.
(ii) The drawings of Asha and Bony for the year 2000 were Rs.8,000 and
Rs.6,000 respectively. The interest on drawings was also to be charged
@ 5% p.a.
(iii) Asha was entitled to salary of Rs.5,000 and Bony, a commission of Rs.2,000
for the whole year.
It was decided to make the necessary adjustments to record the above
omissions. Give the necessary journal entries and prepare the profit and loss
adjustment account and Partners' capital accounts.

Solution
(1) Partners capital at the beginning
Asha Bony
(Rs.) (Rs.)
Capital at the end 60,000 50,000
Less: Share of Profit (10,000) (10,000)
(Rs. 20,000 shared equally) 50,000 40,000
Add: Drawings 8,000 6,000
Capital at the beginning 58,000 46,000

(2) Interest on Capital

For Asha : 58,000 × 6/100 = Rs. 3,480
For Bony : 46,000 × 6/100 = Rs. 2,760
ACCOUNTING FOR PARTNERSHIP — BASIC CONCEPTS 31

(3) Interest on Drawings

For Asha : on Rs. 8,000 @ 5% p.a. for 6 months.
5 6
8,000 × × = Rs. 200
100 12

For Bony : on Rs. 6,000 @ 5% p.a. for 6 months

5 6
6,000 × × = Rs . 150
100 12

Books of Asha and Bony

Journal

Date Particulars L.F. Debit Credit

Amount Amount
2000 (Rs.) (Rs.)
Dec 31 Profit and Loss Adjustment a/c Dr. 6,240
Asha's Capital a/c 3,480
Bony's Capital a/c 2,760
(Amount of interest on capital )
,, Asha's Capital a/c Dr. 200
Bony's Capital a/c Dr. 150
Profit and Loss Adjustment a/c 350
(Amount of interest on drawings )
,, Profit and Loss Adjustment a/c Dr. 5,000
Asha's Capital a/c 5,000
(Amount of salary )
,, Profit and Loss Adjustment a/c Dr. 2,000
Bony's Capital a/c 2,000
(Amount of commissions )
,, Asha's Capital a/c Dr. 6,445
Bony's Capital a/c Dr. 6,445
Profit and Loss Adjustment a/c 12,890
(Amount of loss on adjustment )
 32 ACCOUNTANCY

Profit and Loss Adjustment Account

for the year ended December 31, 2000
Dr. Cr.
Particulars Amount Particulars Amount
(Rs.) (Rs.)
Capital (Interest on capital) Capital ( Interest on Drawings )
Asha 3,480 Asha 200
Bony 2,760 6,240 Bony 150 350
Asha's capital (Salary) 5,000 Capital (Loss on adjustments)
Bony's capital (Commission ) 2,000 Asha 6,445
Bony 6,445 12,890

Total 13,240 Total 13,240

Partners' Capital Account

Dr. Cr.
Date Particulars J.F. Asha's Bony's Date Particulars J.F. Asha's Bony's
2000 Rs. Rs. 2000 Rs. Rs.

Dec31 Profit and Loss Dec 31 Balance b/f 60,000 50,000

Adjustment: 200 150 Profit and Loss
(interest on Adjustment: 3,480 2,760
drawings) (Interest on
Profit and Loss capital)
Adjustment: 6,445 6,445 Profit and Loss
(Loss on Adjustment: 5,000
Adjustment) (Salary)
Balance c/f 61,835 48,165 Profit and Loss
Adjustment: 2,000
(Commission)
68,480 54,760 68,480 54,760
Balance b/f 61,835 48,165

For a Single adjustment entry an analysis table to find out the amount to
be debited or credited to the capital accounts of the partners individually.
ACCOUNTING FOR PARTNERSHIP — BASIC CONCEPTS 33

Analysis Table

Particulars Asha Bony

(Rs.) (Rs.)
Amount credited 8,480 4,760
(Interest on capital, salary and commission)

Amount debited 6,645 6,595

(Interest on drawings and share of loss)
Cr. 1,835 Dr. 1,835

Journal Entry

Bony's Capital a/c Dr. 1,835

Asha's Capital a/c 1,835

Alternatively: A detailed statement can be prepared as follows :

Statement of Adjustment

Particulars Amount already Amount as should Adjustment

recorded have been recorded
Dr. (Rs.) Cr. (Rs.) Dr. (Rs.) Cr. (Rs.) Dr./Cr (Rs.)
Asha's Capital : -- -- --
Interest on Capital -- -- 3,480
Interest on Drawings -- -- 200
Salary -- -- 5,000
Share of Profit 10,000 3,555
200 12,035
NET 10,000 -- 11,835 Cr. 1,835
Bony's Capital :
Interest on Capital -- -- -- 2,760
Interest on Drawings -- -- 150 --
Commission -- -- -- 2,000
Share of Profit -- 10,000 -- 3,555
150 8,315
NET 10,000 -- 8,165 Dr. 1,835
 34 ACCOUNTANCY

Direct Adjustment Entry

Bony's Capital a/c Dr. 1,835
Asha's Capital a/c 1,835
Note : Share of Profit has been worked out as under :

Profit and Loss Appropriation Account

for the year ended December 31, 2000
Dr. Cr.
Particulars Amount Particulars Amount
(Rs.) (Rs.)
Interest on Capital Profit as per Profitand Loss a/c 20,000
Asha 3,480 Interest on Drawings :
Bony 2,760 6,240 Asha's 200
Asha's Capital (Salary) 5,000 Bony's 150 350
Bony's Capital (Commission) 2,000
Share of Profit :
Asha 3,555
Bony 3,555 7,110
Total 20,350 Total 20,350

1.6 Goodwill

Goodwill is also one of the special aspects of partnership accounts which

requires adjustment at the time of a change in the profit sharing ratio, the
admission of a partner or the retirement or death of a partner.

1.4.1 Meaning of Goodwill

Over a period of time, a well-established business develops an advantage of
good name, reputation and wide business connections. This helps the business
to earn more profits as compared to a newly set up business. In accounting,
the monetary value of such advantage is known as 'goodwill'.
It is regarded as an intangible asset. In other words, goodwill is the value
of the reputation of a firm in respect of the profits expected in future over and
above the normal profits. It is generally observed that when a person pays for
goodwill, he/she pays for something, which places him in the position of being
able to earn super profits as compared to the profit earned by other firms in
the same industry.
ACCOUNTING FOR PARTNERSHIP — BASIC CONCEPTS 35

In simple words, goodwill can be defined as ''the present value of a firm's

anticipated excess earnings'' or as "the capitalized value attached to the
differential profit capacity of a business". Thus, goodwill exists only when the
firm earns super profits. Any firm that earns normal profits or is incurring
losses has no goodwill.

1.6.2 Factors giving rise to Goodwill

The main factors helping the creation of goodwill are as follows :
1. Nature of Business : A firm that produces high value added products or
having a stable demand is able to earn more profits and therefore has
more goodwill.
2. Location : If the business is centrally located or is at a place having heavy
customer traffic, the goodwill tends to be high.
3. Efficiency of Management : A well-managed concern usually enjoys the
advantage of high productivity and cost efficiency. This leads to higher
profits and so the value of goodwill will also be high.
4. Market situation : The monopoly condition or limited competition enables
the concern to earn high profits which leads to higher value of goodwill.
5. Special Advantages : The firm that enjoys special advantages like import
licences, low rate and assured supply of electricity, long-term contracts
for supply of materials, well-known collaborators, patents, trade marks,
etc. enjoy higher value of goodwill.

1.6.3 Need for Valuation

Normally, the need for valuation of goodwill arises at the time of the sale of a
business. But, in case of a partnership firm it may also arise in the following
circumstances:
1. Change in the profit sharing ratio amongst the existing partners;
2. Admission of a new partner;
3. Retirement of a partner;
4. Death of a partner;
5. Dissolution of a firm which involves sale of business as a going concern; and
6. Amalgamation of firms.
 36 ACCOUNTANCY

1.6.4 Methods of Valuation of Goodwill

The important methods of valuation of goodwill are as follows :
1. Average Profits Method : Under this method, the goodwill is valued at agreed
number of 'years' purchase of the average profits of the past few years. It
is based on the assumption that a new business will not be able to earn
any profits during the first few years of its operations. Hence, the person
who purchases a running business must pay in the form of goodwill a
sum which is equal to the profits he is likely to receive for the first few
years. The goodwill, therefore, should be calculated by multiplying the
past average profits by the number of years during which the anticipated
profits are expected to accrue.
For example, if the past average profits of a business works out at
Rs. 20,000 and it is expected that the same profits will be available in
future, the value of goodwill will be Rs. 60,000 (Rs. 20,000 × 3), if three
years, purchase of the past average profits constitute the basis of valuation
of the goodwill.

Illustration 12 (Goodwill)
The profit for the last five years of a firm were as follows year 1999 Rs. 4,00,000;
year 2000 Rs. 3,98,000; year 2001 Rs. 4,50,000; year 2002 Rs. 4,45,000 and
year 2003 Rs. 5,00,000. Calculate goodwill of the firm on the basis of 4 years
purchase of 5 years average profits.

Solution
Year Profit
Rs. Rs.
1999 4,00,000
2000 3,98,000
2001 4,50,000
2002 4,45,000
2003 5,00,000
Total 21,93,000

Total profit of last 5 years Rs. 21,93,000

Average Profit = = = Rs. 4,38,600
No. of years 5
Goodwill = Average Profits × No. of years purchased
= Rs. 4,38,600 × 4 = Rs. 17,54,400
ACCOUNTING FOR PARTNERSHIP — BASIC CONCEPTS 37

Illustration 13 (Goodwill)
Compute the value of goodwill on the basis of four years' purchase of the average
profits based on the last five years.

The profits for the last five years were as follows :

Year Rs.
1999 40,000
2000 50,000
2001 60,000
2002 50,000
2003 60,000

Solution
Calculation of Average Profits

(Profits)
Year Rs.
1999 40,000
2000 50,000
2001 60,000
2002 50,000
2003 60,000
Total 2,60,000
Average Profits = 2,60,000/5
= Rs. 52,000
Goodwill = Rs. 52,000 × 4
= Rs. 2,08,000

Illustration 14 (Goodwill)
The following were the profits of a firm for the last three years.
Year ending Profit (Rs.)
March 31
2000 4,00,000 (including an abnor mal gain of
Rs. 50,000)
2001 5,00,000 (after charging an abnor mal loss of
Rs. 1,00,000)
2002 4,50,000 (excluding Rs. 50,000 payable on the
insurance of plant and machinery )
 38 ACCOUNTANCY

Calculate the value of firm's goodwill on the basis of two years purchase of the
average profits for the last three years.

Solution
Calculation of average maintainable profits.

Year ended Profit

(Rs.)
2000 (4,00,000 – 50,000) 3,50,000
2001 (5,00,000 + 1,00,000) 6,00,000
2002 (4,50,000 – 50,000) 4,00,000
Total 13,50,000

Rs.13,50,000
Average profit = = Rs. 4,50,000
3

Goodwill at 2 years purchase of Average Profit

= Rs. 4,50,000 × 2 = Rs. 9,00,000
The above calculation of goodwill is based on the assumption that no change
in the overall situation of profits is expected in the future.
1. Weighted Average Profit Method : This method is a modified version of the
earlier method. Under this method each year's profit is multiplied by the
respective number of weights i.e. 1,2,3,4 etc., in order to find out value of
product and the total of products is then divided by the total of weights in
order to ascertain the weighted average profits. Thereafter, the weighted
average profit is multiplied by the agreed number to find out the value of
goodwill.
Total of Products of Profits
Weighted Average Profit = Total of Weights
Goodwill = Weighted Average Profits × Agreed
Number of years'(Purchase)
Weighted average profit method of valuation of goodwill is better than the
simple average profit method because it gives weightage to latest
profit,which is likely to be maintained in the future by the firm. It is
applicable when the profit shows a rising or falling trend.
ACCOUNTING FOR PARTNERSHIP — BASIC CONCEPTS 39

Illustration 15 (Goodwill)
The profits of a firm for the year ended 31st March for the last five years were as
follows :

Year Profit (Rs.)

1999 20,000
2000 24,000
2001 30,000
2002 25,000
2003 18,000
Calculate the value of goodwill on the basis of three years' purchase of
weighted average profits after weights 1,2,3,4 and 5 respectively to the profits
for 1999, 2000, 2001, 2002 and 2003.

Solution
Year Profit
ended 31 March Rs. Weight Product
1999 20,000 1 20,000
2000 24,000 2 48,000
2001 30,000 3 90,000
2002 25,000 4 1,00,000
2003 18,000 5 90,000
Total 15 3,48,000

3,48,000
Weighted Average Profit = Rs. 23,200
15
Goodwill = 23,200 × 3 = Rs. 69,600

Illustration 16 (Goodwill)
Calculate goodwill of a firm on the basis of three years' purchase of the weighted
average profits of the last four years. The profit of the last four years were : 2000
Rs. 20,200; 2001 Rs. 24,800; 2002 Rs.20,000 and 2003 Rs. 30,000. The weights
assigned to each year are : 2000-1; 2001- 2; 2002- 3 and 2003-4.
You are supplied the following information :
(i) On September 1, 2002 a major plant repair was undertaken for Rs. 6,000
which was charged to revenue. The said sum is to be capitalized for goodwill
 40 ACCOUNTANCY

calculation subject to adjustment of depreciation of 10% p.a. on reducing

balance method.
(ii) The closing stock for the year 2001 was overvalued by Rs. 2,400.
(iii) To cover management cost an annual charge of Rs. 4,800 should be made
for the purpose of goodwill valuation.

Solution
Calculation of adjusted 2000 2001 2002 2003
profit Rs. Rs. Rs. Rs.
Given Profits 20,200 24,800 20,000 30,000
Less Management Cost 4,800 4,800 4,800 4,800
15,400 20,000 15,200 25,200
Add Capital expenditure
charged to revenue - - 6,000 -
15,400 20,000 21,200 25,200
Less unprovided
depreciation - - 200 580
15,400 20,000 21,000 24,620
Less over valuation of
closing stock - 2,400 - -
15,400 17,600 21,000 24,620
Add over value of opening - - 2,400 -
stock
Adjusted Profit 15,400 17,600 23,400 24,620

Calculation of weighted average profits :

Year Profit Weight Product

Rs.
2000 15,400 1 15,400
2001 17,600 2 35,200
2002 23,400 3 70,200
2003 24,620 4 98,480
Total 10 2,19,280

2,19,280
Weight Average Profit = = Rs. 21,928
10
Goodwill = 21,928 × 3 = Rs. 65,784
ACCOUNTING FOR PARTNERSHIP — BASIC CONCEPTS 41

Notes to the Solution

(i) Depreciation of 2002 = 10% of Rs. 6,000 for 4 months
= 6,000 × 10/100 × 4/12 = Rs. 200
(ii) Depreciation of 2003 = 10% of Rs. 6,000 – Rs. 200 for one years
= 5,800 ×10/100 = Rs. 580
(iii) Closing stock of 2001 will become opening stock of 2002.
2. Super Profits Method : The basic assumption in the average profits method
of calculating goodwill is that, if a new business is set up, it will not be able
to earn any profits during the first few years of its operations. Hence, the
person who purchases an existing business has to pay in the form of goodwill
a sum equal to the total profits he is likely to receive for the first 'few years'.
It is also contended that the buyer's real benefit does not lie in total profits;
it is limited to such amounts of profits which are in excess of the normal
return on capital employed in similar business. Therefore, it is desirable to
value, goodwill on the basis of the excess profits and not the actual profits.
The excess of actual profits over the normal profits is termed as super profits.
Normal profits can be ascertained as follows :

Capital Employed × Normal Rate of Return

Normal Profits =
100
Suppose an existing firm earns Rs. 18,000 on the capital of Rs. 1,50,000
and the normal rate of return is 10%. The Normal profits will work out at
Rs.15,000 (1,50,000 × 10/100). The super profits in this case will be Rs. 3,000
(Rs. 18,000 – 15,000).
The goodwill under the super profits method is ascertained by multiplying
the super profits by certain number of years' purchase. If, in the above example,
it is expected that the benefit of super profits is likely to be available for 5 years
in future, the goodwill will be valued at Rs. 15,000 (3,000 × 5). Thus, the steps
involved under the method are :
1. Calculate the average profit,
2. Calculate the normal profit on the capital employed on the basis of the
normal rate of return,
3. Calculate the super profits by deducting normal profit from the average
profits, and
4. Calculate goodwill by multiplying the super profits by the given number of
years' purchase.
 42 ACCOUNTANCY

Illustration 17 (Goodwill)
The books of business showed that the capital employed on December 31,2001,
Rs. 5,00,000 and the profits for the last five years were: 1997-Rs. 40,000; 1998-
Rs. 50,000; 1999-Rs. 55,000; 2000-Rs. 70,000 and 2001-Rs. 85,000. You are
required to find out the value of goodwill based on 3 years purchase of the super
profits of the business, given that the normal rate of return is 10%.

Solution

Capital Employed × Normal Rate of Return

Normal Profit =
100

5,00,000 × 10
= = Rs. 50,000
100

Average Profits :
Year Profit
Rs.
1997 40,000
1998 50,000
1999 55,000
2000 70,000
2001 85,000
Total Profit Rs. 3,00,000

Average Profit = Rs. 3,00,000/5 = Rs. 60,000

Super Profit = Rs. 60,000 – Rs. 50,000 = Rs. 10,000
Goodwill = Rs. 10,000 × 3 = Rs. 30,000

Illustration 18 (Goodwill)
Capital employed in a business on March 31, 2003 was Rs. 20,00,000 and the
profits for the last five years were as follows :
Year ending Profit
31st March Rs.
1999 2,60,000
2000 2,80,000
2001 2,70,000
2002 2,50,000
2003 2,10,000
ACCOUNTING FOR PARTNERSHIP — BASIC CONCEPTS 43

Calculate the value of goodwill on the basis of 3 years' purchase of the super
profits of the business. The normal rate of return is 10%.

Solution

Capital Employed × Normal Rate of Return

Normal Profit =
100

Rs. 20,00,000 × 10
= = Rs. 2,00,000
100

Rs. 2,60,000 + 2,80,000 + 2,70,000 + 2,50,000 + 2,10,000

Average Profit =
5

Rs.12,70,000
= = Rs. 2,54,000
5
Super Profit = Average Profit – Normal Profit
= 2,54,000 – 2,00,000
= Rs. 54,000
Goodwill = Super Profit × No. of years purchase
= 54,000 × 3
= Rs. 1,62,000

Illustration 19 (Goodwill)
The capital of the firm of Anu and Benu is Rs. 1,00,000 and the market rate of
interest is 15%. Annual salary to partners is Rs. 6,000 each. The profits for
the last 3 years were Rs. 30,000; Rs. 36,000 and Rs. 42,000. Goodwill is to be
valued at 2 years purchase of the last 3 years' average super profits. Calculate
the goodwill of the firm.

Solution

15
Interest on capital = 1,00,000 × = Rs. 15,000 ..................... (i)
100
Add partner's salary = Rs. 6,000 × 2 = Rs. 12,000 ..................... (ii)
Normal Profit (i + ii) = Rs. 27,000
Rs. 1,08,000
Average Profit = Rs. 30,000 + Rs. 36,000 + Rs. 42,000 =
3

= Rs. 36,000
 44 ACCOUNTANCY

Super Profit = Average Profit – Normal Profit

= Rs. 36,000 – Rs. 27,000
= Rs. 9,000
Goodwill = Super Profit × No of years' purchase
= Rs. 9,000 × 2
= Rs. 18,000
3. Capitalization Method : Under this method the goodwill can be calculated
in two ways : (a) by capitalizing the average profits, or (b) by capitalizing
the super profits.
(a) Capitalization of Average Profit : In this method, the value of goodwill
is ascertained by deducting the actual capital employed (net assets)
in the business from the capitalized value of the average profits on
the basis of normal rate of return. This involves the following steps :
(i) Ascertain the average profits based on the past few years'
performance.
(ii) Capitalize the average profits on the basis of the normal rate of
return as follows :
Average Profits × 100/Normal Rate of Return
This will give the total value of business.
(iii) Ascertain the actual capital employed (net assets) by deducting
outside liabilities from the total assets (excluding goodwill).

Capital Employed = Total Assets (excluding goodwill) – outside liabilities

(iv) Compute the value of goodwill by deducting net assets from the
total value of business, i.e. (ii) – (iii).

Illustration 20 (Goodwill)
A business has earned average profits of Rs. 1,00,000 during the last few
years and the normal rate of return in a similar type of business is 10%.
Ascertain the value of goodwill by capitalization method, given that the value
of net assets of the business is Rs. 8,20,000.

Solution
Capitalized Value of Average Profits

Rs. 1,00,000
= × 100 = Rs 10,00,000
10
ACCOUNTING FOR PARTNERSHIP — BASIC CONCEPTS 45

Goodwill = Capitalized Value – Net Assets

= 10,00,000 – 8,20,000
= Rs. 1,80,000
(b) Capitalization of Super Profits : Under this method following steps are
involved :
(i) Calculate Capital employed of the firm, which is equal to total
assets minus outside liabilities.
(ii) Calculate required profit on capital employed by using the
following formula :
Profit = Capital Employed × Required Rate of Return/100
(iii) Calculate average profit of past years, that is, 3 to 5 years.
(iv) Calculate super profits by deducting required profits from average
profits.
(v) Multiply the super profits by the required rate of return multiplier,
that is,
Goodwill = Super Profits × 100/Normal Rate of Return
In other words, goodwill is the capitalized value of super profits.
Illustration 21(Goodwill)
Calculate Goodwill if :
(i) The goodwill of a firm is estimated at three years' purchase of the average
profits of the last five years which are as follows :
Years: 1998 1999 2000 2001 2002
Profits (Loss): Rs.10,000 15,000 4,000 (5,000) 6,000
(ii) If in the firm total capital employed is Rs.1,00,000 and normal rate of
return is 8%, the average profit for last 5 years is Rs. 12,000 and goodwill
is estimated at 3 years' purchase of super profits, remuneration to partners
Rs. 3000.
(iii) Rama Brothers earn a net profit of Rs. 30,000 with a capital of Rs. 2,00,000.
The normal rate of return in the business is 10%. Use capitalization of
super profits method to value the goodwill.
Solution
(i) Total Profit = Rs. 10,000 + 15,000 + 4,000 + 6,000 – 5,000 = Rs. 30,000
Average Profit = Rs. 30,000/5 = Rs. 6,000
Goodwill = Average Profit × 3 = Rs. 6,000 × 3 = Rs. 18,000.
 46 ACCOUNTANCY

(ii) Average Profit = Rs. 12,000

Remuneration to Partners = Rs. 3,000
Average actual profit = Rs. 12,000 – Rs. 3,000 = Rs. 9,000
Normal Profit = Rs. 1,00,000 × 8/100 = Rs. 8,000
Super Profit = Average Profit – Normal profit = Rs. 9,000 – 8,000
= Rs. 1,000
Goodwill = Super Profit × 3 = 1,000 × 3 = Rs. 3,000
(iii) Normal Profit = Rs. 2,00,000 × 10/100 = Rs. 20,000
Super Profit = Average Profit – Normal Profit = Rs. 30,000 – 20,000
= Rs. 10,000
Goodwill = Super Profit × 100/Normal Rate of Return
= 10,000 × 100/10 = Rs. 1,00,000
4. Present Value of Super Profits : Under this method, goodwill is estimated
as the present value of the future super profits. This requires following
steps :
(i) Calculate the future super profits for next 5 to 7 years depending
upon the business potential.
(ii) Choose the required rate of return.
(iii) Calculate present value factors.
(iv) Multiply present value factors with future super profits.
(v) The sum of product of present value factors and super profits is the
value of goodwill.

Illustration 22 (Goodwill)
A firm has the forecasted profits for the coming 5 years as follows :
Year I II III IV V
Profits (Rs.) 1,00,000 1,20,000 90,000 1,00,000 1,50,000
The total assets of the firm are Rs. 10,00,000 and outside liabilities are
Rs. 2,00,000. The present value factor at 10% are as follows :
Year I II III IV V
PVF 0.9091 0.8264 0.7513 0.6830 0.6209
Calculate the Value of goodwill.
ACCOUNTING FOR PARTNERSHIP — BASIC CONCEPTS 47

Solution
Year I II III IV V

Profits (Rs.) 1,00,000 1,20,000 90,000 1,00,000 1,50,000

Normal Profit 80,000 80,000 80,000 80,000 80,000
Super Profit 20,000 40,000 10,000 20,000 70,000
PVF 0.9091 0.8264 0.7513 0.6830 0.6209
Present Value 18,182 33,056 7,513 13,660 43,463
of Super Profits
Value of Goodwill = Rs. 18,182 + 33,056 + 7,513 + 13,660 + 43,463
= Rs. 1,15,874

1.7 Change in Profit Sharing Ratio

Sometimes, the partners of a firm may agree to change their existing profit
sharing ratio. As a result of this, some partners will gain in future profits while
others will lose. In such a situation, the partner who gains by the change in
the profit sharing ratio must compensate the partner who has made the sacrifice
because this effectively amounts to one partner buying the share of profits
from another partner. For example, Anu and Benu are partners in a firm sharing
profits in the ratio of 3:2. They decide to have an equal share in profits in
future. In this case, Anu looses 1/l0th (3/5 – 1/2) share of profits and Benu
gains this 1/l0th. Hence, Benu must compensate Anu for her loss in the share
of future profits.
The amount of compensation will be equal to the proportionate amount of
goodwill. Suppose, the total value of goodwill is ascertained as
Rs. 50,000/-, then Benu must pay 1/10 of Rs. 50,000/-, i.e. Rs. 5,000 to Anu.
Alternatively, Benu's Capita1 Account be debited by Rs 5,000 and Anu's Capital
Account credited with Rs. 5,000. The entry, thus, will be :
Benu's Capital a/c Dr. 5,000
Anu's Capital a/c 5,000
Alternatively, if the amount is paid privately by the gaining partner to the
other partner, then no entry is made in the books of the firm.
Apart from the payment of compensation for goodwill, the change in profit
sharing ratio may also necessitate adjustment in the partners' capital accounts
with regard to reserves, revaluation of assets and liabilities, etc. These are
 48 ACCOUNTANCY

similar to those made at the time of the admission or retirement of a partner. All
these aspects will be discussed in details in chapter dealing with admission of a
partner.
 49

Terms Used in this Chapter

Partnership
Partnership Firm
Partners
Partnership Deed
Partner's Capital Account
Partners Current Account
Profit and Loss Appropriation Account
Profit and Loss Adjustment Account
Goodwill
Super Profit
Average Profit
Capitalized Value of Business
Capital Employed

Summary

1. Definition of partnership and its essential features

"Relation between persons who have agreed to share the profits of a business
carried on by all or any one of them acting for all", is called 'partnership'. The
essential features of partnership are : (i) To form a partnership there must be
50 ACCOUNTANCY

at least two persons; (ii) It is created by an agreement; (iii) The agreement

should be for carrying on some legal business; (iv) The agreement must be for
sharing the profits of the business; and (v) It is based on mutual agency
relationship amongst the partners.
2. Meaning and contents of partnership deed
A document which contains the terms of partnership as agreed among the
partners is called 'Partnership Deed'. It usually contains all mutual rights
and obligations of partners, rules relating to the safe custody of books of
accounts and other documents, mode of appointment of an auditor, if
required, and the rules to be followed in case of admission, retirement,
death, dissolution, etc.
3. Provision of Partnership Act applicable to accounting
Normally, a partnership deed includes all mutual rights and duties of partners.
But if it is silent in respect of certain aspects, the relevant provisions of the
Indian Partnership Act, 1932 become applicable. According to the Partnership
Act, the partners share profits equally, no partner is entitled to remuneration,
no interest on capital is allowed and no interest on drawings is charged.
However, if any partner has given some loan to the firm, he is entitled to
interest on such amount @ 6% per annum.
4. Preparation of capital accounts under fixed and fluctuating capital methods
All transactions relating to partners are recorded in their respective capital
accounts in the books of the firm. The partners' capital accounts may be
maintained according to fluctuating capital method or fixed capital method.
Under fluctuating capital method all the transactions relating to a partner
are recorded in his capital account itself. But under fixed capital method, the
amount of capital remains fixed, the transactions like interest on capital,
drawings, interest on drawings, salary, commission, share of profit or loss are
not shown in his capital account. They are recorded in a separate account
called partner's current account.

5. Distribution of profit and loss

The distribution of profits among the partners is shown through a Profit and
Loss Appropriation Account which is merely an extension of the Profit and
Loss Account. It is usually debited with interest on capital and salary/
commission allowed to the partners, and credited with net profit as per Profit
and Loss Account and the interest on drawings. The balance being profit or
loss is distributed among the partners in the profit sharing ratio and transferred
to their respective capital accounts.
6. Treatment of guarantee of minimum profit to a partner
Sometimes, a partner may be guaranteed a minimum amount by way of his
share in profits. If, in any year, the share of profits as calculated according to
ACCOUNTING FOR PARTNERSHIP — BASIC CONCEPTS 51

his profit sharing ratio is less than the guaranteed amount, the deficiency is
made good by the guaranteeing partners' in the agreed ratio which usually
is the profit sharing ratio. If, however, such guarantee has been given by
any of them, he or they alone shall bear the amount of deficiency.
7. Treatment of past adjustments
If, after the final accounts have been prepared, some omission or commissions
are found in respect of the interest on capital, interest on drawings, partner's
salary, commission, etc. the necessary adjustment can be made in the
partner's capital accounts through the Profit and Loss Adjustment Account.
8. Meaning of goodwill and the methods of its valuation
Over a period of time, a firm on account of a variety of factors, develop an
advantage of name and wide business connections which enable it to earn
more profits as compared to a newly set-up business. The value of such
advantage is termed as goodwill. In relation to a firm, the valuation of goodwill
is needed whenever some change takes place in the constitution of the firm
such as admission of a partner, retirement of a partner, etc. There are three
methods of calculating value of goodwill viz., purchase of average profits
method, purchase of super profits method and capitalization method.
9. Accounting implication of change in the profit sharing ratio
When the partners decide to change their profit sharing ratio, some partners
will gain while others will lose. Hence, the gaining partner has to compensate
the partner who makes the sacrifice by paying (or through necessary
adjustment in their respective capital accounts) the proportionate amount
of goodwill.

Questions and Exercises

A. Objective Type Questions

1. State whether each of the following statements is true or false?
(i) It is compulsory to have a partnership agreement in writing.
(ii) Under fixed capital method, any addition to capital will be shown
in partner's capital account.
(iii) Interest on money advanced by a partner as loan to the firm shall be
paid even if there are losses in the business.
(iv) Interest on drawings is always calculated for full year on the total
drawings.
(v) The business of the firm can be conducted even by one partner.
(vi) Change in profit sharing ratio involves almost the same adjustments as
those in case of the admission of a new partner.
52 ACCOUNTANCY

(vii) Current accounts of partners are maintained under the fluctuating capital
method.
(viii) Partners are mutual agents of each other so far as the business of the
firm goes.
2. Mohan and Shyam are partners in a firm. State whether the claim is valid if
the partnership agreement is silent in the following matters.
(i) Mohan is an active partner. He wants a salary of Rs 10,000 per year.
(ii) Shyam had advanced a loan to the firm. He claims interest @ 10% per
annum.
(iii) Mohan has contributed Rs 20,000 and Shyam Rs 50,000 as capital.
Mohan wants that the profits be shared equally.
(iv) Shyam wants interest on capital to be credited @ 6% p.a.
3. Short Answer Questions
(i) Define Partnership Deed?
(ii) Explain in 50 words why is it considered better to make a partnership
agreement in writing?
(iii) List the items which usually appear on the debit side of a partner's capital
account, if the capitals are (i) Fixed, (ii) Fluctuating.
(iv) Why does the need for valuation of goodwill arise in relation to a
partnership firm?
(v) List the factors which give rise to goodwill.
4. Essay Type Questions
(i) What is partnership? State the chief characteristics of a partnership?
Describe the main provisions of the Partnership Act that are relevant to
partnership accounts.
(ii) Distinguish between:
a) Fixed and Fluctuating methods of capital.
b) Average Profits and Super Profits.
(iii) Illustrate how interest on drawings will be calculated under various
situations?
(iv) Define goodwill. Describe various methods of valuing goodwill.

Exercises

5. Raj and Neeraj are partners in a firm. Their capitals as on April I, 2001 were
Rs 2,50,000 and Rs 1,50,000, respectively. They share profits equally. On
July 1, 2001, they decided that their capitals should be Rs. 2,00,000 each.
ACCOUNTING FOR PARTNERSHIP — BASIC CONCEPTS 53

The necessary adjustment in the capitals were made by introducing or

withdrawing cash. Interest on capital is allowed at 8% p.a. Compute interest
on capital for both the partners for the year ending on March 31, 2002.
6. A and B are partners in a firm. They share profits in the ratio of 3:2. As
per their partnership agreement, interest on drawings is to be charged
@ 10% p.a. Their drawings during 2002 were Rs. 24,000 and Rs. 16,000,
respectively.
Calculate interest on drawings based on the assumption that the amounts
withdrawn evenly throughout the year.
7. Hasan is a partner in a firm. He withdraws the following amounts during the
year 2002 :
February 1 Rs. 4,000
May 1 Rs. 10,000
June 30 Rs. 4,000
October 31 Rs. 12,000
December 31 Rs. 4,000
Interest on drawings is to be charged @ 7½ % p.a.
Calculate the amount of interest to be charged on Hasan's drawings for the
year 1989.
8. Menon and Thomas are partners in a firm. They share profits equally. Their
monthly drawings are Rs. 2,000 each. Interest on drawings is to be charged @
10% p.a. Calculate interest on Menon's drawings for the year 1989 assuming
drawings are made (i) in the beginning of every month, (ii) in the middle of
every month, and (iii) at the end of every month.
9. On March 31, 2003, after the close of books of accounts, the capital account
of Ram, Shyam and Mohan showed balance of Rs. 24,000, Rs. 18,000 and
Rs.12,000 respectively. But, it was later discovered that interest on capital
@ 5% had been omitted. The profit for the year ended March 31, 2003,
amounted to Rs. 36,000 and the partners drawings had been Ram Rs. 3,600,
Shyam Rs. 4,500 and Mohan Rs. 2,700. The profit sharing ratio of Ram,
Syham and Mohan was 3:2:1. Calculate interest on capital.
10. Lokesh and Azad are partners sharing profits in the ratio 3:2 with capitals of
Rs. 50,000 and Rs. 30,000 respectively. Interest on capital is agreed @ 6%
p.a. Azad is allowed a salary of Rs. 2,500 p.a. During 2002, the profits for the
year prior to the calculation of interest on capital but after charging Azad's
salary amounted to Rs. 12,500. A provision of 5% of profits is to be made in
respect of manager's commission. Prepare an account showing the allocation
of profits and partner's capital accounts.
54 ACCOUNTANCY

11. Simmi and Sonu are partners in a firm, sharing profits and losses in the
ratio of 3:1. The profit and loss account of the firm for the year ending March
31, 1999 shows a net profit of Rs. 1,50,000. Prepare the Profit and Loss
Appropriation Account by taking into consideration the following information
:
(i) Partners capital on April 1,1999:
Simmi — Rs. 30,000: Sonu — Rs. 60,000.
(ii) Current accounts balances on April 1, 1999:
Simmi — Rs. 30,000 (cr.) ; Sonu — Rs. 15,000 (cr.)
(iii) Partners drawings during the year amounted to
Simmi — Rs. 20,000 ; Sonu — Rs. 15,000.
(iv) Interest on capital was allowed @ 5%p.a.
(v) Interest on drawings was to be charged @ 6% p.a. at an average of six
months.
(vi) Partners salaries : Simmi Rs. 12,000 and Sonu Rs. 9,000. Also show
the partners current accounts.
12. Ramesh and Suresh were partners in a firm sharing profits in the ratio of
their capitals contribted on commencement of business which were Rs. 80,000
and Rs. 60,000 respectively. The firm stared business on April 1,2001.
According to the partnership agreement interest on capital and drawings are
12% and 10% p.a. respectively. Ramesh and Suresh are to get a monthly
salary of Rs. 2,000 and Rs. 3,000 respectively.
The profits for year ended March 31, 2002 before making above
appropriation was Rs. 1,00,300. The drawings of Ramesh and Suresh were
Rs. 40,000 and Rs. 50,000, respectively. Interest on drawings amounted to
Rs. 2,000 for Ramesh and Rs 2,500 for Suresh.
Prepare Profit and Loss Appropriation Account and partners capital accounts
assuming that their capitals are fluctuating.
13. Sharma and Verma were partners in a firm. Their partnership agreement
provides that,
(i) Profits shared by Sharma and Verma in the ratio of 3:2.
(ii) 5% interest is to be allowed on capital.
(iii) Verma should be paid a monthly salary of Rs. 600.
The following balances are extracted from the books of the firm on
December 31,2002.
ACCOUNTING FOR PARTNERSHIP — BASIC CONCEPTS 55

Sharma Verma
Rs. Rs.
Capital Accounts 40,000 40,000
Current Accounts 7,200(cr.) 2,800(cr.)
Drawings 10,850 8,150
Net profit for the year, before charging interest on capital and partner's
salary was Rs. 9,500. It was found that Verma was regularly drawing his
monthly salary. But it was not recorded in drawings account nor debited to
the profit and loss account.
Prepare the Profit and Loss Appropriation Account and the Partner's Current
Accounts
14. The partnership agreement of Maneesh and Girish provides that
(i) Profits will be shared equally.
(ii) Maneesh will be allowed a salary of Rs. 400 p.m.
(iii) Girish who manages the sales department will be allowed a commission
equal to 10% of the net profit after allowing Maneesh's salary.
(iv) 7% interest will be allowed on partner's fixed capital.
(v) 5% interest will be charged on partner's annual drawings.
(vi) The fixed capitals of Maneesh and Girish are Rs. 1,00,000 and Rs. 80,000
respectively. Their annual drawings were Rs. 16,000 and Rs. 14,000
respectively. The net profit for the year ending March 31,2002 amounted
to Rs. 40,000.
Prepare firm's profit and loss Appropriation account.
15. Ram, Raj and George are partners sharing profits in the ratio 5 : 3 : 2.
According to the partnership agreement George is to get a minimum amount
of Rs .10,000 as his share of profits every year. The net profit for the year
1989 amounted to Rs. 40,000.
Prepare the Profit and Loss Appropriation Account.
16. Aman, Babita and Suresh are partners in a firm. Their profit sharing ratio is
2:2:1. However, Suresh is guaranteed a minimum amount of Rs. 10,000 as
share of profit every year. Any deficiency arising if any, on that account shall
be met by Babita. The profits for two years ending December 31, 2000 and
2001 were Rs. 40,000 and Rs. 60,000 respectively.
Prepare the Profit and Loss Appropriation Account for the two years.
17. On December 31, 2001 the capital accounts of Elvin, Monu and Ahmed after
making adjustments for profits, drawings, etc. were as, Elvin — Rs. 80,000,
Monu — Rs. 60,000, and Ahmed — Rs. 40,000. Subsequently, it was discovered
that interest on capital and interest on drawings had been omitted. The
partners were entitled to interest on capital @ 5% p.a. The drawings during
56 ACCOUNTANCY

the year were: Elvin — Rs. 20,000: Monu — Rs. 15,000: and Ahmed —
Rs. 9,000. Interest on drawings chargeable to the partners was Elvin —
Rs. 500, Monu — Rs. 360 and Ahmed — Rs. 200. The net profit during the year
amounted to Rs 1,20,000. The profit sharing ratio of the partners was
3:2:1.
Record the necessary adjustment entries for rectifying the above errors of
omission. Show your workings.
18. Azad and Benny are equal partners. Their capitals are Rs. 40,000 and
Rs. 80,000, respectively. After the accounts for the year have been prepared it
is discovered that interest at 5% p.a. as provided in the partnership agreement,
has not been credited to the capital accounts before distribution of profits. It
is decided to make an adjustment entry at the beginning of the next year.
Record the necessary journal entry.
19. Goodwill of a firm is to be valued at two years' purchase of three years' average
profits. The profits of the last three years were : 2000 — Rs. 30,000, 2001 —Rs.
40,000 and 2002 — Rs. 35,000
Calculate amount of goodwill.
20. The average net profits expected in future by Girdhari Lal Tankak and Co. are
Rs. 30,000 per year. The average capital employed in the business by firm is
Rs. 2,00,000. The normal rate of return on the capital employed in similar
business is 10%.
Calculate goodwill of the firm by :
(a) Super Profit Method on the basis of two year purchase, and
(b) Capitalization Method.
21. Rajendra and Madhu were partners in a firm sharing profits in the ratio of
5:3. On January 1,2001 they decided that they will share the profits equally in
future. The goodwill of the firm was valued at Rs. 60,000. No goodwill appeared
in the books.
Rajendra being the gainer, ascertain the amount of compensation to be made
by him to Madhu and state two ways in which it can be adjusted.
22. Chandrakala and Anita were partners in a firm sharing profits in the ratio of
2:1. They decide that with effect from January 1, 2000, they would share profits
in the ratio of 3:2. But, this decision was taken after the profits for the year
2000 amounting to Rs. 30,000 has been distributed in the old ratio.
Goodwill was to be valued at the aggregate of two years profits preceding the
date decision became effective. The profits for 1998 and 1999 were Rs. 20,000
and Rs. 25,000, respectively. It was decided that no goodwill would be raised
and the necessary adjustment be made through capital accounts which, on
ACCOUNTING FOR PARTNERSHIP — BASIC CONCEPTS 57

December 31, 2000 stood at Rs. 50,000 for ChandraKala and Rs. 30,000 for
Anita.
Record the necessary journal entries.
23. From the following information, calculate the value of goodwill of a firm of
Chander and Gupta
(a) At 3 years purchase of Average Profits.
(b) At 3 years purchase of Super Profits.
(c) On the basis of capitalization of Super Profits.
(d) On the basis of capitalization of Average Profits :
(i) Average capital employed in the business Rs. 7,00,000.
(ii) Net Trading results of the firm for the past years -profit 2002 Rs.
1,4,7,600. Loss 2003 Rs. 1,48,100, Profit 2004, Rs. 4,48,700.
(iii) Rate of interest expected from capital having regard to the risk
involved 18%.
(iv) Remuneration to each partner for his service Rs. 500 p.m.
(v) Assets (excluding goodwill) Rs. 7,54,762. Liabilities Rs. 31,329.
24. Kothari and Pradeep are partners sharing profits in the ratio of 3:2. They
employed Chandan as their manager to whom they paid a salary of Rs. 750
p.m. Chandan deposited Rs. 20,000 on which interest is payable at the rate of
9% p.a. At the end of 2001 (after the division of profit, it was decided that
Chandan should be treated as partner w.e.f. Jan1., 1998 with 1/6th share in
profits. His deposit being considered as capital carrying interest at 6% p.a.
like capital of other partners. Firm's profits after allowing interest on capital
were as follows ;
Rs.
1998 Profit 59,000
1999 Profit 62,000
2000 Loss (4,000)
2001 Profit 78,000
Record the necessary journal entries to give effect to the above.
25. X , Y, and Z entered into partnership on April 1, 1992. there is no agreement
as the sharing-profits except that X guaranteed Z's share of profits after
charging interest would not be less than Rs. 7,800 p.a. The initial capital was
provided as follows :
X Rs.1,00,000
Y Rs. 60,000
Z Rs. 20,000 (which was increased on 1 Oct.,1993 to Rs. 30,000).
In addition to the above, capital X and Y made temporary loan to the firm as
follows : X Rs. 40,000 advanced on March 1,1993 and repaid on Sept.1, 1993.
Y Rs. 80,000 advanced on Feb.1, 1993 and repaid on 1 May 1993. The profit
58 ACCOUNTANCY

for the year ended March 31, 1993 was Rs. 21,000 before providing for interest
show the profit and loss appropriation account for the year.

Answers

Objective Type Questions

1. True : (II), (III), (V), (VI) and (VIII) False : (I) (IV) and (VII)
2. (I) not valid (II) not valid (III) valid (IV) not valid.
5. Raj — Rs. 17,000: Neeraj — Rs. 15,000
6. A — Rs. 1,200: B — Rs. 800
7. Rs. 1,075
8. (i) Rs. 1,300; (ii) Rs. 1,200; (iii) Rs. 1,100
9. Interest on capital Ram Rs. 480; Shyam Rs. 525; Mohan Rs. 435
10. Profit as per P and L Appro. a/c Rs. 7,315
Lokesh's capital a/c balance Rs. 57,389
Ahmed's capital a/c balance Rs. 37,226
11. Profit : Simmi Rs. 94,163; Sonu Rs. 31,387
Current Accouunt Balances : Simmi Rs. 11,706
Sonu Rs. 42,938
12. Share of profit : Ramesh Rs. 16,000; Suresh Rs. 12,000; Balance in
Capital Accounts : Ramesh Rs. 87,600; Suresh Rs. 62,700
13. Share of loss : Sharma Rs. 1,020: Verma Rs. 680
Current Accounts Balances : Sharma Rs. 2500
Verma Rs. 4200
14. Share of profit : Manish Rs. 10,290
Ganesh Rs. 10,290
15. Share of Profit : Ram Rs. 18,750
Rahim Rs. 11,250
George Rs. 10,000
16. Share of Profit : 2000 Aman Rs. 16,000 :
Babita Rs. 14,000,
Suresh Rs. 10,000
2001 Aman Rs. 24,000 :
Babita Rs. 24,000
Suresh Rs. 12,000
17. Adjusted Capital Elvin Rs. 79,430; Debit Elvin with Rs. 570
ACCOUNTING FOR PARTNERSHIP — BASIC CONCEPTS 59

Account Balances Monu Rs. 60,010: Credit Monu with Rs. 10

Ahmed Rs. 40,560; Credit Ahmad with
Rs. 560
18. Debit Azad and Credit Benns by Rs. 1,000
19. Goodwill — Rs. 70,000
20. Goodwill by Super Profit Method — Rs. 20,000.
Goodwill by Capitalization Method Rs. 1,00,000.
21. Rajendra is to pay Rs. 7,500 to Madhu. It can be adjusted through cash
or by an adjustment entry in their capital accounts — Debit Rajendra's
Capital Account and Credit Madhu's Capital Account by Rs. 7,500.
23. Rs. 4,12,200, Rs. 34,200, Rs. 63,333, Rs. 39,900
24. Debit Kothari with Rs. 300
Debit Pradeep with Rs. 200
Credit Chandan with Rs. 500.
25. Interest on X's Loan Rs. 1,200
Interest on Y's loan Rs. 1,200
Profit X: Rs.4,600, Y: Rs.,6200, Z: Rs.7,800

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