IGCSE Accounting Ch 16: Partnerships

Cambridge IGCSE Accounting

Partnerships

This chapter explains partnership accounts, including partnership agreements, profit-sharing ratios, the profit and loss appropriation account, interest on capital, partners’ salaries, interest on drawings, partner’s loans, current accounts, fixed capital accounts, fluctuating capital accounts and the partnership statement of financial position.

PartnershipAgreementProfit-sharing ratioAppropriation accountInterest on capitalPartner’s loanCurrent accountsCapital accounts

Partnership overview showing partners, agreement, appropriation account and partner accounts

Topic 1: Partnership Basics and Agreement

A partnership has more than one owner, so accounting must show how profit, capital, drawings and responsibilities are shared.

1. What is a Partnership?

A partnership is a business owned by two or more people, called partners, who operate the business together to make a profit.

Partnerships are common among:

Doctors
Lawyers
Accountants
Family businesses

The textbook states that ordinary partnerships normally have up to 20 partners, with some exceptions.

2. Advantages and Disadvantages

Advantages

More capital can be raised.
Partners can bring different skills and experience.
Responsibilities are shared.
Risks and losses are shared.
More ideas may improve decision-making.
Easy and relatively inexpensive to establish.

Disadvantages

Profits must be shared.
Partners may disagree.
Decisions may take longer.
Ordinary partners normally have unlimited liability.
A partner may be liable for actions taken by another partner on behalf of the business.

3. Partnership Agreement

A partnership agreement is a contract between the partners explaining how the partnership will operate. It helps prevent disagreements.

Important contents	Why it matters
Amount of capital contributed by each partner	Shows how much each partner has invested.
Profit and loss sharing ratio	Shows how profits and losses are divided.
Limits on drawings	Controls how much partners may withdraw.
Interest on capital	Rewards partners for capital invested.
Interest on drawings	Discourages excessive withdrawals.
Interest on partners’ loans	Sets the return on money lent to the partnership.
Partners’ salaries	Rewards partners for extra work or responsibility.

4. Profit-Sharing Ratio

Partners do not necessarily share profits equally. The partnership agreement states the profit-sharing ratio.

Example
Ali and Omar share profits 2:1.
Residual profit = $30,000
Ali receives: 2/3 × $30,000 = $20,000
Omar receives: 1/3 × $30,000 = $10,000

The same ratio is normally used to share losses unless the agreement states otherwise.

Topic 2: Profit and Loss Appropriation Account

The appropriation account starts with profit for the year and shows how that profit is distributed between the partners.

Profit and loss appropriation account flow showing residual profit calculation

5. Profit and Loss Appropriation Account

A partnership prepares the normal income statement, but then also prepares a Profit and Loss Appropriation Account.

Its purpose is to show how the profit for the year is distributed between the partners.

Profit for the year+ Interest on drawings− Partners’ salaries− Interest on capital= Residual profit

Residual profit is then divided using the profit-sharing ratio.

6. Interest on Capital

Interest on capital rewards partners for the money they have invested in the business.

Example
Ali’s capital = $40,000
Interest on capital = 5%
Interest = $40,000 × 5% = $2,000

Appropriation account

The $2,000 is deducted in the appropriation account.

Current account

The $2,000 is credited to Ali’s current account.

7. Partners’ Salaries

A partner may receive a salary for working extra hours, taking greater responsibility or carrying out additional duties.

Important: A partner’s salary is not an ordinary business expense like the wages of an employee. It is an appropriation of profit.

Type of salary	Treatment
Staff salary	Income statement expense
Partner’s salary	Appropriation account

Example
Profit = $20,000
Partner A receives salary = $4,000
Amount remaining before other appropriations = $20,000 − $4,000 = $16,000

8. Interest on Drawings

Partners may be charged interest on drawings to discourage them from withdrawing too much money from the business.

Example
Ahmed’s drawings = $10,000
Interest on drawings = 5%
Interest = $10,000 × 5% = $500

Interest on drawings is added to the profit available for appropriation.

9. Complete Appropriation Example

Ali and Sara share profits 1:2. Profit for the year is $30,000. Interest on drawings: Ali $200, Sara $400. Sara’s salary is $3,000. Interest on capital: Ali $1,000, Sara $2,000.

Appropriation

Profit for the year$30,000

Add: Interest on drawings ($200 + $400)$600

Amount available$30,600

Less: Sara’s salary($3,000)

Remaining amount$27,600

Less: Interest on capital ($1,000 + $2,000)($3,000)

Residual profit$24,600

Ali’s share

1/3 × $24,600 = $8,200

Sara’s share

2/3 × $24,600 = $16,400

The textbook uses this process: profit plus interest on drawings, less salaries and interest on capital, followed by division of residual profit.

Topic 3: Partner’s Loan and Key Distinctions

A partner’s capital, interest on capital and partner’s loan must not be confused.

10. Partner’s Loan

A partner may lend additional money to the partnership. This is different from capital.

A partner’s loan is normally shown as a non-current liability.

Example
Partner lends business $20,000.

Dr Bank$20,000

Cr Partner’s Loan$20,000

11. Interest on Partner’s Loan

This is a very important distinction: interest on a partner’s loan is a business expense. It is charged in the income statement, not in the appropriation account.

Example
Partner’s loan = $20,000
Interest rate = 5%
Interest = $20,000 × 5% = $1,000
The $1,000 is deducted as an expense before profit for the year is calculated.

Topic 4: Fixed Capital, Current Accounts and Fluctuating Capital

The capital section depends on whether the partnership uses fixed capital accounts or fluctuating capital accounts.

Partner current accounts showing credit and debit entries

12. Fixed Capital Accounts

With fixed capital accounts, each partner’s capital account normally remains unchanged.

Example
Ali contributes = $40,000
Sara contributes = $30,000
Their fixed capital accounts remain: Ali = $40,000, Sara = $30,000.

Profit shares, drawings, salaries and interest are recorded in separate current accounts.

13. Current Accounts

When fixed capital accounts are used, each partner also has a current account.

Items Credited to Current Account

Interest on capital
Partner’s salary
Share of profit

Items Debited to Current Account

Drawings
Interest on drawings
Share of loss

Example
Ali has interest on capital = $1,000, salary = $3,000, share of profit = $6,000, drawings = $4,000, interest on drawings = $200.
Closing current account = $1,000 + $3,000 + $6,000 − $4,000 − $200 = $5,800 credit.

14. Debit and Credit Current Account Balances

Credit Balance

Usually means the partnership owes the partner money. The partner has earned more than they have withdrawn.

Debit Balance

Usually means the partner has withdrawn more than they have earned and therefore owes money to the partnership.

Fixed capital compared with fluctuating capital

15. Fluctuating Capital Accounts

With a fluctuating capital account, there is normally no separate current account. Everything is entered directly into the capital account.

Credits

Capital introduced
Interest on capital
Salary
Share of profit

Debits

Drawings
Interest on drawings
Share of loss

Because these items are entered directly into capital, the capital balance changes from year to year.

16. Fixed vs Fluctuating Capital

Fixed Capital	Fluctuating Capital
Capital normally remains unchanged.	Capital changes each year.
Separate current account needed.	No separate current account.
Profit, salary, drawings and interest go to current account.	Profit, salary, drawings and interest go directly to capital account.

Topic 5: Statement of Financial Position and Exam Guide

A partnership statement of financial position is similar to a sole trader’s, but the capital section shows more than one owner.

17. Statement of Financial Position

A partnership’s statement of financial position is similar to that of a sole trader. The main difference is the capital section, because there is more than one owner.

If fixed capital accounts are used, both partners’ capital accounts and partners’ current accounts are shown.

Capital Section Example
Capital Section	Ali $	Sara $	Total $
Capital accounts	40,000	30,000	70,000
Current accounts	5,000	3,000	8,000
Total partners’ funds			78,000

18. Year-End Adjustments

Partnerships make the same normal year-end adjustments as sole traders, including:

Depreciation

Charged before profit is distributed.

Accruals

Expenses owing are adjusted.

Prepayments

Amounts paid in advance are adjusted.

Irrecoverable debts

Bad debts are written off before appropriation.

Provision for doubtful debts

Provision changes are included before distribution.

Closing inventory

Used when calculating profit for the year.

These adjustments are made before the profit is distributed between the partners.

19. Quick Appropriation Guide

Item	Treatment
Profit for year	Start appropriation account
Interest on drawings	Add
Interest on capital	Deduct
Partner’s salary	Deduct
Residual profit	Share between partners
Interest on partner’s loan	Income statement expense – not appropriation

Remember

Appropriation Account: Profit + Interest on drawings − Interest on capital − Partners’ salaries = Residual profitThen share residual profit using the agreed ratio.

Current Accounts — Credit
Interest on capital + Salary + Share of profit

Current Accounts — Debit
Drawings + Interest on drawings + Share of loss