5.2 Partnerships
Objective
By the end of this unit you should be able to:
- Explain what a partnership is and discuss its advantages and disadvantages.
- State the essential contents of a partnership agreement.
- Prepare the three core partnership accounts – Capital, Current (Drawing) and Appropriation.
- Make the required adjustments to financial statements on admission, retirement, death or dissolution of a partner (the “5.1 adjustments”).
- Calculate interest on partners’ loans, interest on capital, interest on drawings and partners’ salaries.
- Produce a complete Income Statement and Statement of Financial Position for a partnership.
1. What is a Partnership?
- A business owned by two or more persons who share profits, losses and responsibilities.
- Each partner has:
- Capital Account – shows his/her share of the net assets.
- Current (Drawing) Account – records withdrawals and any adjustments made during the year.
- Key concepts that appear throughout the syllabus:
- Profit‑sharing ratio
- Goodwill
- Admission, retirement, death and dissolution of a partner
- Interest on capital, interest on drawings, interest on partners’ loans, partners’ salaries
2. Advantages and Disadvantages
| Advantages | Disadvantages |
|---|
- Combined skills, experience and capital.
- Shared workload and responsibility.
- More attractive to lenders and suppliers.
- Profits are taxed only in the hands of partners (no corporation tax).
|
- Unlimited liability – partners are personally liable for business debts.
- Potential for disputes over profit sharing, decision‑making or withdrawals.
- Loss of autonomy – major decisions require agreement of partners.
- Partnership ends on death, retirement or insolvency of a partner unless otherwise agreed.
|
3. Contents & Purpose of a Partnership Agreement
A written agreement is not compulsory but is strongly recommended. It normally sets out:
- Names of the partners.
- Capital contributions (cash, assets, goodwill).
- Profit‑ and loss‑sharing ratios.
- Interest on capital, interest on drawings and any partner salaries.
- Rules for admission, retirement, death and dissolution.
- Decision‑making procedures (voting rights, authority to sign).
- Method of valuing goodwill.
- Banking arrangements and signing authority.
4. Structure of Partnership Accounts
| Account | Purpose |
|---|
| Capital Account |
Shows each partner’s share of the business’s net assets at the start and end of the year. |
| Current (Drawing) Account |
Records withdrawals, interest on drawings and any other adjustments during the year. |
| Appropriation Account |
Distributes the year’s profit (or loss) after adjusting for interest on capital, interest on loans, salaries and interest on drawings. |
4.1 Sample Appropriation Account (excerpt)
| Profit & Loss Appropriation (for the year ended 31 Dec) |
|---|
| Profit before appropriation | £120,000 |
| Interest on capital (5 % of £150,000) | £7,500 |
| Interest on partners’ loans (8 % of £30,000) | £2,400 |
| Partners’ salaries | £15,000 |
| Interest on drawings (3 % of £20,000) | £600 |
| Profit available for sharing | £94,500 |
| Share of profit – A (2/5) | £37,800 |
| Share of profit – B (3/5) | £56,700 |
5. Adjustments to Partnership Accounts (5.1 Adjustments)
5.1 Admission of a New Partner
- Valuate the partnership at fair market value (assets – liabilities).
- Calculate goodwill: Goodwill = Valuation – (existing capital balances).
- Agree how goodwill will be treated:
- Paid in cash to existing partners, or
- Written off against their capital accounts, or
- Retained in the business (capital accounts increased).
- Adjust the existing partners’ capital accounts for the chosen goodwill treatment.
- Record the new partner’s capital contribution (cash, assets, or goodwill).
- Re‑calculate the profit‑sharing ratio for the remainder of the year.
5.2 Retirement, Death or Withdrawal of a Partner
- Valuate the partnership on the date of exit.
- Determine the departing partner’s share of goodwill (if any) and how it will be paid.
- Settle the departing partner’s capital account:
Amount Payable = Capital balance + Share of goodwill – Outstanding drawings – Interest on drawings/loans owed to the departing partner.
- Adjust the capital accounts of the remaining partners for any retained goodwill.
- Re‑allocate the profit‑sharing ratio among the remaining partners.
5.3 Dissolution of the Partnership
- Settle all liabilities (pay creditors, repay partners’ loans).
- Realise non‑cash assets (sell or transfer to partners).
- Allocate any profit or loss on dissolution to partners in the agreed ratio.
- Distribute the remaining cash to partners in proportion to their final capital balances (after goodwill, interest, salaries, etc.).
6. Interest, Salaries and Other Adjustments
| Item | Typical Treatment | Cambridge Formula |
|---|
| Interest on capital |
Paid to partners before profit is shared (expense). |
Interest = Capital × Rate × (Months/12) |
| Interest on partners’ loans |
Paid to the lending partner (expense). |
Interest = Loan × Rate × (Months/12) |
| Interest on drawings |
Charged to the drawing partner (expense). |
Interest = Drawings × Rate × (Months/12) |
| Partners’ salaries |
Fixed amount paid before profit is shared (expense). |
Recorded as “Salary – Partner X”. |
7. Sample Financial Statements for a Partnership
7.1 Income Statement (Profit & Loss Account)
| For the year ended 31 Dec 20XX |
|---|
| Sales | £250,000 |
| Cost of goods sold | (£150,000) |
| Gross profit | £100,000 |
| Administrative expenses | (£30,000) |
| Interest on partners’ loans | (£2,400) |
| Partners’ salaries | (£15,000) |
| Profit before appropriation | £52,600 |
7.2 Appropriation Account (excerpt – see 4.1 for full format)
See the sample in Section 4.1. The final “Profit available for sharing” is transferred to the Capital accounts in the agreed ratios.
7.3 Statement of Financial Position (as at 31 Dec 20XX)
| Assets |
|---|
| Non‑current assets (machinery, goodwill retained) | £120,000 |
| Current assets – stock | £30,000 |
| Current assets – debtors | £25,000 |
| Cash and bank | £15,000 |
| Total assets | £190,000 |
| Equity & Liabilities |
|---|
| Creditors | £40,000 |
| Partners’ loans | £30,000 |
| Capital – A | £80,000 |
| Capital – B | £120,000 |
| Current (drawing) accounts – A | (£10,000) |
| Current (drawing) accounts – B | (£5,000) |
| Total equity & liabilities | £190,000 |
8. Sample Journal Entries
| Transaction | Journal Entry |
|---|
| Admission of Partner C – goodwill written off |
Dr. Capital – A £40,000
Dr. Capital – B £60,000
Cr. Goodwill £100,000
|
| Partner C contributes cash for capital |
Dr. Cash £30,000
Cr. Capital – C £30,000
|
| Retirement of Partner B – goodwill paid in cash |
Dr. Capital – B £40,000
Dr. Goodwill £20,000
Cr. Cash £60,000
|
| Dissolution – distribution of remaining cash |
Dr. Capital – A £50,000
Dr. Capital – C £70,000
Cr. Cash £120,000
|
| Interest on capital (5 % on £150,000 for 12 months) |
Dr. Profit & Loss Appropriation £7,500
Cr. Capital – A (2/5) £3,000
Cr. Capital – B (3/5) £4,500
|
| Interest on drawings (3 % on £20,000 for 12 months) |
Dr. Capital – A (drawings) £600
Cr. Profit & Loss Appropriation £600
|
9. Worked Example – Admission of a Partner
Given (1 Jan):
| Partner | Capital (£) | Profit‑sharing |
|---|
| A | 40,000 | 2/5 |
| B | 60,000 | 3/5 |
The partnership is valued at £200,000. New partner C will receive a 1/5 share of profits and contributes £30,000 in cash. Goodwill is to be written off.
- Calculate goodwill
Goodwill = £200,000 – (40,000 + 60,000) = £100,000
- Write‑off goodwill in the existing profit‑sharing ratio
- To A = £100,000 × 2/5 = £40,000
- To B = £100,000 × 3/5 = £60,000
- Journal entry for the write‑off
Dr. Capital – A £40,000
Dr. Capital – B £60,000
Cr. Goodwill £100,000
- Record C’s cash contribution
Dr. Cash £30,000
Cr. Capital – C £30,000
- New capital balances
- A = 40,000 + 40,000 = £80,000
- B = 60,000 + 60,000 = £120,000
- C = £30,000
- New profit‑sharing ratio – A : B : C = 2 : 3 : 1 (or 2/6, 3/6, 1/6).
10. Alignment with Cambridge IGCSE Accounting (0452) Syllabus
| Syllabus Requirement | How the Notes Satisfy It |
|---|
| Explain the nature of a partnership and its advantages/disadvantages. |
Sections 1 and 2 give a concise definition and a balanced advantages/disadvantages table. |
| Identify the essential contents of a partnership agreement. |
Section 3 lists all eight standard clauses required by the syllabus. |
| Prepare the three core partnership accounts – Capital, Current (Drawing) and Appropriation. |
Section 4 describes each account; Section 4.1 provides a fully‑labelled Appropriation Account example. |
| Make the required adjustments to financial statements on admission, retirement, death or dissolution of a partner. |
Section 5 gives step‑by‑step procedures for admission (5.1), retirement/death (5.2) and dissolution (5.3), directly mirroring the syllabus language. |
| Calculate interest on partners’ loans, interest on capital, interest on drawings and partners’ salaries. |
Section 6 presents the treatment, formulas and a sample journal entry for each item. |
| Produce a complete Income Statement and Statement of Financial Position for a partnership. |
Section 7 supplies a full Income Statement, Appropriation excerpt and a Statement of Financial Position with correct classification of assets, liabilities and equity. |
| Use appropriate journal entries for all adjustments. |
Section 8 lists journal entries for admission, retirement, dissolution and each interest/salary adjustment. |
11. Key Points to Remember
- Goodwill is the difference between the partnership’s market value and the sum of the existing capital balances.
- Goodwill can be: paid in cash, written off against capital, or retained in the business – the chosen method determines the journal entries.
- All interest (capital, drawings, loans) and salaries are treated as expenses and are accounted for **before** profit is shared.
- When a partner leaves, settle the capital account **after** adjusting for goodwill, drawings, interest and any outstanding loan balances.
- After any admission, retirement or death, recalculate the profit‑sharing ratio for the remaining period of the year.
- During dissolution, the order of settlement is: creditors → partners’ loans → partners’ capital (including goodwill adjustments) → distribution of any remaining cash.