1. Chapter 9: Financial statements of a partnership
After completing this topic you should be able to
Construct a profit and loss account for a partnership
Construct a balance sheet for a partnership
Account for the admission of a new partner
Account for the cessation of a partnership
Independent study
Study Chapter 9
Progress test and practice question(s) as set
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2. Financial statements of a partnership
The story so far …
Requirements for a partnership (unincorporated)
Minimum 2 partners to set up
Business Names Act 1985 requires the names of partners to be shown on stationery
In the absence of a partnership deed, the Partnership Act 1890 applies to profit sharing, interest on capital, interest on loans and partners’ salaries (see Chapter 2)
Capital is restricted to what partners can invest
Partners have ‘joint and several’ liability
Must keep accounting records, but no requirement to disclose financial information
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3. Commonly used methods for profit sharing
Financial statements of a partnership
Commonly used methods for profit sharing
Fixed ratio
Partners may agree to share the profits equally (eg 50:50)
If a partner has contributed more capital or spends more time working for the partnership than the other, they may decide an alternative basis (eg 75:25)
Ratio based on capital balances
If partners have contributed unequal amounts of capital, they may agree to share the profits in the same ratio (eg if one partner has contributed £60,000 capital and the other only £40,000, the profit sharing ratio will be 60:40)
(Continued)
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4. Commonly used methods for profit sharing (continued)
Financial statements of a partnership
Commonly used methods for profit sharing (continued)
Making allocations and sharing the balance
The partners may agree that interest will be paid on the capital contributed by the partners, that partners who spend a certain amount of time working in the business will receive a salary or that interest will be charged on any drawings
All these transactions will be allocations of the net profit earned by the business
Once these allocations have been made, any balance (whether a profit or a loss) will be shared amongst the partners in an agreed ratio
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5. Profit and loss appropriation account
Financial statements of a partnership
Profit and loss appropriation account
The profit and loss account of an unincorporated partnership is similar to that of a sole trader except the net profit or loss is transferred to an additional section known as an appropriation account
An appropriation account is ‘a record of how the net profit/(loss) for the period has been distributed’ (Collis and Hussey, 2007, p. 153
It is part of the double-entry bookkeeping system and shows the partners’ interest on loans and drawings, as well as their interest on capital and salaries, before showing how the net profit/(loss) is shared
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6. Introducing Hearth & Home
Rob and John own a business called Hearth & Home which is an unincorporated partnership
They have agreed to share the profits/(losses) of the business equally
A profit and loss account has been drawn up from the trial balance and additional information for the year ending 31 December 2005 and you can see that so far it is similar to that of a sole trader …
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7. Financial statements of a partnership
Hearth & Home Profit and loss account for the year ending 31 December 2005
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8. Exercise 1 Hearth & Home Profit and loss appropriation account
We are now ready to add the appropriation account which shows the interest of drawings, interest on capital and salaries, and then how the balance of profit has been distributed between the partners, Rob and John
Required
Complete the pro forma appropriation account in the profit and loss account for Hearth & Home from the trial balance and additional information provided
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9. Exercise 1 Hearth & Home Trial balance at 31 December 2005
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10. Pro forma Hearth & Home Profit and loss appropriation account
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11. Solution 1 Hearth & Home Profit and loss appropriation account
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12. Capital accounts and current accounts
Financial statements of a partnership
Capital accounts and current accounts
In a double-entry bookkeeping system, the bookkeeper/accountant opens a capital account and a current account for each partner
The capital account shows the capital subscribed and withdrawn
The current account shows salaries, interest on capital, interest on drawings, share of profit and drawings
These entries correspond with those made in the profit and loss appropriation account and the balances on these accounts at the end of the accounting period are needed for the balance sheet
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13. Example Hearth & Home Current accounts
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14. Exercise 2 Hearth & Home Balance sheet
Financial statements of a partnership
Exercise 2 Hearth & Home Balance sheet
The first half of a balance sheet of an unincorporated partnership is similar to that of a sole trader, but the second half shows the balances on the partners’ capital and current accounts
There have been no transactions on Rob and John’s capital accounts during the year and we now have the closing balances on their current accounts
Required
Complete the pro forma balance sheet for Hearth & Home from the trial balance and additional information provided
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15. Exercise 2 Hearth & Home Trial balance at 31 December 2005
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16. Pro forma Hearth & Home Balance sheet
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17. Solution 2 Hearth & Home Balance sheet
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18. Admitting a new partner
Financial statements of a partnership
Admitting a new partner
When a new partner is admitted, a goodwill account is opened so the existing partners can benefit from the goodwill they have generated
Goodwill is ‘the difference between the value of the separable net assets of an entity and the total value’ (Collis and Hussey, 2007, p. 160)
Total net assets of new partnership less the net assets of the old partnership + capital invested by the new partner
Goodwill is either written off immediately or over a period of time
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19. Dissolving a partnership
Financial statements of a partnership
Dissolving a partnership
When a partnership is dissolved, a realization account is opened, so that the profit can be calculated and shred among the partners in their agreed profit-sharing ratios
If the reason for the cessation of the partnership is due to the insolvency of one of the partners, the rules of Garner v. Murray (1905) apply
These require the other partners to bear the loss in the ratio of their capital accounts
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20. Financial statements of a partnership
Conclusions
We have been looking at the financial statements of unincorporated partnerships
LLPs are bound by the same rules governing limited liability companies, which are covered in Chapter 10
The financial statements of a partnership are similar to those of a sole trader except
The profit and loss account includes an appropriation account at the end to show how the net profit or loss has been divided among the partners
The balance sheet includes the closing balances on the partners’ capital accounts and current accounts
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