Chapter 1: Accounting for Partnership Firms

1.1 Fundamentals of Partnership

Partnership is an association of two or more persons who have agreed to share the profits of a business carried on by all or any of them acting for all.

Characteristics of Partnership:

• Two or more persons (Max: 50 as per Companies Act 2013).
• Agreement (Partnership Deed).
• Lawful Business.
• Sharing of Profits.
• Mutual Agency.

Provisions of Indian Partnership Act, 1932 (in absence of Partnership Deed)

• Profit Sharing Ratio: Equal.
• Interest on Capital: Not allowed.
• Interest on Drawings: Not charged.
• Salary/Commission: Not allowed.
• Interest on Partner’s Loan: \( 6\% \) p.a.

Fixed vs. Fluctuating Capital Accounts

1.2 Valuation of Goodwill

Goodwill is an intangible asset representing the good name and reputation of the firm.

Methods of Valuation:

1. Average Profit Method: \[ \text{Goodwill} = \text{Average Profits} \times \text{Number of Year’s Purchase} \]

2. Super Profit Method: \[ \text{Normal Profit} = \text{Capital Employed} \times \frac{\text{Normal Rate of Return}}{100} \] \[ \text{Super Profit} = \text{Average Profit} - \text{Normal Profit} \] \[ \text{Goodwill} = \text{Super Profit} \times \text{Number of Year’s Purchase} \]

3. Capitalisation Method (Super Profit): \[ \text{Goodwill} = \text{Super Profit} \times \frac{100}{\text{Normal Rate of Return}} \]

1.3 Reconstitution of Partnership Firm

Reconstitution implies a change in the existing agreement among partners, leading to a change in the relationship among partners but the firm continues.

Change in Profit Sharing Ratio

• Sacrificing Ratio: Ratio in which existing partners surrender their share in favor of another partner. \[ \text{Sacrificing Ratio} = \text{Old Ratio} - \text{New Ratio} \]
• Gaining Ratio: Ratio in which a partner acquires share from another partner. \[ \text{Gaining Ratio} = \text{New Ratio} - \text{Old Ratio} \]

Revaluation Account

When a new partner is admitted, or there is a change in the profit-sharing ratio, or during retirement/death, the assets and liabilities of the firm are revalued. The net gain or loss is transferred to the partners’ capital accounts in their old profit-sharing ratio.

Admission of a Partner

• Adjustment of Goodwill (AS 26).
• Revaluation of Assets and Reassessment of Liabilities.
• Adjustment of Reserves, Accumulated Profits, and Losses.

Retirement and Death of a Partner

• Identifying new profit sharing and gaining ratio.
• Ascertaining retreating/deceased partner’s share in goodwill and accumulated reserves.
• In case of death: calculation of profit till the date of death: \[ \text{Share of Profit} = \text{Estimated Profit} \times \frac{\text{Time from last balance sheet to death}}{12 \text{ months}} \times \text{Deceased Partner’s Share} \]
• Preparation of the deceased partner’s executor’s account.

1.4 Dissolution of Partnership Firm

Dissolution of the firm closes down the business permanently. Settlement of accounts includes the preparation of the Realisation Account, Partners’ Capital Accounts, and Cash/Bank Account.

Realisation Account: All assets are transferred to the debit side (excluding cash/bank) and all outside liabilities are transferred to the credit side. The proceeds from the sale of assets are credited, and payments of liabilities are debited.

Competency-Based Questions (CBQs)

Q1. A and B are partners without a partnership deed. A has advanced a loan of ₹ 50,000 to the firm, and he demands interest @ 10% p.a. Assess A’s claim in light of the Indian Partnership Act, 1932. Context: Real-world application of partnership fundamentals when the deed is silent.

Q2. The average profit of a firm is ₹ 80,000. Capital employed is ₹ 5,00,000 and the normal rate of return is 10%. Calculate the value of goodwill based on 3 years’ purchase of super profits. Context: Application of mathematical formulas to value intangible assets.

Q3. X and Y are partners sharing profits in the ratio 3:2. They admit Z into partnership for 1/4th share. Calculate the sacrificing ratio of X and Y. Context: Identifying mathematical shifts in sharing ratios during reconstitution.

Q4. On the date of dissolution of a firm, unrecorded typed writers valued at ₹ 5,000 were taken over by a partner, Q, at ₹ 4,000. Analyze how this transaction will be recorded in the Realisation Account. Context: Scenario-based assessment regarding dissolution and unrecorded assets.

Q5. Explain the treatment of the deceased partner’s share of profits from the beginning of the year until the date of death. Provide the necessary journal entry. Context: Application of conceptual rules regarding death of a partner.

Answers to CBQs

Ans 1. In the absence of a partnership deed, the provisions of the Indian Partnership Act, 1932 apply. According to the Act, interest on a partner’s loan is allowed at \( 6\% \) p.a., not 10%. Therefore, A’s claim is invalid, and he will only receive interest at \( 6\% \) p.a.

Ans 2.

• Capital Employed = ₹ 5,00,000
• Normal Rate of Return = 10%
• Normal Profit = \( 5,00,000 \times \frac{10}{100} = ₹ 50,000 \)
• Average Profit = ₹ 80,000
• Super Profit = Average Profit - Normal Profit = \( 80,000 - 50,000 = ₹ 30,000 \)
• Goodwill = Super Profit × 3 = \( 30,000 \times 3 = ₹ 90,000 \)

Ans 3. Z is admitted for 1/4th share. Since no information is given about how Z acquires his share, it is assumed X and Y sacrifice in their old ratio. Thus, the Sacrificing Ratio of X and Y = 3:2.

Ans 4. The typewriter is an unrecorded asset. When it is taken over by a partner, the firm receives value through a deduction in the partner’s capital. The journal entry is: Q’s Capital A/c Dr. 4,000 To Realisation A/c 4,000 In the Realisation Account, this will be recorded on the Credit side as “By Q’s Capital A/c - ₹ 4,000”.

Ans 5. The deceased partner is entitled to their share of profit up to the date of death. This is usually calculated linearly based on time or turnover. The journal entry is: Profit & Loss Suspense A/c Dr. To Deceased Partner’s Capital A/c (Being share of profit credited to the deceased partner)