A partnership is a type of business organization. Partnership firms are governed by The Indian Partnership Act, 1932. A partnership is formed when two or more people start a business and divide profits in an agreed ratio. The profit-sharing ratio of a firm is mentioned in the partnership deed of a firm. If the partnership deed is silent then the distribution of profit and losses is considered to be equal among all the partners. When the existing partners of the company decide to bring a change in profit sharing ratio of the partnership firm then the old partnership deed comes to an end and a new deed is enforced with the necessary changes.

Partnership Deed

A partnership deed is a permissible document containing all the necessary terms and conditions which are to be followed in a partnership firm. A partnership deed contains the following:

  1. Purpose of Partnership
  2. Principal place of business of the partnership
  3. Partnership duration
  4. Account details
  5. Duties of a partner
  6. Interest on Capital to be received
  7. Interest on Drawings to be received
  8. Rules for admission of a new partner
  9. Treatment of Profit and Loss Appropriation Account

Interest on Capital

A partnership business is a separate legal entity. The business and the partners are two different entities so when the partners invest money to start a partnership business, they are to be paid some interest on that capital. This is known as interest on Capital. Interest on capital is an expense for the firm. The formula to calculate internet of capital is:

Amount of capital × Period of Interest × Rate of interest per annum = Interest on Capital

There are different ways to treat partners’ capital and they are:

  • When the partnership deed does not contain any information about interest on capital then interest on capital is not allowed.
  • When the partnership deed does not specify whether the interest on capital is a charge or an appropriation then interest on Capital is only allowed if there is profit and is accounted as appropriation of profit.

Accounting Treatment of Interest on Capital

  • Interest on capital is credited to the Partner’s capital account.
  • Interest on capital is debited to the Profit and Loss Appropriation account.

Interest on Drawings

A partnership business is a separate legal entity. The business and the partners are two different entities so when the partners withdraw money from the business, they at regular intervals have to pay interest to the firm for it. This is known as Interest on Drawings. Interest on Drawings is an income for the firm. There are three methods to calculate Interest on Drawings:

Direct Method 

Amount of drawings x Rate of interest x Period of interest = Interest on Drawings

Product Method 

Sum of products x Rate of interest per annum × 1/12 = Interest on Drawings

Average Period Method 

  • Number of months from the date of first withdrawal to the end of the year + Number of months from the date of last withdrawal to the end of the year / 12 = Average period
  • Total number of drawings made during the year × Rate of interest per annum × Average period/12 = Interest on Drawings

Accounting treatment for Interest on Drawings

  • Interest on Drawings is debited to the Capital account.
  • Interest on capital is credited to the Profit and Loss Appropriation account.

Salary and Commission to Partners

If there is a provision regarding the payment of remuneration to the partners then it is paid in terms of salary and commission. This is the payment that a partner receives in exchange for all the work he has done for the firm.

Profit and Loss Appropriation Account

This account is made after all the adjustments relating to the Interest of Capital, Interest on Drawings, Loan to Partners, salary to partners, etc is done. This is a nominal account in which all the accumulated profits and losses are distributed amongst the partners of the company. Profit and Loss Appropriation account is made to specify how the profits from the profit and loss account are spent. It is an addition to the profit and loss account which only records the partner’s claims.

Accounting treatment for Profit and Loss Appropriation Account

  • Net Loss transferred from Profit and Loss account is debited
  • Salary to Partners is debited
  • Commission to Partners is debited
  • Interest on Capital is debited
  • Transfer of profit to Reserves is debited
  • Dividend payments are debited
  • Interest on Drawings is credited
  • Money withdrawn from the general reserve is credited
  • Net Profit from Profit and Loss account is credited

Conclusion

A partnership is formed when two or more people start a business and divide profits in an agreed ratio. The profit-sharing ratio of a firm is mentioned in the partnership deed of a firm. If the partnership deed is silent then the distribution of profit and losses is considered to be equal among all the partners. Profit and Loss Appropriation account is made after all the adjustments relating to the Interest of Capital, Interest on Drawings, Loan to Partners, salary to partners, etc is done. It is an addition to the profit and loss account which only records the partner’s claims.