1 Topic Nine Partnership

2  A business carried out by people in agreement to share profits and losses  Each partner is a partner of the others  Business has unlimited liability  Partners property could be attached for a firm’s debts  We shall learn how to account for a partnership’s capital

3 Learning outcomes  After this lesson you should be in a position to, - Describe partnership business - Explain the contents of a partnership agreement - Differentiate between fixed and fluctuating partnership capital accounts - Value partnership goodwill using different methods as might be agreed upon by partners - Value goodwill as a result of change in profit-sharing ratios of existing partners - Value goodwill as a result of introduction of a new partner - Value goodwill as a result of a partner leaving the business either through retirement or death

4 Partnership agreement  An agreement between partners contain items such as; The period of time that the business will be carried out. Partners’ names and addresses Amount of capital contributed by each partner Interest on capital Interest on loans and drawings

5 Partnership agreement  Salaries and commissions  The profit and loss sharing ratios for the partners  Method of valuing goodwill  The place where a firm’s accounts will be held  Management partners  Admission of a new partner  Withdrawal/retirement of a partner  How to solve a dispute, if any arises between the partners  Procedure to be followed in dissolving the business

6 Partnership agreement In absence of a written agreement the following will be implied as agreed upon by the partners; Partners will share profits equally Partners will have equal participation in the business No interest on capital and drawings Admissions will be after agreement by old partners Partners will not be entitled to a salary or commission Books of account will be kept at the firm’s head office

Fixed and fluctuating capital accounts  Capital accounts could either be fluctuating or fixed  Where capital accounts are fluctuating they will be affected by transactions between the business and the partner  If fixed, dealings between a partner and the business will be shown in a different account, current account, while the capital account will only be affected by capital injection. 7

Fluctuating capital accounts 8 DrAbacha Partnership BusinessCr Partners Capital Account for the period ended 31 July 2011 Ref AstraBakerCharlieAstraBakerCharlie Amount ($) Ref Amount ($) Interest on drawings 1, Bal b/f250,000200,000150,000 Drawings 14,0002,0008,000 Interest on capital25,00020,00015,000 Salaries5,0004,00010,000 Bal c/d 381,100311,800234,700Comm.4,0001,000 Profit share112,50090,00067, ,500314,000243,500396,500314,000243,500

9 Fixed capital accounts DrAbacha Partnership BusinessCr Partners’ Capital Accounts for the period ended 31 July 2011 Ref AstraBakerCharlieAstraBakerCharlie Amount ($) Ref Amount ($) Bal b/f250,000200,000150,000 Bal c/d 250,000200,000150, ,400200,200150,800250,000200,000150,000

Current accounts 10 DrAbacha Partnership BusinessCr Partners’ Current Accounts for the period ended 31 July 2011 Ref AstraBakerCharlieAstraBakerCharlie Amount ($) Ref Amount ($) Interest on drawings 1, Interest on capital25,00020,00015,000 Drawings 14,0002,0008,000Salaries5,0004,00010,000 Commission4,0001,000 Bal c/d 131,100111,80084,700Profit share112,50090,00067, ,500114,00093,500146,500114,00093,500

Methods of valuing goodwill Average of profits Computation of super profits Capitalization 11

12 Average profits  Goodwill is estimated at the average profits earned in the past years.  Goodwill assumed to be worth a factor of these profits.  For instance if profits of $725,000 are earned over 5 years; average profits will be $145,000  Goodwill could be agreed at 4 years average profits that is, $580,000

13 Super Profit Method  Using the super profits method, the partners charge goodwill based on the firm’s profits in excess of the normal profits  This requires calculation of the firm’s capital and then multiplying this with the normal rate of returns agreed upon

Illustration  Using the illustration of Abacha Partnership above, assume the normal rate of return for their capital is 15 percent.  Normal profits are15 percent of total capital $90,000 (0.15*600,000).  Supernormal profits are difference between the average returns, $145,000 and normal profits, $90,000.  Goodwill is then based on a multiple of the supernormal profits, in this case assume 6 years, $330,000 (145, ,000)*6). 14

Capitalization method  Profits are capitalized using the market rate cost of capital.  In this case, assume average profits of $145,000 are capitalized at 20 percent.  Value = Average profits/ interest rate =$145,000/.20 = $725,000  Goodwill is difference between capitalized profits and capital contribution. That is, $125,000 ($725,000-$600,000). 15

Goodwill and partnerships  We have learnt that goodwill is shared by old partners and charged to new partners.  The following are illustrations where;  profit-sharing ratios change,  a new partner is introduced, or  a partner leaves We shall illustrate the three scenarios using Abacha partnership reviewed earlier assuming a goodwill of $300,000 16

Change in profit ratios  Suppose partners have decided to change their profit sharing ratios as follows; OldNew Astra5/121/2 Baker1/31/4 Charlie1/41/4 17

Change in profit ratios  Goodwill will be shared using the old ratios as follows:-  Astra $137,500 (5/12*330,000)  Baker $110,000 (1/3*330,000)  Charlie $82,500 (1/4*330,000)  Goodwill should be written off as follows:-  Astra $165,000 (1/2*330,000)  Baker $82,500 (1/4*330,000)  Charlie $82,500 (1/4*330,000)  Partners’ capital will be as noted in the next slide 18

Change in profit ratios 19 DrAbacha Partnership BusinessCr Partners Capital Account for the period ended 31 July 2011 Ref AstraBakerCharlieAstraBakerCharlie Amount ($) Ref Amount ($) Goodwill charge 165,00082,500 Bal b/f250,000200,000150,000 Bal c/d 222,500227,500150,000 share of goodwill137,500110,00082, ,500310,000232,500387,500310,000232,500

 New joiners will be charged goodwill  Use the case of Abacha Partnership  Mr. Dakar has been accepted in the firm subject to contribution of capital of $180,000  Change in profit sharing ratios OldNew Astra5/124/10 Baker1/33/10 Charlie1/42/10 Dakar-1/10 20 Introduction of a new partner

21 DrAbacha Partnership BusinessCr Partners Capital Account for the period ended 31 July 2011 Ref AstraBakerCharlieDakarAstraBakerCharlieDakar Amount ($) Ref Amount ($) Goodwill charge 132,00099,00066,00033,000Bal b/f250,000200,000150,000- Bal c/d 255,500211,000166,500147,000 share of goodwill137,500110,00082,500- Cash---180, ,500310,000232,500180,000387,500310,000232,500180,000

Withdrawal of a partner  Partner may be expelled, retire or die  Goodwill and capital should be paid  Suppose that Charlie retires and paid his capital including his share of goodwill.  After his exit the remaining partners, Astra and Baker will share profits in the ratio of 3/5 and 2/5 respectively 22

Withdrawal of a partner 23 DrAbacha Partnership BusinessCr Partners Capital Account for the period ended 31 July 2011 Ref AstraBakerCharlieAstraBakerCharlie Amount ($) Ref Amount ($) Goodwill charge 198,000132,0000Bal b/f250,000200,000150,000 Bal c/d 189,500178,000 share of goodwill137,500110,00082,500 Cash 232,500Cash 387,500310,000232,500387,500310,000232,500

Conclusion  Partnerships accounts prepared just like sole proprietorship or company accounts as learnt in lesson 3  Differences are in disclosure of capital accounts  We have learnt how to prepare capital accounts and how to value goodwill 24

Questions 25