TOPIC :

AUDIT OF

PARTNERSHIP FIRM

“INDIA SILICATE

WORKS”

DEFINATION OF PARTNERSHIP :

Indian Partnership Act, 1932,,,,,,

"Partnership" is the relation between persons who have agreed to share the profits of a business

carried on by all or any of them acting for all.

Persons who have entered into partnership with one another are called individually "partners"

and collectively a "firm", and the name under which their business is carried on is called the

"firm name".

ESSENTIAL ELEMENTS OF PARTNERSHIP :

From the statutory definition of partnership, the essential elements of partnership can be

understood as

"Partnership" is the relation between persons who have agreed to share the profits of a

business carried on by all or any of them acting for all.

persons

There should be at least two persons to form a partnership or partnership firm.

Restrictions on the number of persons

The maximum number of members that can exist in partnership is 10 in case of a

firm carrying on banking business and 20 in case of any other business.

This restriction is placed by the companies act and not the partnership act.

Companies Act, 1956 show

who have agreed

There should be an agreement between those persons who are forming the

partnership. The agreement is the foundation for the partnership. Partnerships can

arise only from a contract and not status.

Indian Partnership Act, 1932 show

the profits of a business

There should be a business carried on by the partnership and that too with an

intention to make and share profits of that business.

Therefore we can say

No Business, No Partnership and

No intention to share profits, No Partnership

Though, no specific mention of sharing of losses is made, we assume that Sharing

profits implies Sharing Losses also.

Indian Partnership Act, 1932 show

carried on by all or any of them acting for all

The business may be carried on by any one or more of the partners.

Acting for all

This implies that a partner conducting the business should be understood as

conducting the business on behalf of all the partners. Each partner would be

responsible for the acts of every other partner in relation to the firm.

As far as the outsiders are concerned, the partners and the firm are one and the same.

Mutual Agency [Principal Agent relationship]

 Concerning each of two or more persons or things; especially given or done in

return

 reciprocal

In his/her role as a partner, a person acts both as a principal as well as an agent.

A partner is an agent of the firm for the acts that the he/she does on behalf of the

firm, whereby he/she can bind the other partners for such acts. The other partners

would be in the position of a principal for such acts.

With regard to the acts of the other partners, he/she will be in the position of a

principal (since he as a partner is bound by the acts of the other partners on behalf of

the firm)

Where a partner cannot be made responsible for the acts of one or more other

partners we cannot say they together form a partnership. This mutual agency is what

really decides whether there is a partnership or not.

Thus it is said the "Mutual Agency" is the real test of partnership.

TYPES OF PARTNERSHIP :

Following are the important types of partnerships.

* Active or actual partnership

* Dormant or sleeping partnership

* Nominal partnership

* Sub partnership

* Partnership in profit only

ACTIVE/ACTUAL PARTNERSHIP

In this type of partnership the partners are actively involved in the business and business

relations and other aspects of the partnership firms.

DORMANT/SLEEPING PARTNERSHIP

In a dormant or a sleeping partnership, the partner will lend his name to the business but neither

interested in the business nor the profit sharing from the business.

NOMINAL PARTNERSHIP

These type of partners are known to the outsiders only. They will not actually involve in the

business.

SUB PARTNERSHIP

If a partner wants to share his profits to others he can enter into the partnership with others

stating the profit sharing levels or ratio. This is sometime referred to as parnership marketing.

PARTNERSHIP IN PROFIT ONLY

Partners who does not like loss bearing can enter into partnership sharing only the profit.

Such a parnership is called as partnership in profit only.

PARTNERSHIP - A FORM OF BUSINESS ORGANISATION :

Partnership is a form of business organisation. A business and its ownership are independent

entities. The idea that the actual business and the form of organisation that is owning it are

different would help you in creating an understanding on the difference in accounting for

partnership firms and other forms of business organizations.

The same business may be owned by a

sole proprietor,

partnership firm,

co-operative society,

company or any other form of business organisation.

Ascertaining the profit or loss is a task related to the business. The process of profit

ascertainment (final accounting) for a business would be more or less the same whatever may be

the form of business organisation that is owning the business.

What's different?

How the profit made is dealt with in distributing it among ownership is an idea related to the

form of business organisation. The way the profits made by an organisation are shared is what is

different from organisation to organisation.

PROFIT AND LOSS APPROPRIATION :

Income Distribution

Appropriation

 Give or assign a resource to a particular person or cause

 Setting aside Money for a specific purpose

 reserve

 set aside

In a partnership firm, the act of distributing profits among the partners is identified as

Appropriation of profits.

Factors of Production and Returns

In economic terms, the four basic factors of production are Land, Labour, Capital and

Organisation. Each of these factors would be compensated by sharing a part of the income

earned. What a factor gets as its share is what is called the return for the factor.

Rent is the return for Land;

Wages are the returns for Labour/Labor;

Interest is the return for Capital; and

Profits are the returns for the Organisation.

Thus profit earned by the partnership firm can be said to be the returns earned by the

Organisation.

In case of a sole proprietary concern, there is only a single person who contributes the capital of

the organisation (the sole proprietor) and as such all the organisation's returns belong to the

owner. For this reason the net profit is generally transferred to the Capital a/c in total.

In case of a partnership firm there would be two or more persons contributing the capital of the

organisation and as such the organisation's returns have to be equitably distributed among them.

Organisation - Partnership Firm

Land, Labour and Capital are factors of production which we see or feel.

Organisation is an intangible factor that combines these three factors to achieve the intended

objective. Organisation in one way can be understood as, the efforts made by those who have

contributed capital in conducting the affairs of the organisation to achieve its objectives. These

efforts may take many different forms.

What constitutes Organisation in a Partnership Firm

In a partnership firm partners contribute capital. They also make contributions to the organisation

in many other forms. All the contributions other than capital that partners contribute to the firm

constitute the factor we call Organisation.

Partners contribution to the firm takes many different forms which may be tangible or intangible.

Some of them are

Time

Partners spend their time and efforts in working for the firm by looking after the day to

day affairs of the firm. This contribution may be full time, part time or intermittent.

Business Relations

Partners through their personal contacts in the society bring in customers which may

result in more sales.

Intelligence

Partners use their intelligence and abilities in various situations like in solving problems

faced by the firm, tiding over tough situations, overcoming competitions etc.

Why is not Capital included

We do not consider the Capital contributed by the partners as a part of the factor organisation,

since Capital itself is considered a distinct factor.

Varied Contributions of Partners towards the Organisation

Since no two beings can be having with the same capabilities, the contributions made by the

partners for the factor called organisation varies from partner to partner. Each partner contributes

according to his/her abilities and possibilities.

REMUNERATING THE FACTORS OF PRODUCTION IN A

PARTNERSHIP FIRM

We are limiting our discussion to remunerating the two factors of production Capital and

Organisation only.

Judicious Distribution of the Firms Profits

A, B and C are partners in a firm. The firm has made a profit of 3,00,000. What would be the

judicious share of profit to be distributed to each partner A, B and C.

Share Equally

A, B and C sharing 1,00,000 each.

This sounds prudent if the contributions of A, B and C towards the firm is the same in all

respects.

Say, A, B and C

are of the same intelligence level,

work for the same time for the firm,

have contributed the same amount of Capital for the firm,

are having more or less the same contacts outside through which sales are generated,

have all withdrawn the same amounts of money for their personal uses (drawings)

In such a situation it would be appropriate to give each an equal share.

when equal Share is not Judicious

Practically, contributions of all the partners being equal in all respects being a no possibility,

sharing the profits of the firm equally amongst partners would not be the judicious way. In such

cases we would try to adjust for the differences in the following ways.

UNEQUAL CAPITAL CONTRIBUTIONS

The Capital Contributed by A, B and C is 2,00,000, 75,000 and 1,00,000 respectively. Now,

since A, B and C have contributed varied amounts of Capital towards the firm, it would not be

appropriate to share the profits equally among them.

Compensate by paying Interest on Capital.

Compensate for the uneven contributions towards capital by paying interest on their capital

contributions. Greater the Capital contributed, greater the interest earned. This would set right

the difference in contributions in the form of capital.

Profit equal to the total "Interest on Capital" on all the capital of the firm is set aside and is

distributed to the partners in the ratio of their capitals.

Rest of the profits can be shared equally if all other contributions are equal.

Unequal time and efforts

B works full time in the firm and A and C are passive partners. Now, since A, B and C have

contributed varied amounts of time and efforts in conduce of the affairs of the firm, it would not

be appropriate to share the profits equally among them.

Compensate by paying Salary to Partner.

Compensate for the uneven contributions of time and efforts towards the firm by paying salary to

partner. The salary paid to B would be compensation for his greater contribution.

Profit equal to the total "Salary to Partners" to all the partners who have made a contribution in

this respect is set aside and is distributed to them in proportion to the value of their contributions

as agreed upon between partners.

Rest of the profits can be shared equally if all other contributions are equal.

PUBLIC RELATIONS/CONTACTS

C has greater contacts in the outside world, a lot of customers are C's contacts. Now, the

contribution of C towards the sales of the firm through his contacts is greater than that of A and

B. Therefore, it would not be appropriate to share the profits equally among them.

Compensate by paying Commission to Partner.

Compensate C for providing more customers to the business by paying commission on sales. The

commission paid to C for sales made to customers who are his contacts would be compensation

for his greater contribution.

Profit equal to the total "Commission to Partners" to all the partners who have made a

contribution in this respect is set aside and is distributed to them in proportion to the value of

their contributions as agreed upon between partners.

Rest of the profits can be shared equally if all other contributions are equal.

Drawings

The Drawings of A, B and C are respectively, 2,000, 15,000 and 5,000 respectively.

Assume that drawings are being recorded using the 'Drawings a/c' which is the general

convention. Therefore, the Capital a/c balances are not affected by drawings made by partners.

The net capital contribution at any time can be obtained by setting off the Capital a/c and

Drawings a/c balances.

The net capital account balances of the partners are not in proportion to their capital account

balances. Therefore paying interest on capital based on capital account balances would be unjust.

Remedy - charge Interest on Drawings.

Greater the drawings greater the interest payable by the partners. This would compensate the

unevenness in drawings made by the partners.

Remunerating Organisation = distributing Profits

As can be seen, Interest on Capital, Salary to Partners, Commission to Partners, etc., are all paid

out of profits made and as such form appropriations of profits. All these appropriations are

intended to ensure an equitable distribution of profits among the partners based on their

contributions for the firm.

All the contributions other than capital together are identified as 'organisation' and it is rightly

said that remuneration for organisation is profit.

Distribution of Profits among Partners

Partners profit sharing ratio

A : B : C = 1 : 1 : 1

The only conclusion that can be drawn straight away reading the postings would be that there is a

transfer to or from the Profit and Loss a/c.

Charge Against Profits Vs. Appropriation of Profits

Classification of Debits to Profit and Loss account

If we consider a single profit and loss account in use, we can classify all the debits being made to

the account into two as

Charge on/against Profits

 Impose a Financial liability

 encumbrance

A charge can be interpreted as a debit to the profit and loss account which represent an

expenditure or loss. A charge will result in reduction of profits. All expenses and losses

are a charge against profits.

Salaries, Wages, Rent, Depreciation, Loss on Sale of Assets etc., are all charges against

profits.

Appropriation of Profit

 Give or assign profits for a particular person or cause

 Setting aside profits for a specific purpose

 reserve

 set aside

Profit appropriated is profit set aside for being used in the future for some purpose

specified or unspecified. It is not for the purpose of an expenditure that has already been

committed or incurred. For this reason, appropriation of profits does not result in a

reduction of profits.

Creation of reserves is an example of profit appropriation.

Using Profit & Loss Appropriation a/c

Interest on Capital, Salary, Commission etc., to Partners - Appropriations

Distribution of profit to partners is appropriation of profits. It can be understood as profit being

kept aside to be given to the owners as a return for their contributions.

"Interest on Capital", "Salary to Partners", 'commission to partners' etc., paid to partners are

different methods adopted to compensate their varied contributions to ensure equitable

distribution of profits. Therefore all these payments made to partners would also be

appropriations of profits and do not constitute a charge against profits.

Segregating charges and appropriations

To segregate charges and appropriations of profits being made to the profit and loss account, the

P/L a/c is divided into two by creating a new account by name "Profit and Loss Appropriation

a/c".

PARTNERSHIP DEED : RELATIONSHIP BETWEEN PARTNERS :

Agreement between Partners is the basis for Partnership

"Partnership" is the relation betweenpersons who have agreed to share the profits of a

business carried on by all or any of them acting for all.

who have agreed

There should be an agreement between the persons who are forming the partnership. The

agreement is the foundation for the partnership. Partnerships can arise only from a contract

created out of an agreement and not just by status.

Indian Partnership Act, 1932 show

Agreement may be Written or Oral

The contract based on the agreement between the partners forms the basis of the relationship

between the partners. It specifies the terms and conditions that bind the partners into the

relationship. This agreement may be written or oral.

Written Agreement » Partnership Deed

The agreement between the partners put down in writing forms the Partnership Deed. It is a

document containing the various aspects agreed upon by the partners. It is also called

a Partnership Agreement orArticles of Partnership.

Contents of the Partnership Deed

The partnership deed generally covers/includes the following aspects

Names of the partners of the firm and their addresses

Duration of Partnership

Capital contribution of each Partner and aspects relevant to it like introduction of

additional capital, drawings that can be made etc.

Interest to be paid on Capital, Loans given by partners to the firm, interest to be

charged on Drawings and the relevant rates of interest

Aspects relating to salaries, commissions, etc., to be paid to partners

The ratio in which the profits and losses are to be shared among partners

Goodwill valuation methodology at the time of incorporating changes in the

partnership.

Rights and Duties of Partners inter se among themselves.

Name of the Bank/Banks where the business banking accounts should be maintained

and the person/persons who are vested with the power to operate the accounts.

The person/persons responsible for accounting for the business transactions and the

place where the books of accounts are to be kept generally.

Everything that is relevant to the relationship between the partners forms part of the agreement.

Even aspects relating to Arbitration (in case of disputes among themselves) etc., will be part of

the agreement.

Role of Partnership Deed in Accounting

Any and every aspect relating to the partnership may be included in the "Partnership Deed". This

deed forms the basis of any transaction involving the partners. Even accounting for partnership

firms is a function that is to be carried on in accordance with the provisions in the "Partnership

Deed".

Salary to be paid to partners, profits to be shared among partners, interest on capital, interest on

drawings, etc., are all to be decided based on the agreement between the partners (i.e. based on

the partnership deed).

Thus in accounting for transactions involving these, compliance with what is agreed upon should

be ensured.

Where the Partnership Deed is silent

Where the partnership deed or the agreement between the partners is silent on any aspect that is

to be decided based on that agreement, the provisions in the "Indian Partnership Act, 1932"

apply.

Role of Partnership Act in Accounting

The following provisions affect the accounting treatments in the absence of an agreement in that

respect.

Partners Share of Profits

In the absence of an agreement between the partners, they would share profits and losses equally

among themselves (and not in the ratio of their capital contributions).

If there is an agreement between the partners then the shares would be decided based on the

agreement.

Separate Ratios for Profits and Losses

The partners may agree that profits be shared in a certain ratio and losses in another ratio.

Share in Profits Only

The partners may agree that one or more partners would share profits only and will not have to

share losses at all.

Share in Losses Only!!!

There is no provision for one or more partners agreeing to share only losses and not sharing any

profits. Partnership would exist only where there is a business and the partners have agreed to

share the profits of the business. Since the fundamental characteristic of sharing profits would be

missing if they agree to share only losses, this is not a possibility.

Indian Partnership Act, 1932 show

Remuneration to Partners

In the absence of an agreement between the partners, a partner is not entitled to receive any

remuneration (salary, commission, brokerage etc.,) for the services rendered by him to the firm.

If there is an agreement between the partners then the partner may receive such remuneration as

agreed upon.

Indian Partnership Act, 1932 show

Interest on Capital

In the absence of an agreement between the partners, a partner is not entitled to receive any

interest on Capital even if there is a variation in the profit sharing ratio and the capital

contribution.

If there is an agreement between the partners then interest is to be paid at the rates agreed upon.

Interest to be paid only out of Profits

Even where the agreement provides for payment of interest on capital, it will not be paid if there

are losses.

Indian Partnership Act, 1932 show

Interest on Drawings

No specific mention is made about drawings in the act. Therefore, it is assumed that the

provisions that are applicable for Capital would also be applicable for Drawings.

In the absence of an agreement between the partners, a partner is not entitled to pay any interest

on Drawings.

If there is an agreement between the partners then interest is to be charged at the rates agreed

upon.

Interest on Partners Loans or Advances

In the absence of an agreement between the partners, a partner is entitled to receive interest at the

rate of 6% p.a. on any payment or advance made beyond the amount of Capital he has to

contribute.

If there is an agreement between the partners then interest is to be paid at the rates agreed upon, .

PROFIT SHARING RATIO, INTEREST ON CAPITAL AND

DRAWINGS, COMMISSION BEFORE AND AFTER CHARGING :

Profit Sharing Ratio

By profit sharing ratio in a partnership firm, we mean the ratio in which the profits and losses of

the firm are to be distributed amongst the partners.

The basis for arriving at the ratio is the agreement between the partners. If there is a partnership

deed, the ratio should be ascertained from the provisions in the partnership deed. In the absence

of a partnership deed and where there is no indication as to the agreement between the partners

in this aspect, it should be considered as equal share for all partners.

The ratio may be specified in terms of absolute values or it may be expressed as the ratio of their

Capital account balances or it may be based on anything else as agreed upon by the partners.

Deriving this ratio (if it is not given) would be one important requirement in problem solving.

Different Ratios for Profit Sharing and Loss Sharing

If the partners so agree, the Profit Sharing Ratio and the Loss Sharing Ratio may be different.

There may be a partner who has a share in profits only but not a partner who has a share in

losses only.

Expressing the Profit Sharing Ratio

The profit sharing ratio may be expressed in a number of different forms. Whatever may be the

form in which the ratio is expressed it can always be converted to a form convenient to us for

being used in problem solving.

Simple Ratio

May, Day and Way are partners sharing profits in the in the ratio 1 : 3 : 4.

Simple Ratio [Fractions represent shares]

Where the shares are represented by fractional numbers, one should always check to see if the

sum of the fractional parts representing shares add up to 1.

Interest on Capital

Interest on Capital is to be paid

Only when agreed upon

Interest on Capital is to be paid to partners only if it is specifically agreed upon. If there is

no mention regarding this, in the partnership agreement (deed), then no interest need be

paid.

Only out of profits

Interest is to be paid only out of profits. Where there is a loss, no interest should be paid

on capital, even if the partnership agreement provides for the same.

@ 6% if rate is not mentioned

Where the partnership deed provides for payment of interest on capital and it does not

mention the rate of interest to be paid, it is a convention to pay interest @ 6% p.a.

On What Balance is Interest calculated

Interest is paid on capital for the reason that it has been used for the purpose of the partnership

business.

The balance in Capital account unless where it is maintained under Fixed Capital Method, keeps

fluctuating on account of a number of reasons, thus making it difficult to assess the amount of

capital employed in the business. There would be a change on account of appropriations made at

the end of the accounting period like salary to partners, commission to partners, etc. Even during

the course of the accounting period, the balances may change on account of additional capital

introduced, capital withdrawn, etc.,

In the absence of appropriate information, it is a convention that interest is paid on the opening

balances in Capital Accounts on the assumption that it has been employed for the full length of

the accounting period and all other changes to the capital account have been done towards the

end of the accounting period.

In problem solving we will come across these situations.

Opening Balance known

Where Capital a/c balances at the beginning of the accounting period are known and there

is no change in the balance through out the period, interest is calculated on the opening

balance.

Closing Balance and Appropriations at the end known

Where Capital a/c balances at the end are known and the changes at the end of the

accounting period that have affected the account are also known, the opening balance in

capital accounts is ascertained using the information relating to the changes and interest

is calculated thereon.

Closing balance and all transactions known

Where the Capital a/c balances at the end are known and the changes over the accounting

period as well as those at the end of the accounting period are known, the capital account

balances at various points of time (when changes take place) and the period for which the

capital has been utilised is ascertained and interest is calculated thereon.

Closing balance known

Where the Capital a/c balances at the end are known and no other information is

available, or where the information relating to transactions affecting the capital account

are known without the information relating to the date/period of occurrence, we calculate

the interest based on the closing balance.

Interest on Drawings

Interest on Drawings is to be charged

Only when agreed upon

Interest on Drawings is to be charged to partners only if it is specifically agreed upon. If

there is no mention in the partnership agreement regarding this, no interest need be

charged.

@ 6% if rate is not mentioned

Where the partnership deed provides for charging interest on drawings and it does not

mention the rate of interest to be charged, it is a convention to charge interest @ 6% p.a.

Calculating Interest on Drawings

Interest is charged on drawings for the reason that the amount has been withdrawn by the

partners without allowing it for being used for the purpose of the business.

In the absence of appropriate information, it is a convention that the interest on drawings is

calculated on the "Drawings a/c" balance at the end.

In problem solving we will come across these variations.

Closing Balance known

Where the Drawings a/c balances at the end of the accounting period are known and there

is no information relating to the time of drawing, interest is calculated on the closing

balance.

Amount and dates of Drawings are known

Where drawings made during the period and the dates on which the drawings have been

made are known, interest is calculated based on the amount drawn and the period of use,

since the period for which the withdrawn amounts are used can be ascertained.

Drawings made at regular intervals

Where the Drawings are made at regular intervals, all the drawings are converted to an

equivalent of drawings for a specified period and interest is calculated thereon.

The information available is the same as the information available in the case of amount

and dates of drawing known. However, since the drawings are made at regular intervals,

converting them to an equivalent amount would make it easier to calculate interest.

Salary to Partners

Salary is to be paid to partners only if it is specifically agreed upon.

If there is no mention in the partnership agreement then no salary need be paid.

Commission to Partners

Commission is to be paid to partners only if it is specifically agreed upon.

If there is no mention in the partnership agreement then no commission need be paid.

Expressing Commission

Commission payable to partners may be expressed in a number of different ways. It may be

Specified amount

Per unit of sales relatable to the partner

Per days of activity of the partner

As a % of Sales, NetProfit, Purchases or any other value.

What method is employed for expressing and calculating commission is dependent on the reason

for which the commission is being offered and the agreement between the partners.

There are two ways commission as a % of a value can be expressed. How it is expressed decides

how the commission is calculated mathematically.

Consider Commission being calculated as a % of Net Profit as an example.

Before charging such commission

Where there is no specific mention we assume that the commission is being expressed as

a % of value before charging such commission. Calculation is straight forward.

Commission = Value × % of Commission.

After charging such commission

Under this method, commission is expressed as a % of value after charging such

commission.

The commission should work out to 8% of the value remaining after charging or

deducting commission.

Partners Capital Accounts

The first difference we can notice, between accounting for sole proprietary form of business

organisation and partnership form of business organisation is with regard to capital and its

related aspects.

Partners Capital Accounts

Interest on Capital, Salaries to Partners, Interest on Drawings, Commission to Partners are

appropriations of profits to ensure equitable distribution of profits based on the various

contributions made by partners to the firm. Along with the Partners Share of Profits, these

amounts conventionally are credited or debited to the Partner's capital accounts which would

result in the balance in the Partners Capital accounts getting altered.

Fluctuating Capital Accounts

Fluctuate

 Having unpredictable ups and downs

 waver

Since the capital account balances changes (fluctuates) with the regular transactions relating to

capital, the Capitals accounts maintained under this method are known as "Fluctuating Capital

Accounts".

Fixed Capital Accounts

Purpose

Profits (revenue) increase capital. By profits we mean all the appropriations of profits that find

their way into the capital account, like interest on capital, salary to partner, commission to

partner, share of profits. Capital also increases when additional capital is brought in by the

partner which is a Capital natured transaction.

Under the fluctuating capital account system, since we use only a single capital account, it gets

affected by transactions of both capital and revenue nature.

If the organisation intends to obtain the information relating to the Capital account balance on

account of Capital natured transactions and Revenue Natured transactions separately, a separate

Capital accounts needs to be maintained to record the revenue natured transactions.

The basic purpose of accounting is derivation of information. The more information we need, the

more accounting heads we need to maintain.

Fixed Capital Accounts

Two ledger accounts are maintained for collecting information relating to capital. The

transactions that affect partners capital accounts are classified as capital and current natured.

Calculation of Interest on Capital

The capital account balance considered for calculation of interest on capital is dependent on the

method adopted for maintaining the capital accounts.

Fixed Capital Accounts

Where the Capital Accounts are being maintained under "Fixed Capital Accounts"

method, interest on capital is to be calculated on the balances in the capital accounts.

Interest on Current account balances is not considered unless there is a specific

instruction regarding the same.

Fluctuating Capital Accounts

Where the Capital Accounts are being maintained under "Fluctuating Capital Accounts"

method, interest on capital is to be calculated on the balances in the capital accounts as

that is the only account that is related to capital.

In both cases any specific agreement between partners has to be considered in arriving at the

balances and calculation of interests. Say if they agree to consider only the balance at the end for

calculating interest, only that balance would be considered even if the partners have brought in

additional capital or withdrawn capital during the accounting period.

GURANTEES MADE BY / TO ONE OR MORE PARTNERS.

Opportunity Cost/Loss

Any decision that involves a choice between two or more mutually exclusive alternatives has an

opportunity cost or loss involved.

Opportunity Cost

Opportunity Cost is the value or utility that is foregone by taking up a particular alternative. It is

the value of the utility that would have been derived had the best of threst of the alternatives been

chosen.

Opportunity Loss

Opportunity Loss is the value or utility that is foregone by taking up a particular alternative. It is

the difference between the value of the utility and its opportunity cost.

Partners in a Firm » Opportunity Loss

The contributions made by partners to the firm take various forms like contribution of assets

(cash, Motor Vehicles, Buildings etc) towards capital, their time and energy by working in the

firm, their personal contacts by generating sales through them, their selling abilities etc.,

In contributing these assets or services to the firm, the partners personally incur an opportunity

cost/loss which they will consider before employing them for the firm.

where the partner is investing capital he/she would be thinking of the earnings they might

get if that capital is employed elsewhere;

where he/she is employing his/her time as a working partner, he/she would be thinking of

his/her earning if he/she employs the same time elsewhere.

Each and every contribution of the partner has an opportunity cost loss attached to it unless they

are sitting idle.

Need for Guarantee

In situations of the sort mentioned here, partners may ask for a guarantee from one or more other

partners so that they would not be at loss by employing their resources for the firm.

Where a partner is participating in a partnership firm, he/she needs to be compensated at

the minimum, to the extent of his/her opportunity loss for the contribution made to the

firm. Otherwise he/she may be desisted from contributing to the firm.

Where a partner is very much sure that he can employ what he/she is contributing to the

firm elsewhere in a more profitable manner, why should he/she invest them for the firm,

unless there is some sort of assurance for the returns they get by contributing to the firm?

When a person is getting into a partnership agreement, he/she will be conscious of his/her

own abilities as well as the limitations of his/her other partners. Moreover, he/she would

be measuring his/her opportunity cost/loss in becoming a partner.

All Partners Cannot be the Guaranteed

In the context of a particular guarantee, one or more partners can be given the guarantee. Since,

there should be at least one partner who is giving the guarantee, not all the partners can be the

guaranteed.

All Partners Cannot be the Guarantors

In the context of a particular guarantee, one or more partners can give the guarantee. Since, there

should be at least one partner who is being guaranteed, not all the partners can be the guarantors.

There should be at least one who is giving and one who is guaranteed, thus eliminating the

chance of all the partners being either guarantors or the guaranteed in such cases.

A Partner can be a guarantor and a guaranteed

One or more partners can be both the guarantor and guaranteed at the same time. A partner may

guarantee one or more other partners and at the same time get a guarantee from one or more

other partners

Guarantee to Partners

Guarantee to One Partner

A, B and C are partners in a firm sharing profits and losses in the ratio 5 : 3 : 2. They now decide

to admit Mr. M as a partner giving him 110th share and taking among

themselves 510th,310thand110th respectively. Mr. M was willing to join as a partner only if he is

guaranteed that his annual share of profits would be not less than 20,000.

Effect of the Guarantee

If Mr. M is to get his guaranteed annual share, the firm would have to make an annual profit of at

least 2,00,000 ( 110th of 2,00,000 = 20,000). If the profit is lesser, then the existing partners

should forego their share to ensure that Mr. M gets his guaranteed share of profits. If the profit is

more than 2,00,000, the guarantee does not affect the share of other partners.

The guarantee may be given by one or more partners.

Guarantee by one Partner

On admitting Mr. M, the firm would benefit in a number of ways. Specifically Mr. A

would be getting a major relief on Mr. M sharing some of his responsibilities.

Mr. B and Mr. C were reluctant to agree to the guarantee proposal put forward by Mr. M.

Mr. A, since he would be benefiting directly and being confident that the firm would

make enough profits to ensure the minimum share asked for by Mr. M, has agreed to

guarantee Mr. M on his own.

Thus Mr. A guarantees Mr. M's minimum share. The burden of guarantee has to be borne

by Mr. A.

Guarantee by two Partners

Mr. B is reluctant to agree to the guarantee proposal put forward by Mr. M. Mr. A and

Mr. C being confident that Mr. M's admission is beneficial to the firm in every way,

together agree to guarantee Mr. M.

The burden of guarantee has to be borne by Mr. A and Mr. B together.

Guarantee by the Firm

Since all partners feel that admitting Mr. M would be benefiting the firm in all ways, they

all agree to the minimum guarantee asked for by Mr. M.

The burden of guarantee has to be borne by all the partners together. In such a situation,

Mr. M is said to have been guaranteed by the firm.

Guarantee to two or more Partners

Guarantee to two or more partners would have be viewed similarly. The guarantee may be given

by

only one partner

two or more partners

the firm, i.e. all the partners together.

Appropriation Guarantee - Shortfall

All appropriations as we see in partnership accounting are arrangements made to ensure an

equitable distribution of profits based on the various contributions made by partners to the firm.

As such the amount guaranteed may relate to

Distributable Profits only

Distributable Profits and other Appropriations

The guaranteed amount, apart from share of profits, may consist of other profit

appropriations like salary to partner, commission to partner etc.

Shortfall

The difference between the amount guaranteed and the amount that a guaranteed partner would

get if the guarantee is not brought into force, is what we call the shortfall.

The terms of guarantee enable us to understand what constitutes the guaranteed amount and

thereby calculate the guaranteed amount and the shortfall that has to be made good if any.

Who bears the shortfall and in what proportion?

Who bears the burden of shortfall is dependent on who has given the guarantee.

Where there is only one partner who has given the guarantee, the total burden inevitably has to

be borne by that partner only.

Where two are more partners have given the guarantee or the firm has given the guarantee, the

proportion in which the burden of shortfall is borne by the partners is dependent on the

agreement between them. In problem solving, where there is no mention of the proportion, we

assume that they share the burden in proportion to the profit sharing ratio inter se between them.

REFERENCES:

(1) http://www.futureaccountant.com/partnership-accounts/study-notes/#.Vg649NKqqkr .