Partnership Account I – SS3 Book Keeping Lesson Note (Second Term)

Partnership accounts are the records of a business owned by two or more people who share its profits in an agreed ratio.

Behavioural objectives

By the end of the lesson, students should be able to:

1. Define a partnership and partnership accounts.
2. State the main features of a partnership.
3. Explain the common terms used in partnership accounts.
4. Describe the types of partner’s capital account.
5. Calculate each partner’s capital contribution from the profit-sharing ratio.
6. State the advantages and disadvantages of a partnership capital account.

What is a partnership?

A partnership is a business in which two or more persons come together to run the business and earn a profit.

• Profit sharing: partners share profits in a ratio decided beforehand, so the firm needs special accounting treatment.
• Agreement: the agreement can be oral or written.
• Basis of sharing: profits can be shared by capital contributions or by mutual decision.
• Why people form partnerships: a sole owner often has limited capital or limited resources.
• Benefit: partners pool their resources, and this helps the business to expand.

What are the features of a partnership?

A partnership has four main features: agreement, business, profit sharing and principal-agency relationship.

Agreement

• Meaning: there must be an agreement between the partners for the firm to work properly.
• Content: it covers the sharing of profits and how the partners work together.
• Form: it may be in writing or oral.
• Purpose: it makes sure every partner knows his or her status and functions.

Business

• Meaning: the partners must carry on a business, which may be a profession, a trade or an occupation.
• Charity: under the Partnership Act, there is no partnership where the partners carry out charitable activities.

Profit sharing

• Meaning: the partners must share the profits produced by the firm.
• Employee: a person who works for the firm without a share of the profits may be called an employee.

Principal-agency relationship

• Meaning: the business may be run by all the partners, or by one partner who acts on behalf of all the others.
• Effect: each partner acts as an agent of the others, and this is the principal-agency relationship.

What is a partnership deed?

A partnership deed is the written agreement that sets out the terms on which the partners run the firm.

• Freedom of terms: partners are free to decide the terms of their relationship.
• Oral or written: they can agree orally or in writing.
• Content: the terms the partners agree on make up the content of the deed.

What are the common terms used in partnership accounts?

The common terms are capital, drawings, profits and losses, distribution of profits, current account, partnership agreement, goodwill, interest on capital, reserves and dissolution.

• Capital: the money or assets that each partner has invested in the partnership.
• Drawings: the money or assets that a partner withdraws from the firm for personal use.
• Profits and losses: the financial gains and losses of the partnership as a whole.
• Distribution of profits: the sharing of profits among partners in the agreed profit-sharing ratio.
• Partner’s current account: the record of a partner’s dealings with the firm, such as drawings, interest on capital and share of profits or losses.
• Partnership agreement: the document that sets out the terms of the partnership, including profit and loss sharing and the role of each partner.
• Goodwill: the value of the firm’s reputation and customer base, shown as an intangible asset on the balance sheet.
• Interest on capital: the amount the firm pays each partner for the use of the capital invested.
• Reserves: the part of profits set aside for future business needs or as a contingency fund.
• Dissolution: the ending of the partnership, which may be due to retirement, death or other reasons in the agreement.

What is a partnership capital account?

A partnership capital account is an account that records the transactions between a partner and the firm.

What does a capital account record?

• Contributions: the capital each partner puts in, from the first contribution to later ones.
• Asset contributions: partners can contribute cash or assets, which are valued at market value.
• Profits and losses: these are shared in the proportions set out in the partnership agreement.
• Distributions: the amounts paid out to partners according to their shares.

What is the use of a capital account?

• Sharing assets: it makes it easy to share assets and liabilities among the partners.
• Change of partners: it makes it easy to settle accounts when a partner is admitted or retires.

What are the types of partner’s capital account?

There are two types of partner’s capital account: the fixed capital account and the fluctuating capital account.

Fixed capital account

• Capital account: only the capital contributed is recorded here, so the balance stays the same unless the partners agree to change it.
• Current account: drawings, interest on capital, salary and share of profit are recorded in a separate current account.

Fluctuating capital account

• One account: all transactions between the partner and the firm go into the capital account.
• Balance: the balance changes every period as profits, drawings and other items are recorded.

Fixed capital and fluctuating capital compared

What is the format of a partnership capital account?

The standard format below shows how contributions and other transactions are recorded.

How is a partner’s capital contribution calculated?

A partner’s capital contribution is usually the total capital needed multiplied by his or her share of profits.

Equal profit-sharing ratio

• Example: the business needs ₦1,000,000 and there are four partners.
• Working: each partner contributes ₦250,000 (₦1,000,000 ÷ 4).

Unequal profit-sharing ratio

Suppose the profit-sharing ratio is 2:5:1:2. The total of the ratio is 10.

Other arrangements

• Mutual decision: partners can contribute more or less than the ratio requires.
• Skill partners: sometimes one partner supplies the capital while the others invest their time and talent.

What are the steps for preparing a partner’s capital account?

The steps below apply to a capital account that records all transactions between the partner and the firm.

1. Credit the account with the capital contributed, share of profit, partner’s remuneration, interest on capital and any receipt or asset directly linked to the partner.
2. Debit the account with drawings, any liability directly related to the partner, and similar items.
3. Share the profit in the profit-sharing ratio before finding the closing capital.
4. Subtract the total debits from the total credits to get the closing capital.
5. Carry the closing capital to the balance sheet as the partner’s capital.

Worked example

A and B share profits 3:2. A’s opening capital is ₦500,000, A draws ₦20,000, and the profit is ₦100,000.

What are the advantages of a partnership capital account?

A partnership capital account lets the firm keep track of each partner’s contributions and share of income.

• Transparency: the records are clear to every partner.
• Closing the business: the amount due to or from each partner is easy to find.
• Liabilities: the liability of each partner is easy to fix.
• Decisions: clear records make decisions that benefit the firm easier to take.
• Evidence: the account is a written record of each partner’s interest in the firm.
• Change of partners: it is easy to admit a new partner or settle with a retiring partner.

What are the disadvantages of a partnership capital account?

The main disadvantage is that the capital account does not limit the partners’ liability for the firm’s debts.

• Joint and several liability: in a partnership other than a limited liability partnership, partners are jointly and severally responsible for outside debts.
• Shared risk: one partner’s risk passes to the others in their profit-sharing ratio.
• Personal estates: if liabilities exceed assets, partners pay from their personal estates.
• Changing capital: if no separate current account is kept, the capital balance changes with each transaction.
• Conflict: salary, interest and a changing capital basis can cause disagreement between partners.

Evaluation

1. Define partnership accounts.
2. State four features of a partnership.
3. Explain any four terms used in partnership accounts.
4. Name the two types of partner’s capital account and state one difference between them.
5. Three partners share profits 4:3:3 and need ₦2,000,000 capital. Find each partner’s contribution.

Assignment

List four features of a partnership, then state two advantages and two disadvantages of a partnership capital account.