Chapter 9: Financial statements of a partnership

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 Business Accounting

2. 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 Act1890 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 Business Accounting

3. 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) Business Accounting

4. 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 Business Accounting

5. 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 appropriationaccount • 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 Business Accounting

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 … Business Accounting

7. Hearth & HomeProfit and loss account for the year ending 31 December 2005 Business Accounting

8. Exercise 1 Hearth & HomeProfit 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 Business Accounting

9. Exercise 1 Hearth & HomeTrial balance at 31 December 2005 Business Accounting

10. Pro forma Hearth & Home Profit and loss appropriation account Business Accounting

11. Solution 1 Hearth & Home Profit and loss appropriation account Business Accounting

12. Capital accounts and current accounts • In a double-entry bookkeeping system, the bookkeeper/accountant opens a capitalaccount 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 Business Accounting

13. Example Hearth & Home Current accounts Business Accounting

14. Exercise 2 Hearth & HomeBalance 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 Business Accounting

15. Exercise 2 Hearth & HomeTrial balance at 31 December 2005 Business Accounting

16. Pro forma Hearth & Home Balance sheet Business Accounting

17. Solution 2 Hearth & Home Balance sheet Business Accounting

18. 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 Business Accounting

19. 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 Business Accounting

20. 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 Business Accounting