Rohit Agarwal 9883248954
Chapter 6: Appropriation of Profits 1
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Partnership is the relation between two or more persons who have agreed to share the profits of the business4 carried on by all or any of t hem acting for all. The persons who have entered into a partnership with one another are individually called partners and collectively a firm. The name under which the business is carried on is called the firm name. The maximum number of partners in banking business is 10 and for other business is 20. Partnership Deed is a document which contains the terms of partnership as agreed among the partners. The deed is required to be duly stamped and duly signed by all the partners. Is it necessary to have a partnership deed? Is it necessary to have an agreement in writing? What are the contents of Partnership deed? In the absence of Partnership deed, the provisions of Indian Partnership Act,1932 applies: Profits & losses are to be shared equally. No interest on capital is to be allowed. No Interest on Drawings to be charged. No remuneration for to be allowed to any partner. Interest @ 6% p.a. is to be allowed on Loan & Advances by a partner. Proforma of Profit & Loss Appropriation Account st Profit & Loss Account for the year ended 31 March, 2009 Dr. Cr. Particu Particular larss Rs. Rs. Partic Particula ulars rs Rs. Rs. To Interest on Capital By Profit & Loss A/c A ** ( Net Net Profit ) ** B ** ** By Interest on Drawings To Salary to Partner – A ** A ** To Commission to Partner – B ** B ** ** To Reserve ** To Partner’s Capital A/c (Share of Profit) A ** B ** ** ** **
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Profit & Loss Appropriation Account is an extension of Profit & Loss Account. It is credited with Net Profit and interest on drawings. It is debited with interest on capital, salary and commission to the partners. Its balance is transferred to Partner’s account in their profit sharing ratio. It is prepared to show how the net profit has been distribut ed among the partners. The purpose for preparing the Profit & Loss Appropriation Account is: 1. To provide for interest on capital to partners. 2. To Provide for salary, commission and any other remuneration to partners. 3. To show the interest on drawings charged from the partners. 4. To distribute the profits among the partners in the profit sharing ratio. Profit & Loss Account Profit & Loss Appropriation Account. It ascertains the net profit. It distributes the net profit. It is made after the preparation of Trading It is made after the preparation of Profit & Loss Account. Account. This is prepared by all form of business. This is prepared by partnership firms & companies.
Interest on Drawings • •
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Why Interest on Drawing? To put an effective check on reckless drawing. When to Charge? Only when the partnership agreement provides for the same.
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Rohit Agarwal 9883248954 How to Charge? By passing the following entries: Partner’s Capital Account Dr. Interest on Drawing Account Dr. To Interest on Drawing Account. To Profit & Loss Appropriation A/c. How to Calculate? • Example 1: Calculate the interest on Drawings of Ram @ 10% p.a. for the year ended 31st December 2009: Case 1: If his drawings during during the year were were Rs.24,000; Case 2: If he withdrew Rs.2,000 p.m. in the beginnin g of every month; Case 3: If he withdrew Rs.2,000 p.m. in the end of every month; Case 4: If he withdrew Rs.2,000 p.m.; Case 5: If he withdrew the following amount as follows: Jan 31 Rs.6,000; Mar 31 Rs.4,000; July 1 Rs.8,000; Sept 30 Rs.3,000 & Nov 1 Rs. 5,000. Case 6: If he withdrew Rs.6,000 p.m. in the end of every quarter; •
Interest on Capital Why Interest on Capital? To compensate those partners who contribute capital in excess of what is required as per profit sharing ratio. When to Charge? Only when the partnership agreement provides and if there are profits. • Nature: Appropriation of profits, hence should be debited t o Profit & Loss Appropriation A/c. • How to Charge? By passing the following entries: • Interest on Capital Account. Dr. Profit & Loss Appropriation A/c Dr. To Partner’s Capital Account To Interest on Capital Account How to Calculate? • st Example 2: X and Y started business on 1 April 2008, with Capitals of Rs.5,00,000 & Rs.3,00,000 respectively. On 1st May, X introduced an additional capital of Rs.1,00,000 and Y Withdrew Rs.50,000 from his capital. On 1st October, Y introduced an additional capital of Rs.2,50,000 and X Withdrew Rs.2,00,000 from his capital. X has also made drawings of Rs. 2,000 p.m. for household expenditure. Calculate Interest on Capital for the year ending 31st March 2009 @ 6% p.a. •
Drawings against Profit Capital is not reduced. It is not considere considered d to calculate calculate of interest interest on capital. capital. It is debited in drawings account.
Drawings against Capital
Capital is reduced. It is considered considered in calculati calculation on of interest interest on capital. capital. It is debited in capital account.
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Example 3: After the closure of the books on 31 March 2009, the Capital Accounts of X, Y & Z showed a balance of Rs.1,00,000, Rs.1,20,000 & Rs.1,80,000 respectively. However it was later discovered that interest on capital @ 6% p.a. had not been taken into consideration while distributing the profits for the year. Their profit sharing ratio was 5:3:2. The profits for the year was Rs.1,20,000. Calculate Interest on Capital. Case Rate as per deed Profits (Rs.) 1 Silent 1500 Example 4: The profit sharing ratio of X & Y is 2:3 with 6% p.a. -1500 capitals of Rs.20,000 & Rs.10,000 respectively. Calculate 2 3 6% p.a. 2100 Interest on Capital in the foll owing Cases: 4 6% p.a. 1500
Interest on Partner’s Loan to the Firm. • • •
At what Rate? As per agreement or 6% p.a. if no agreement. Nature : Charge against profits, hence should be debited to Profit & Loss A/c. How to Charge? By passing the following entries: Interest on Partner’s Loan Account. Dr. Profit & Loss A/c Dr. To Partner’s Loan Account To Interest on Partner Loan A/c
Salary or Commission to Partner • • •
When to Charge? Only when the partnership agreement provides for the same. Nature : Appropriation of profits, hence should be debited to Profit & Loss Appropriation A/c. How to Charge? By passing the following entries:
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Rohit Agarwal 9883248954 Salary or Commission Account. Dr. To Partner’s Capital Account How to Calculate? On Net Profit before charging such Commission Net Profit X Rate of Commission / 100
Profit & Loss Appropriation A/c Dr. To Salary or Commission A/c.
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On Net Profit after charging such Commission Net Profit X Rate of Commission / (100 + Rate)
Partners’ Capital Accounts There are two methods by which the capital accounts of p artners can be maintained. These are: Fluctuating Capital method Fixed Capital method. •
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Fluctuating Capital method: Under the fluctuating capital method, only one account, viz., the capital account for each partner, is maintained. It records all adjustments relating to drawings, interest on capital, interest on drawings, salary and share of profit or loss in the capital account itself. As a result, the balance in the capital accounts keeps on fluctuating. Partners' Capital Account A B C A B C Particulars Particulars Rs. Rs. Rs. Rs. Rs. Rs. To Balance b/f By Balance b/f To Bank A/c By Bank A/c (Withdrawal of Capital) (Additional Capital) To Drawings By Interest on Capital To Interest on Drawings By Salary To Profit & Loss A/c By Commission (Share of Loss) To Profit & Loss Appro A/c (Share of Profit) To Balance c/d By Balance c/d
Fixed Capital Method: Under this method, two accounts are maintained for each partner viz., (i) Capital account and (ii) Current account. The capital account will continue to show the same balance from year to year unless some amount of capital is introduced or withdrawn. Partners' Capital Account A B C A B C Particulars Particulars Rs. Rs. Rs. Rs. Rs. Rs. To Bank A/c By Balance b/f (Withdrawal of Capital) By Bank A/c To Balance c/d (Additional Capital)
In the current account, the transactions relating to drawings, interest on capital, interest on drawings, salary, share of profit or loss etc., are recorded. Hence, the balance changes every year. Partners' Current Account A B C A B C Particulars Particulars Rs. Rs. Rs. Rs. Rs. Rs. To Balance b/f By Balance b/f To Bank (Drawings) By Interest on Capital To Interest on Drawings By Salary By Commission To Profit & Loss A/c (Share of Loss) To Profit & Loss Appro A/c To Balance c/d (Share of Profit) By Balance c/d
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Rohit Agarwal 9883248954 Capital account It is prepared under both the methods. It always shows a credit balance. Basis of distinction 1. Change in capital 2. Number of Accounts
Current Account It is prepared only under Fixed Capital method. It shows either a debit balance or a credit balance.
Fixed Capital Method
Fluctuating Capital Method
The capital normally remains unchanged The capital is changing from period to except under special circumstances. period. Each partner has two accounts, namely, Each partner has only one account i.e., Capital Account and Current Account. Capital Account. Capital Account shows always a credit Capital Account may show a debit 3. Balance balance. balance. All adjustments relating to partners are All adjustments relating to partners partners are 4.Adjustments recorded in the Current Accounts. recorded directly in the Capital Accounts. Drawings Account It is prepared under both the methods. It always shows a debit balance. •
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Current Account It is prepared only under Fixed Capital method. It shows either a debit balance or a credit balance.
Guaranteed Partnership: When the share of profits of a newly admitted partner is guaranteed at a certain minimum, it is known as guaranteed partnership. Such guarantee is given by one or more of the existing partners. Rent paid to Partner: Rent paid to partner for use of his premises is an expense for the firm and hence should be charged against profit. Such expense should be debited to Profit & Loss Account and credited to the concerned partner’s capital or current account. Goodwill: It refers to the value of the reputation of the firm in respect of the extra earning power of the firm over other similar firms, belonging to the same industry.
Methods of Valuation of Goodwill:
1. Average Profit method a) Simple Average Profit method Step 1: Calculate normal profits of each year by adding abnormal losses, deducting abnormal gains and income from non trade investments. Step 2: Calculate Total Profits. Step 3: Calculate Average Profit (Average Profit Profit = Total Profits / No. of years) Step 4: Calculate Goodwill. (Goodwill = Average Profit X No. of years’ purchase) b) Weighted Average Profit method Step 1: Prepare a statement in following way: Years Profit X
Weights
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Weighted Profit
Step 2: Calculate the total of weights and the total of weighted profits. Step 3: Calculate Weighted Average Average Profit (WAP (WAP = ∑ Weighted Profit / ∑ Weights) Step 4: Calculate Goodwill. (Goodwill = WAP X No. of years’ purchase) 2. Super profit Method Step 1: Calculate Capital employed (Capital employed = Assets less Liabilities) Step 2: Calculate Normal Profit (Normal Profit = Capital employed X Normal Rate of Return) Step 3: Calculate Average profit (As discussed earlier) Step 4: Calculate Super Profit (Super Profit = Average profit - Normal Profit) Step 5: Calculate Goodwill. (Goodwill = Super Profit X No. of years’ purchase)
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