outline the importance and contents of a partnership agreement

Resources → Subject Notes → Accounting → Lesson Plan

Partnerships – Topic 5.2 (Cambridge IGCSE Accounting 0452)

Objective

By the end of this topic you should be able to:

  • Explain why a partnership agreement is essential.
  • List the clauses that are normally included in a written agreement.
  • Use the information in the agreement to prepare the full set of partnership accounts:
    • Income statement
    • Appropriation account
    • Partners’ capital and current (drawings) accounts (ledger format)
    • Statement of financial position (balance sheet)
  • Show the link between the agreement and the figures that appear in the accounts (profit‑sharing ratio, interest on capital, interest on drawings, partners’ salaries).

1. Advantages & Disadvantages of Forming a Partnership

AdvantagesDisadvantages
  • Pooling of capital – each partner needs to provide less cash.
  • Combination of complementary skills and expertise.
  • Shared workload and responsibility.
  • More flexible decision‑making than a limited company.
  • Joint and several liability for all partnership debts.
  • Potential for disputes over profit sharing, control or withdrawals.
  • Partnership normally ends on death, bankruptcy or retirement of a partner unless the agreement says otherwise.
  • Limited ability to raise large amounts of external finance.

2. Purpose & Importance of a Partnership Agreement

  • Provides a written framework that sets out the rights and duties of each partner.
  • Reduces the risk of disputes by agreeing profit‑sharing, loss‑sharing, capital contributions, interest on capital, interest on drawings and salaries in advance.
  • Acts as evidence in legal proceedings if the partnership is dissolved or a partner breaches the terms.
  • Helps new partners understand what is expected before they join.
  • Although the agreement itself is not examined, the information it contains (e.g., profit‑sharing ratios, interest rates, admission/withdrawal rules) is required for the preparation of the partnership accounts.

Note (syllabus requirement)

The Cambridge IGCSE syllabus states that admission of new partners, withdrawal/retirement, dissolution and any change of profit‑sharing ratio are NOT required for this exam. The agreement should therefore focus on the clauses listed below; any additional clauses are optional and will not be marked.

3. Typical Contents of a Written Partnership Agreement

ClauseWhat it should cover
Names of partnersFull legal names and residential addresses.
Business name & purposeTrading name and description of the activities.
Capital contributionsCash, assets or services each partner will contribute at start (and any later additions).
Profit & loss sharing ratiosHow profit and loss will be divided – e.g. in proportion to capital or a fixed percentage.
Interest on capitalRate (if any) to be paid on each partner’s capital balance.
Interest on drawingsRate (if any) charged on money withdrawn by partners.
Partners’ salariesWhether partners receive a fixed salary and the amount.
Decision‑making proceduresVoting rights, quorum and method for approving major decisions.
Partner duties & responsibilitiesSpecific roles (e.g., managing partner, finance partner) and day‑to‑day tasks.
Admission of new partnersProcedure, required approvals and valuation of the incoming share (included for completeness – not examined).
Withdrawal / retirementNotice period, method of valuing the departing partner’s share and settlement terms (included for completeness – not examined).
Dissolution & winding‑upEvents that trigger dissolution and steps for distributing assets and liabilities (included for completeness – not examined).
Dispute resolutionUse of mediation, arbitration or other mechanisms.
Accounting & record‑keepingFrequency of accounts preparation, audit requirements and partners’ access to records.

4. Example Partnership – Data from the Agreement

PartnerCapital contributedProfit‑sharing ratio
A$30 00050 % (30 000 ÷ 60 000)
B$20 00033 ⅓ % (20 000 ÷ 60 000)
C$10 00016 ⅔ % (10 000 ÷ 60 000)

Agreement‑based adjustments (all for the year ended 31 Dec 20XX):

  • Interest on capital – 5 % per annum
  • Interest on drawings – 6 % per annum
  • Partners’ salaries – $2 000 each per year
  • Total drawings during the year – $5 000 (same for each partner for simplicity)

5. Partnership Income Statement

Partnership Income Statement – Year ended 31 Dec 20XX
Revenue (sales)$120 000
Cost of goods sold($70 000)
Gross profit$50 000
Operating expenses($30 000)
Net profit for the year$20 000

6. Appropriation Account

Appropriation Account – Year ended 31 Dec 20XX
Net profit (from income statement)$20 000
Add: Interest on capital (5 % of total capital $60 000)$3 000
Less: Interest on drawings (6 % of $5 000)($300)
Less: Partners’ salaries (3 × $2 000)($6 000)
Profit available for sharing$16 700
Share of profit – A (50 %)$8 350
Share of profit – B (33 ⅓ %)$5 567
Share of profit – C (16 ⅔ %)$2 783
Total transferred to partners’ current accounts$16 700

7. Partners’ Capital & Current (Drawings) Accounts – Ledger Layout

Only Partner A is shown in full; the same structure is used for Partners B and C.

Partner A – Capital Account (Ledger)
DateParticularsDebit ($)Credit ($)
1 Jan 20XXOpening balance – capital introduced30 000
31 Dec 20XXInterest on capital (5 % of 30 000)1 500
31 Dec 20XXClosing balance31 500
Partner A – Current Account (Ledger)
DateParticularsDebit ($)Credit ($)
1 Jan 20XXOpening balance0
31 Dec 20XXSalary2 000
31 Dec 20XXShare of profit (from appropriation)8 350
31 Dec 20XXDrawings5 000
31 Dec 20XXClosing balance5 600

Closing balances (used in the balance sheet)

  • Capital accounts: A $31 500, B $21 000, C $10 500 (total $63 000)
  • Current accounts: A $5 600, B $3 733, C $1 667 (total $11 000)

8. Statement of Financial Position (Balance Sheet)

Statement of Financial Position – As at 31 Dec 20XX
Non‑current assets$55 000
Current assets$34 000
Total assets$89 000
Current liabilities (e.g., creditors)($15 000)
Net assets$74 000
Partners’ equity (capital + current accounts)$74 000
   – Capital (A $31 500, B $21 000, C $10 500)
   – Current accounts (A $5 600, B $3 733, C $1 667)
Liabilities + Equity$89 000

The equity section is labelled “partners’ equity (capital + current accounts)” exactly as required by the syllabus.

9. Diagram – Flow of Information

Flowchart (textual description)
  • Partnership Agreement → determines profit‑sharing, interest rates, salaries, drawings.
  • Record capital contributions and any adjustments in capital & current accounts.
  • Prepare Income Statement → Net profit.
  • Prepare Appropriation Account (add interest on capital, deduct interest on drawings & salaries, allocate profit).
  • Transfer the profit shares to partners’ current accounts.
  • Close capital & current accounts → use balances in Statement of Financial Position.
  • Statement of Financial Position shows assets, liabilities and partners’ equity.

10. Summary Checklist for the Examination

  1. State the **advantages** and **disadvantages** of a partnership.
  2. Explain why a **partnership agreement** is required (framework, dispute avoidance, legal evidence).
  3. List the **key clauses** that should be in the agreement. Remember to note that **admission, withdrawal, dissolution and change of profit‑sharing ratio are NOT required** for this exam.
  4. Prepare a **partnership income statement** (revenue, COGS, expenses, net profit).
  5. Prepare an **appropriation account** – add interest on capital, deduct interest on drawings and salaries, then allocate the remaining profit using the agreed ratios.
  6. Show **capital and current accounts** for each partner in ledger format, recording every adjustment (interest, salary, profit share, drawings) and the closing balance.
  7. Present a **statement of financial position** where the equity section is labelled **partners’ equity (capital + current accounts)** and where Total assets = Liabilities + Equity.
  8. Check all calculations:
    • Profit‑sharing percentages must be derived from the capital contributions (e.g., 30 000 ÷ 60 000 = 50 %).
    • Interest on capital = rate × closing capital balance.
    • Interest on drawings = rate × total drawings.
    • Appropriation account must balance with the net profit.
  9. Review the agreement regularly – any change in profit‑sharing, interest rates or salary amounts must be reflected in the accounts.

Create an account or Login to take a Quiz

47 views
0 improvement suggestions

Log in to suggest improvements to this note.