0452 · 5.2Partnerships

Partnership features and agreement

0:00Nila and Omar run Reed Cycle Workshop together, but they contribute different amounts of money and do different jobs. Their agreement decides how the profit of the business is shared between them. This video covers the advantages and disadvantages of forming a partnership, the partnership agreement, the appropriation account, interest on partners’ loans, and partners’ capital and current accounts. One worked example follows their figures from the year’s trading to each partner’s closing current account balance.

0:26A partnership is two or more people carrying on business together with a view to profit. A partnership can be a trading, service, manufacturing business or a combination of these. Reed Cycle Workshop sells bicycles and provides repair services, so it combines trading and service activities. Making bicycles would also give it a manufacturing activity. Forming a partnership can provide more capital because several owners contribute money. The partners can share the workload and combine different skills when making decisions.

0:56Losses are shared according to their agreement. Nila might manage bicycle sales while Omar handles repairs, so each contributes expertise as well as money. Unlimited liability means the partners are personally responsible for all the business’s debts. It is a major disadvantage of forming a partnership. Partners also share profit, and disagreements can disrupt the business. Decisions may take longer because the owners need to consult one another. More people can provide better judgement, but consultation can delay an urgent purchase.

1:25A partnership agreement sets out the terms on which the owners operate their business together. Its importance is that agreed rules help avoid disputes. It should specify capital to be contributed, the profit-sharing ratio, interest on capital, interest on drawings, and partners’ salaries. Interest on partners’ loans and procedures for decisions and disputes should also be included.

Profit, appropriations and partner loans

1:46Financial statements are summaries that show a business’s profit or loss for a period and what it owns and owes at a date. The partnership must calculate its business result before deciding how to share it. Revenue is the income a business earns from its main activity, such as selling goods or providing services. For Reed Cycle Workshop, that means bicycle sales and repair fees. Expenses are the costs used up in running the business and earning revenue during a period.

2:10The statement of profit or loss is the financial statement that shows the revenue, expenses and profit or loss for a period. Its final line gives the business result for the year. Profit for the year is the amount by which revenue exceeds expenses over one financial year. An appropriation account shows how the profit for the year is shared between partners. Calculating the business result and allocating that result are separate stages.

2:34Owner’s equity, also called capital, is the owner’s investment in the business, or the amount the business owes the owner. Under the business entity concept, the partners and Reed Cycle Workshop are treated as two separate parties. The owner’s capital is therefore owed by the business to the owner. Each partner needs an individual record of that entitlement. Interest on capital is an allocation to partners based on their investment in the business.

2:59Partners who do extra work may also receive an agreed allocation called a partner’s salary. Neither allocation represents the cost of employing an outside worker. They belong in the appropriation account because they divide the business result between its owners. Drawings are money or goods taken from the business by its owner for private use. They are not a business expense, so they never reduce the profit for the year.

3:21They reduce owner’s equity instead. Interest on drawings is a charge to partners for taking resources from the business for private use. A partner’s loan is money lent to the business separately from that owner’s capital contribution. The business pays interest on partners’ loans as its cost of borrowing from them. It is an expense in the statement of profit or loss before profit for the year. The lender receives this interest as a creditor, not as an allocation for being an owner.

Adjusted profit calculation

3:46Our worked example covers the year ended the thirty-first of December, twenty twenty-eight. Nila has capital of thirty thousand dollars, while Omar has twenty thousand dollars. The profit-sharing ratio is the agreed proportion in which partners share the residual profit or loss. Nila and Omar’s ratio is two to one, so Nila receives two shares of the remaining result and Omar receives one. The agreement allows interest on capital at five per cent and an annual salary for Omar of three thousand four hundred dollars.

4:16Nila also lends the business ten thousand dollars for the whole year at six per cent interest. Ten thousand dollars multiplied by six per cent gives six hundred dollars. This interest remains unpaid at the year end. Its treatment must recognise both the borrowing expense and the amount still owed to Nila. For Nila, thirty thousand dollars multiplied by five per cent produces interest on capital of fifteen hundred dollars.

4:39Omar’s twenty thousand dollars multiplied by five per cent gives one thousand dollars. Their combined allocation is fifteen hundred plus one thousand dollars, which equals two thousand five hundred dollars. Omar’s salary allocation remains three thousand four hundred dollars. The partnership makes adjustments to financial statements as detailed for sole traders. Partnership ownership does not change the treatment of those adjustments. Each one is taught in its own accounting procedures video.

5:05Here we apply prepaid rent, unpaid wages and unpaid loan interest before sharing the result. A prepaid expense is a cost paid in advance that belongs to a future period. Reed Cycle Workshop paid rent of thirteen thousand dollars, including one thousand dollars for the following year. Thirteen thousand minus one thousand gives this year’s rent expense of twelve thousand dollars. Other receivables are current assets, such as amounts due to the business and payments for benefits not yet used.

5:33An accrued expense is a cost of the current year that is still unpaid at the year end. Wages paid were twelve thousand five hundred dollars, and another fifteen hundred dollars remains unpaid. Twelve thousand five hundred plus fifteen hundred gives a wages expense of fourteen thousand dollars. Unpaid expenses and money received before it is earned are grouped as other payables, which are current liabilities. Double entry means every transaction is recorded as a debit in one account and a credit of the same amount in another.

6:02Debit other receivables and credit rent by one thousand dollars because a future benefit is recognised and this year’s expense falls. For unpaid wages, debit wages and credit other payables by fifteen hundred dollars because employment costs rise and an obligation is recognised. Unpaid loan interest of six hundred dollars needs one more pair of entries. The loan interest account is debited and other payables is credited, because borrowing costs rise and a liability is recognised.

6:29Inventory means goods held for resale. Opening inventory is the value of goods held for resale at the start of a financial period. The goods remaining at its end are called closing inventory. Cost of sales is the cost of inventory sold during a period. Goods still held at the year end are therefore excluded. Purchases records the cost of goods bought for resale and normally has a debit balance.

6:51Revenue is ninety thousand dollars, opening inventory is seven thousand dollars, and purchases are forty-five thousand dollars. Seven thousand plus forty-five thousand gives goods available for sale of fifty-two thousand dollars. Subtract closing inventory of nine thousand dollars to obtain cost of sales of forty-three thousand dollars. Gross profit is revenue minus cost of sales. Ninety thousand minus forty-three thousand gives gross profit of forty-seven thousand dollars. We then deduct the business’s operating and borrowing expenses.

7:21Interest on Nila’s loan belongs at this stage because the business incurred it to obtain finance. Depreciation is the loss in value of a non-current asset over its useful life. It is an estimate that is charged as an expense in each year of use. Equipment depreciation is two thousand four hundred dollars. Twelve thousand plus fourteen thousand plus two thousand four hundred plus six hundred gives total expenses of twenty-nine thousand dollars.

7:47Forty-seven thousand minus twenty-nine thousand gives profit for the year of eighteen thousand dollars. That result already includes every business expense in this example.

Appropriating profit and losses

7:56We now use the appropriation account to apply Nila and Omar’s agreement. Omar’s salary and both partners’ interest on capital divide this result; they do not recalculate the business’s expenses. Nila’s drawings are six thousand dollars, and Omar’s drawings are five thousand dollars. The question gives interest on drawings of three hundred dollars for Nila and two hundred dollars for Omar. If a question requires calculation, use its specified rate and timing.

8:21Three hundred plus two hundred gives total interest on drawings of five hundred dollars. Add interest on drawings because those charges reduce the individual partners’ entitlements and increase the amount available for allocation. Eighteen thousand plus five hundred gives eighteen thousand five hundred dollars available for appropriation. Subtract interest on capital of two thousand five hundred dollars and Omar’s salary of three thousand four hundred dollars. Eighteen thousand five hundred minus two thousand five hundred minus three thousand four hundred leaves twelve thousand six hundred dollars.

8:53This residual profit is the balance left to share in the profit-sharing ratio. The ratio contains two plus one shares, so there are three shares altogether. Twelve thousand six hundred divided by three gives four thousand two hundred dollars per share. Nila receives four thousand two hundred multiplied by two, which equals eight thousand four hundred dollars. Omar receives four thousand two hundred multiplied by one, which gives four thousand two hundred dollars.

9:19Eight thousand four hundred plus four thousand two hundred equals twelve thousand six hundred dollars, so the shares match the residual profit. The profit-sharing ratio applies to this balance after the agreed allocations. It does not automatically apply to the original eighteen thousand dollars. Interest on capital and salary have already recognised investment and work before that remaining amount is shared. A loss is the amount by which expenses exceed revenue for a period.

9:46Agreed allocations can also produce a residual loss, even when the business initially reports a profit. A debit residual is shared in the profit-sharing ratio. Each partner’s share then reduces that person’s entitlement. Suppose the same business instead makes a loss of twelve hundred dollars. The five hundred dollars of interest on drawings reduces it to seven hundred dollars. Seven hundred plus two thousand five hundred plus three thousand four hundred produces a residual loss of six thousand six hundred dollars.

10:13In the ratio two to one, Nila bears four thousand four hundred dollars and Omar bears two thousand two hundred dollars. Four thousand four hundred plus two thousand two hundred equals six thousand six hundred dollars.

Capital and current accounts

10:26Back in the original profitable year, partners’ capital accounts record each owner’s permanent investment under the fixed capital method. Partners’ current accounts record routine changes in each owner’s entitlement. A ledger is a collection of accounts, and each account records changes relating to one particular item. A debit is an entry on the left side of an account, while a credit belongs on the right. A balance is the difference between the debit and credit totals of an account.

10:52Fixed capital changes only when permanent capital is introduced or withdrawn. For balancing, place balance carried down on the smaller side and balance brought down on the opposite side. Balance carried down completes the arithmetic rather than recording another payment. Neither partner changes permanent capital during our original example. Nila’s capital therefore remains thirty thousand dollars and Omar’s remains twenty thousand dollars. Nila’s capital account has thirty thousand dollars on each side after balancing.

11:22Omar’s corresponding totals are twenty thousand dollars on each side. Both balances are brought down on the credit side on the first of January, twenty twenty-nine. Their current accounts will show the year’s allocations and drawings separately from these fixed investments. Credit a partner’s current account for interest on capital, salary and a share of residual profit. The matching debit is in the appropriation account because the amount available for allocation falls.

11:45For interest on drawings, debit the partner’s current account and credit the appropriation account because personal entitlement falls and the allocation pool rises. A share of residual loss is instead a debit entry in the current account, with a matching credit entry in the appropriation account. The details column names the other account involved, so each record points towards its matching entry. At the year end, debit each partner’s current account and credit that partner’s drawings account to transfer the private-use amount.

12:14This reduces the partner’s entitlement and clears the separate drawings record. These allocations and transfers do not themselves represent payments through the bank. Nila starts with a credit balance of two thousand dollars. Two thousand plus fifteen hundred plus eight thousand four hundred gives credits of eleven thousand nine hundred dollars. Her debits before balancing are six thousand plus three hundred, which equals six thousand three hundred dollars. Eleven thousand nine hundred minus six thousand three hundred leaves a credit balance of five thousand six hundred dollars.

12:45Both sides of Nila’s account total eleven thousand nine hundred dollars after balancing. Omar begins with a debit balance of eight hundred dollars, so that amount reduces his entitlement. One thousand plus three thousand four hundred plus four thousand two hundred gives credits of eight thousand six hundred dollars. Eight hundred plus five thousand plus two hundred gives debits before balancing of six thousand dollars. Eight thousand six hundred minus six thousand leaves Omar with a credit balance of two thousand six hundred dollars.

13:14His balanced totals are eight thousand six hundred dollars on each side. Both closing balances are brought down as credits for the next year. A current account can instead finish with a debit balance when its deductions exceed its opening credit and allocations. In that case, balance carried down sits on the credit side and balance brought down on the debit side.

Statement of financial position

13:33A statement of financial position shows assets, liabilities and owner’s equity at a particular date. Assets are resources owned or controlled by a business that bring future benefit. Liabilities are amounts the business owes to others. We present each partner’s capital and current account within equity, while the partner’s loan remains a separate liability. Non-current assets are assets held for continuing use in the business rather than for resale. Accumulated depreciation is the running total of depreciation charged on an asset since it was acquired.

14:04Carrying amount is the asset’s cost less its accumulated depreciation. Equipment costing forty thousand dollars has accumulated depreciation of eight thousand dollars, so its carrying amount is thirty-two thousand dollars. Current assets are assets expected to be turned into cash or used up within twelve months. Inventory is nine thousand dollars, and prepaid rent appears as other receivables of one thousand dollars. Trade receivables are amounts owed by credit customers who have not yet paid for goods or services.

14:33Here they total sixteen thousand dollars, and the bank balance is seventeen thousand two hundred dollars. Nine thousand plus sixteen thousand plus one thousand plus seventeen thousand two hundred gives current assets of forty-three thousand two hundred dollars. Thirty-two thousand plus forty-three thousand two hundred gives total assets of seventy-five thousand two hundred dollars. Trade payables are amounts owed to credit suppliers that the business has not yet paid. Here they amount to four thousand nine hundred dollars.

15:01Current liabilities are amounts due for payment within twelve months. Unpaid wages of fifteen hundred plus loan interest of six hundred gives other payables of two thousand one hundred dollars. Four thousand nine hundred plus two thousand one hundred gives current liabilities of seven thousand dollars. Non-current liabilities are amounts due for payment after more than twelve months. Nila’s ten thousand dollar loan is repayable after that time, so it is a non-current liability.

15:27Net assets are total assets minus total liabilities. Total liabilities are seven thousand plus ten thousand, which equals seventeen thousand dollars. Seventy-five thousand two hundred minus seventeen thousand gives net assets of fifty-eight thousand two hundred dollars. This must agree with the partners’ combined equity. Within equity, the current accounts can be shown line by line, with a column for each partner. Omar’s opening debit balance of eight hundred dollars is shown in brackets because it is deducted.

15:56Two thousand minus eight hundred gives a combined opening balance of twelve hundred dollars. Interest on capital totals two thousand five hundred dollars, and Omar’s salary adds three thousand four hundred dollars. Eighty-four hundred plus four thousand two hundred gives shares of profit totalling twelve thousand six hundred dollars. Drawings of six thousand plus five thousand, which equals eleven thousand dollars, are deducted. Interest on drawings of five hundred dollars is also deducted.

16:23Nila’s closing balance is five thousand six hundred dollars, while Omar’s is two thousand six hundred dollars. Thirty thousand plus twenty thousand gives total capital of fifty thousand dollars. Current accounts total five thousand six hundred plus two thousand six hundred, which equals eight thousand two hundred dollars. Nila’s combined entitlement is thirty-five thousand six hundred dollars, and Omar’s is twenty-two thousand six hundred dollars. Total equity is fifty thousand plus eight thousand two hundred, which equals fifty-eight thousand two hundred dollars.

16:55The accounting equation states that assets equal liabilities plus owner’s equity. Our check is seventy-five thousand two hundred dollars equals seventeen thousand dollars plus fifty-eight thousand two hundred dollars. A debit current balance would be deducted within equity. The partner’s loan principal stays separate because it represents borrowing, not ownership investment. Common examination mistakes centre on the distinction between expenses and allocations. Record loan interest before profit for the year, and place partners’ salaries and interest on capital in the appropriation account.

17:27Add interest on drawings there and debit the individual current accounts. Apply the profit-sharing ratio to the residual result, and place opening debit current balances on the debit side. Paper One contains forty multiple-choice questions, while Paper Two contains five compulsory structured questions. Calculate means work out from given figures, and prepare means present information in a suitable format. Explain means give reasons, why and how, supported by evidence. Questions can combine an adjusted statement of profit or loss with appropriation calculations and partners’ accounts.

18:01Interest on Nila’s loan is an expense because the business incurs a cost for borrowed money. It reduces profit for the year in the statement of profit or loss. Interest on her capital is an allocation under the partnership agreement. It appears in the appropriation account because it determines how the owners share the business result. The statement of profit or loss calculates the partnership’s business result after adjustments and loan interest.

18:24The appropriation account applies the owners’ agreement and divides the residual profit or loss. Fixed capital accounts record permanent investment, while current accounts record allocations and drawings. The statement of financial position then separates the partners’ equity from loans and other liabilities.