BAFS Study Notes: Accounting for Partnership
Hey everyone! Ever wondered what happens when friends, like the founders of Apple or Google, start a business together? That's a partnership! It's a super common way to run a business, sharing the risks, the work, and of course, the profits.
In this chapter, we're going to dive into the special accounting rules for partnerships. It's a bit different from a sole proprietorship because now we have to figure out how to share everything fairly between the partners. Don't worry, we'll break it all down with simple examples. Let's get started!
1. The Basics of a Partnership
What makes a partnership special?
A partnership is a business owned by two or more people. The biggest difference in accounting is that we need a clear and fair way to show how profits, losses, and the owners' money are divided among the partners.
The Partnership Agreement: The 'Rulebook'
Imagine playing a game without any rules – it would be chaos! A Partnership Agreement (or Partnership Deed) is the official rulebook for the partners. It sets out important details like:
- How profits and losses will be shared (the Profit-Sharing Ratio or PSR).
- Whether partners will get a salary for their work.
- If partners will earn interest on the money they invested (Interest on Capital).
- If partners will be charged interest on money they take out (Interest on Drawings).
What if there's no agreement? The Hong Kong Partnership Ordinance says that profits and losses are shared equally, and there are no salaries or interest on capital/drawings. That's why having an agreement is so important!
General vs. Limited Partners
This is a key concept! Not all partners are the same.
- General Partners: These partners are involved in the daily management of the business and have unlimited liability. This is a bit scary – it means if the business fails, they could lose their personal assets (like their car or home) to pay off business debts.
- Limited Partners: These partners are more like passive investors. They contribute capital but don't manage the business. The good news for them is they have limited liability. This means the most they can lose is the amount they invested in the business. Their personal assets are safe!
Key Takeaway
Partnerships need special accounting to divide profits fairly. The Partnership Agreement is the most important document, and partners can have either unlimited liability (general) or limited liability (limited).
2. Sharing Profits & Losses: The Appropriation Account
Why not just use a normal Income Statement?
A normal Income Statement finds the total Net Profit for the business. But in a partnership, we need an extra step to show how that profit is distributed or appropriated among the partners according to their 'rulebook'.
Analogy: Think of the Net Profit as a big pizza. The Appropriation Account is the plan for how you're going to slice it up. Some partners might get a special slice (a salary), some might get a bonus topping (interest on capital), and then everyone shares the rest of the pizza.
The Ingredients of the Appropriation Account
Here are the common items you'll see:
- Interest on Capital: A 'reward' paid to partners for keeping their money invested in the business. It's treated as an expense of the partnership.
- Partner's Salary: A payment to a partner for doing extra work or managing the business.
- Interest on Drawings: A 'penalty' charged to partners for withdrawing money during the year. It's income for the partnership, as it increases the profit available to share.
- Share of Residual Profit/Loss: This is the leftover profit (or loss) after all the salaries and interest have been dealt with. It's shared among partners according to their Profit-Sharing Ratio (PSR).
Step-by-Step: Preparing the Appropriation Account
It's just like a recipe! Follow these steps.
- Start with the Net Profit for the year (from the Income Statement).
- Add any Interest on Drawings. (This increases the 'pizza' size).
- Subtract any Interest on Capital.
- Subtract any Partner's Salaries.
- The result is the Residual Profit.
- Divide this residual profit among the partners using their PSR.
Example Format: Appropriation Account
Appropriation Account for the year ended 31 December 20X1
Net Profit
Add: Interest on Drawings:
Partner A
Partner B
Less: Interest on Capital:
Partner A
Partner B
Less: Partner's Salary:
Partner A
Residual Profit to be shared
Share of Profit:
Partner A (e.g., 1/2)
Partner B (e.g., 1/2)
Key Takeaway
The Appropriation Account is a special financial statement for partnerships. It starts with the Net Profit and shows how it's distributed among partners as interest, salaries, and a final share of profit, all based on the Partnership Agreement.
3. Tracking Partner's Money: Capital and Current Accounts
In a partnership, we need to track what each partner is owed. We usually do this with two separate accounts for each partner. Don't worry, it's simpler than it sounds!
The Two-Account System: Fixed Capital Accounts
Analogy: Think of your own money. You might have a Savings Account you rarely touch (for long-term savings) and a Current Account for daily spending.
- Capital Account (The 'Savings Account'): This holds the partner's long-term, stable investment. It only changes if a partner permanently invests more money or withdraws capital. It's usually a fixed amount.
- Current Account (The 'Daily Account'): This account is much more active! It tracks all the day-to-day changes in what the partner is owed. It's where we record their share of profits, salaries, and interest, as well as the money they've taken out (drawings).
What goes into the Current Account?
This account shows the fluctuations in a partner's stake.
Things that INCREASE the partner's balance (Credit entries):
- Interest on Capital
- Partner's Salary
- Share of Profit
Things that DECREASE the partner's balance (Debit entries):
- Drawings (money taken out for personal use)
- Interest on Drawings
- Share of Loss (if the business made a loss)
Quick Review: Where does it go?
Goes into Capital Account:
- Initial investment of capital.
- Any additional PERMANENT capital introduced.
Goes into Current Account:
- Salaries, Interest on Capital, Share of Profits (+)
- Drawings, Interest on Drawings, Share of Loss (-)
Key Takeaway
We use two accounts to track each partner's stake. The Capital Account is for the fixed, long-term investment. The Current Account is for all the fluctuating, day-to-day items like profits, salaries, and drawings.
4. When The Partnership Changes: Goodwill
Businesses grow and change. A new partner might join, a partner might retire, or they might just decide to share profits differently. When this happens, we have to deal with something called Goodwill.
What on earth is Goodwill?
Goodwill is an intangible asset. You can't touch it, but it has real value. It's the value of a business's good reputation, its loyal customers, its brand name, and its prime location.
Analogy: Imagine two cafes. One is a brand new, unknown cafe. The other is a famous cafe that everyone in town loves. The famous cafe is worth more than just its tables and coffee machines – it has the extra value of its reputation. That extra value is its goodwill.
What affects the value of Goodwill?
- Strong brand name and reputation
- Good relationship with customers
- Skilled employees
- Good location
Accounting for Goodwill during Partnership Changes
When a partnership changes, the partners who built up the goodwill deserve to be recognised for it. The accounting treatment for goodwill ensures fairness.
Example: A new partner joins. It's not fair for them to immediately get the benefit of the reputation the old partners spent years building. So, the old partners' capital is adjusted to reflect the value of the goodwill they created.
HKDSE EXAM ALERT!
According to the syllabus, you only need to define goodwill and understand how to prepare the accounting entries for it. You are NOT required to calculate the value of goodwill – this value will always be given to you in the question!
Key Takeaway
Goodwill is the value of a firm's reputation. When a partnership's structure changes, we must make adjustments to the partners' Capital Accounts to fairly account for the goodwill that has been built up.
5. Scenarios: Changes in a Partnership
Let's look at the three main ways a partnership can change. The logic for adjusting goodwill is the same in all cases, we just apply it to different situations.
Super Important Note: The HKDSE syllabus says that revaluation of non-current assets is NOT required. We will only focus on the adjustments to Capital Accounts for goodwill.
Scenario 1: Change in Profit-Sharing Ratio (PSR)
Why it happens: Maybe one partner decides to work more hours, or another partner takes a step back. The partners agree to share future profits differently.
The Adjustment: The partner(s) whose share is decreasing are "selling" a part of their interest in the firm's goodwill to the partner(s) whose share is increasing. We adjust their capital accounts to reflect this.
Scenario 2: Admission of a New Partner
Why it happens: The business needs more money (capital) or a new partner with special skills.
The Adjustments:
- The new partner contributes cash/assets as their capital.
- Goodwill is adjusted. The old partners, who created the goodwill, will have their capital accounts credited. All partners (including the new one) will then have the goodwill written off against their capital accounts in the new PSR. The net effect is that the new partner 'buys' their share of the goodwill from the old partners.
Step-by-Step Example (Admission):
A and B share profits 1:1. Their Capital accounts are $50,000 each. They admit C for a 1/3 share. The new PSR is 1:1:1. Goodwill is valued at $30,000. C brings in $60,000 capital.
Step 1: Record C's Capital Contribution
Dr Bank $60,000
Cr Capital: C $60,000
Step 2: Adjust for Goodwill
First, raise goodwill for the old partners in the OLD ratio (1:1):
Dr Goodwill $30,000
Cr Capital: A $15,000
Cr Capital: B $15,000
Then, write off goodwill for ALL partners in the NEW ratio (1:1:1):
Dr Capital: A $10,000
Dr Capital: B $10,000
Dr Capital: C $10,000
Cr Goodwill $30,000
Net Effect: A's capital increased by $5,000. B's capital increased by $5,000. C's capital decreased by $10,000. C has effectively paid A and B for her share of the goodwill!
Scenario 3: Retirement of a Partner
Why it happens: A partner wants to leave the business, perhaps due to old age or a career change.
The Adjustments:
- Goodwill is adjusted to give the retiring partner their share of the firm's reputation that they helped build.
- We calculate the final total amount owed to the retiring partner (their Capital account balance + their Current account balance).
- This amount is either paid to them in cash (Cr Bank) or, more commonly, it is transferred to a Loan from Retiring Partner account, which the business will pay off over time.
FINAL SYLLABUS ALERT!
You need to know how to handle the 3 scenarios above. You are NOT required to prepare entries for the dissolution of a partnership (when the entire business closes down for good).
Key Takeaway
When a partnership changes (PSR change, admission, retirement), the key accounting step is to adjust for goodwill through the partners' Capital Accounts to ensure fairness for everyone involved.