Fundamentals of Accounting for Partnership

“Great partnerships begin with shared financial clarity” 

When two or more entrepreneurs collaborate to run a business and share equal profits, that’s a partnership. Success here hinges not just on profits, but completely depends on how efficiently they manage the finances or profits/ loss. That’s where accounting for partnership becomes crucial. 

Accurate financial reporting, compliance, and seamless operations form the crux of a business’s success. If you are new to the space or are collaborating to run a business, understanding the basic concepts of accounting for partnership firms becomes crucial. 

This blog will take you through the key concepts, partnership deeds, profit-sharing ratios, and more. Let’s scroll below to understand partnership accounting in more detail. 

What is Partnership in Accounting? 

Partnership in accounting refers to the process of managing, recording, and reporting the financial transactions and operations of a partnership firm under a special agreement. 

Basic Concepts Under Partnership Accounting

1. Nature of Partnership Firm  

• It is established when multiple individuals agree, through a legal contract, to share the responsibilities and profits of a business. 
• Under section 2(3) of the IT Act, 1961, a partnership firm is considered to be a completely separate entity. 
• The partners have joint ownership where they equally contribute to capital, skills, and accounts. 
• Legally, the partnership firm isn’t different from its partners. But accounting for partnership firms treats it separately. 

2. Partnership Deed 

• A partnership deed is a verbal or written partnership agreement between two or more business partners. 
• It legally outlines the roles, responsibilities, capital sharing, profit/ loss ratio, and other functional regulations. 
• The partnership deed also highlights rules for salaries, capital, interest, settlement, and exit terms. 
• It prevents disputes between the partners by clarifying the terms in advance. 

What Does a Partnership Deed Cover? 

• The firm and Partner Name
• Commencement Date of a Business
• Capital Contribution By Each Partner 
• Withdrawal Limit and Period Allocated to Each Partner 
• Interest rate applied to capital, withdrawals, and loans to the firm for each partner. 
• Profit/Loss Ratio Sharing
• Applicable Conditions to draw the salary 
• Variations in Mutual Rights and Duties of All the Partners 
• Goodwill Valuing Process for Upgrades in the Constitution
• Retirement Procedure and Payment of Dues 
• Loss Treatment That Arrives Out of Partnership Insolvency 
• Procedures to Follow for Dispute Settlement Between Partners
• Preparation of Accounts and Audits 

3. Profit-Sharing Ratio

• Profit-sharing ratio on the partnership deed decides the distribution of profits and losses amongst the partners. 
• If it isn’t mentioned in the agreement, equal profit/ loss sharing is considered. 

4. Capital Contribution 

• In terms of accounting for a partnership, each partner contributes to capital generation. 
• Partners can invest through funds, professional expertise, or tangible assets. 
• These contributions from individual partners are reported in separate accounts, also called capital accounts. 

5. Withdrawals and Interests 

• Partners can withdraw money or assets for their individual use, which are known as drawings.
• It attracts interests which are termed to be an interest in drawings. 
• This interest is generally referred to the income for the partnership firm. 

By now, the foundational principles of partnership accounting should be clear. Let’s move ahead to understand accounting rules for the absence of partnership deeds.  

No Partnership Deed? Here’s What Applies 

Without a formal partnership deed, these standard rules from the Partnership Act, 1932 come into effect. 

• Interest doesn’t apply to withdrawals made by partners. 
• The partners remain ineligible to receive commission or salary. 
• A partner can earn interest on the additional amount given as a loan to the firm along with the share he receives. 
• The profit shared by the partners will be equal, irrespective of their capital contributions. 
• No interest is payable to partners on their capital contribution.

So, agreement forms the crux of accounting for partnership to outline the terms and conditions. Now, let’s move ahead to explore the insights into capital accounts and interests. 

Accounting for Partnership: Capital Accounts and Interests

Capital Accounts 

For partnership firms, there are two ways to maintain capital accounts! Check them below. 

1. Fluctuating Capital Method

• For business capital that keeps changing based on every transaction, a single account called partners capital is maintained. 
• All entries, like profits, losses, withdrawals, interest, salary, and commission, are recorded here. 
• It provides a live snapshot of each partner’s capital contribution.
• It encourages strategic decision-making and profit allocation. 

2. Fixed Capital Method 

• Under partnership for accounting, Fixed Capital Method is where the original capital of each partner is fixed for the entire accounting tenure. 
• All entries like interest, salary, profit/loss, etc are recorded in a separate ‘current account’ for every partner. 

Also, explore the key accounting principles every business should follow.

Partnership Accounting: Interest On Partners Loan 

• Rate of Interest

If any of the partners has given a loan to the company, the partner can receive an interest based on the rate defined in the partnership deed. 

In case of the absence of agreement, the partner can receive interest at the rate of 6% per annum under section 13 (D) 

• Nature of Interest 

The interest is charged irrespective of the profit or loss the firm undergoes. Accounting for partnership firms defines that interest is charged for the profit value.  

• Accounting Treatment 

The accounting treatment records and reports all the financial transactions of the partnership firm accurately. It ensures fair distribution of profits as well as liabilities between all the partners. 

Partner’s Salary or Commission 

• Under partnership accounting, salary or commission is allowed to the partners if the agreement specifies it. 
• Partners can draw a salary or commission only if the business is in profit. 

What is Goodwill and How is it Treated? 

Goodwill in accounting for partnership firms is termed as an intangible value like reputation, esteemed clientele, brand name, or efficient experts earned by the business during its tenure. It depicts the original value of the firm apart from its net assets. 

How is Goodwill Treated? 

A New Partner Has Joined 

• When a new partner joins, he also gets a share of the goodwill. 
• The new partner can bring goodwill in terms of cash or even be adjusted through the existing partner’s gain.  

A Partner Has Retired 

• The retired partner gets his share of goodwill, where the remaining partners compensate by adjusting their capital. 

A Partner Has Expired 

• The goodwill is computed until the expiry date of the partner and his legal heirs are paid the share. 
• This is adjusted between the other partners who are alive. 

The Partnership is Sold

• Here, Goodwill is an asset for which the buyer pays the lump sum amount. 

Conclusion 

Managing a partnership firm doesn’t just mean taking care of products, services, or expansion plans. It also caters to efficient financial management, partnership terms, and more. That’s where accounting for partnership steps in to ensure seamless financial operations and long-term success. 

It considers the partnership deed, its norms, capital contribution, profit-sharing ratio, drawings, interest, partner’s loan, goodwill and more. If you are a new partner or own a partnership firm, understanding the basic concepts of partnership accounting is crucial.  

Hopefully, the blog has guided you well. Bookmark and share the article with your partners for further use. 

Handling all the accounting standards and finances can sound a little daunting, but here’s the catch. Munim accounting and billing just makes it easier for you to manage all your finances while you are busy with the core tasks. Start exploring today. 

FAQs on Accounting for Partnership 

What are the accounting rules for partnership firms

• The partnership deed should be in place 
• Capital Accounts must be properly maintained
• Interest on capital and drawing should be mentioned 
• Profit-sharing ratio should be specified 
• Interest on the partner’s loan to be specified 

What is the basic concept of accounting for partnership? 

Basically, an accounting for partnership firms caters to maintaining separate records for partners’ capital, profit-sharing ratios, as well as current accounts. 

How to Calculate Goodwill in a Partnership firm? 

Goodwill = P – (A – L) 

P→ The complete purchase price of the firm 

A→ market value of recognised assets 

L→ Fair market value for all the listed liabilities 

What is the fundamental accounting equation for partnerships? 

The accounting equation is assets = Liabilities + Owners’ Equity 

How to calculate partnership ratio? 

The ratio normally depends on multiple factors like investment, contribution, and other pre-defined norms.