Consider a partnership if the number of people involved is small [up to about 20] and limited liability is not necessary.
Advantages of a partnership include that:
- two heads [or more] are better than one
- your business is easy to establish and start-up costs are low
- more capital is available for the business
- you’ll have greater borrowing capacity
- high-calibre employees can be made partners
- there is opportunity for income splitting, an advantage of particular importance due to resultant tax savings
- partners’ business affairs are private
- there is limited external regulation
- it’s easy to change your legal structure later if circumstances change.
Disadvantages of a partnership include that:
- the liability of the partners for the debts of the business is unlimited
- each partner is ‘jointly and severally’ liable for the partnership’s debts; that is, each partner is liable for their share of the partnership debts as well as being liable for all the debts
- there is a risk of disagreements and friction among partners and management
- each partner is an agent of the partnership and is liable for actions by other partners
- if partners join or leave, you will probably have to value all the partnership assets and this can be costly.
To end or dissolve a partnership in Tasmania we recommend seeking legal advice regarding what is required.
The income statement of a sole proprietorship and a regular corporation reports their revenues, expenses, gains, losses, and net income. However, there are two noteworthy differences: Neither income statement reports distributions of profits to the owners. Assume that both a sole proprietorship and a regular corporation had revenues and gains of $350,000 and expenses and losses of $200,000 [not counting any compensation for the owner]. In addition, the stockholder working in the corporation earns a salary of $80,000. The owner of the sole proprietor works as hard, but instead of a salary, draws $80,000 for personal use. The regular corporation pays a $10,000 cash dividend and its income tax rate is 15%. The income statement of the sole proprietorship will report net income of $160,000 [$360,000 - $200,000]. The corporation's income statement will report net before income tax of $80,000 [$360,000 - $280,000] and net income after tax of $68,000 [$80,000 - $12,000]. As a result of these two differences, the net income [which is the bottom line of the income statements] will be different. In the case of the sole proprietorship, the net income is the total amount that the owner has earned before income taxes for 1] the capital invested in the business and 2] the owner's compensation for working in the business. In the case of a regular corporation owned by one person, the owner has earned the salary [which was included in salary expense on the income statement] and has also earned the reported amount of net income or net loss. Neither the draws made by the sole proprietor nor the dividends distributed by a regular corporation are reported on the income statement.
Examples of Income Statements of Sole Proprietorship and Regular Corporation
Free Financial Statements Cheat Sheet
This article concentrates on the preparation of partnership financial statements.
There are no material differences between UK and international practice in partnership accounts apart from minor variations in terminology and format. This article uses international terminology. For students taking the UK paper the conversion is:
International term UK equivalent
Income statement Profit and loss account
Statement of division of profit Appropriation account
Differences between sole traders' accounts and partnership accounts
If you can handle the financial statements of sole traders, with adjustments for accruals, prepayments, depreciation and the like, it is an easy matter to add the requirements for partnership accounts. The differences are:
1. Balance sheet
[a] There is a separate capital account for each partner instead of just the one required for a sole trader
[b] We often maintain a separate current account for each partner, recording drawings and profit shares. If this is done, the capital account is only used for 'capital' transactions such as the introduction of extra long-term capital by partners.
2.Income statement – the division of the net profit among the partners has to be shown. There are several possibilities:
[a] profit is shared in agreed proportions [b] as [a], but partners are credited with a 'salary' to allow for the work they put into the partnership [c] as [a] or [b], but partners are credited with 'interest on capital' to allow for differences in the amounts of fixed capital partners have contributed.It is important to note that partners' salaries and interest on capital are not charges in the main part of the Income statement. They are simply part of the process of dividing up the profit among the partners. The division is shown in the statement of division of profit. This may be presented in a tabular format as shown in the next section.
Preparing partnership financial statements
Income statement
The main part of the income statement is prepared exactly as for a sole trader.
Points to watch:
[a] Do not put partners' salaries or interest on capital into the main income statement. They belong only in the division of profit statement section.
[b] Do not include drawings anywhere in the income statement or statement of division of profit. Drawings are debited to partners' current accounts.
Statement of division of profit
The easiest format to adopt here is a simple columnar presentation. See Figure 1 below [figures invented]. Points to watch:
[a] One partner may guarantee that another partner's total profit share is not less than a certain minimum amount. To deal with this, make a transfer from one column to another in the tabulated statement. [b] Changes to the profit-sharing arrangements or changes in partnership personnel part way through the year. You have to divide the profit on a time basis between the periods, then apply the details given to the apportioned profits. Remember to take half a year's salary for a half-year period. Your table then shows the total profit shares for the year calculated for the two periods involved.
[c] Change in partnership personnel part way through the year, with an agreement that certain expenses charged in the income statement relate to one part of the year only. This is a variation on [b] above and always causes problems for candidates. What you have to realise is that for the partners not bearing the expense, the profit is that shown by the income statement plus the special expense. You have to split that increased profit among the partners, then deduct the special expense from the partners who are to bear it.
| A | B | C | Total | |
| $ | $ | $ | $ | |
| Salaries | 20,000 | 15,000 | - | 35,000 |
| Interest on capital | 4,000 | 3,000 | 2,000 | 9,000 |
| Share of balance 3:2:1 | 90,000 | 60,000 | 30,000 | 180,000 |
| 114,000 | 78,000 | 32,000 | 224,000 |
P, after having been a sole trader for some years, entered into partnership with Q on 1 July 20X2, sharing profits equally. The business profit for the year ended 31 December 20X2 was $340,000, accruing evenly over the year apart from a charge of $20,000 for a bad debt relating to trading before 1 July 20X2, which it was agreed P should bear entirely.
| P | Q | |
| $000 | $000 | |
| A | 245 | 95 |
| B | 250 | 90 |
| C | 270 | 90 |
| D | 255 | 85 |
Decide what you think the answer should be, and then read on.
Discussion
A little clear thinking is required. The profit excluding the $20,000 is to be used, then $20,000 deducted from P's share.Thus we have:
| P | Q | |
| $000 | $000 | |
| 6 months to 30 June 20X2 | 180 | |
| 6 months to 31 December 20X2 | 90 | 90 |
| 270 | 90 | |
| less: bad debt | 20 | |
| 250 | 90 |
The answer is B. If you didn't get it right, re-read note [c].
d the question states that there is no partnership agreement and tells you nothing about profit shares. In this case, assume the following [Partnership Act 1890 provisions]:
[i] no partnership salaries [ii] no interest on capital [iii] profit shared equally among the partners but [iv] if any partner has loaned money to the partnership [as opposed to introducing capital], the loan carries interest at 5 per cent per year, charged in the income statement. Questions rarely bring in this point, because it makes the question easier. [e] Interest on drawings – partners sometimes agree that interest should be charged on drawings made. In reality, partners will agree the amount of drawings the business can stand rather than charge interest. If the point should come up, calculate the total interest due from all partners and add that to the net profit in the statement of division of profit. Then deduct each partner's interest charge from the individual shares at the end of the statement.
Balance sheet
Each partner has to have a capital account and, probably, a current account in the balance sheet. The easiest way to present these is to use columns. See Figure 2 [figures invented].
Figure 2
| Capital accounts | ||||
| A | B | C | ||
| $ | $ | $ | ||
| Balance at 1 January | 40,000 | 30,000 | 20,000 | |
| Capital introduced | 20,000 | 10,000 | ---- | |
| Balance at 31 December | 60,000 | 40,000 | 20,000 | 120,000 |
| A | B | C | ||
| $ | $ | $ | ||
| Balance at 1 January | 14,800 | 16,100 | 12,400 | |
| Profit share [the total from the division of profit statement] | 68,000 | 49,000 | 46,000 | |
| 82,800 | 65,100 | 58,400 | ||
| Drawings | 70,000 | 60,000 | 60,000 | |
| Balance at 31 December | 12,800 | 5,100 | [1,600] | 16,300 |
If a partner has a debit balance, as does C here, it is easy to include it in the tabulation as shown. There is no need to complicate matters by putting C's account on the assets side of the balance sheet.
A practice question
Here is a practice question to test your understanding. Try to complete it for yourself, then take a look at the discussion and answer below.
Alamute and Brador have been in partnership for several years, compiling their financial statements for the year ended 31 March and sharing profits in the ratio 60:40 after allowing for interest on capital account balances at 5 per cent per year. Extracts from their trial balance at 31 March 20X3 are given in Figure 3.
| Reference to notes | $ | ||
| Capital accounts: | Alamute | 50,000 | |
| Brador | 50,000 | ||
| Current accounts | Alamute | 3,800 credit | |
| Brador | 2,600 debit | ||
| Drawings: | Alamute | 48,400 | |
| Brador | 36,900 | ||
| Office equipment | Cost | 1 | 48,300 |
| Accumulated depreciation, 1 April 20X2 | 12,800 | ||
| Inventory, 1 April 20X2 | 2 | 16,600 | |
| Trade receivables | 3 | 68,400 | |
| Allowances for receivables, 1 April 20X2 | 3 | 3,800 | |
| Sales revenue | 448,700 | ||
| Purchases | 184,600 | ||
| Rent paid | 4 | 30,000 | |
| Salaries | 88,000 | ||
| Insurance | 5 | 4,000 | |
| Sundry expenses | 39,400 |
Notes to Figure 3
- Office equipment should be depreciated at 20% per year on the reducing balance basis.
- Closing inventory amounted to $21,400.
- Debts of $2,400 are to be written off, and the allowance for receivables is to be adjusted to 5% of trade receivables.
- Rent paid of $30,000 is the amount for the nine months to 31 December 20X2. From that date the rent was increased by 10%.
- Insurance paid in advance amounted to $1,500
Required:
[a] Prepare the partnership's trading and income statement and statement of division of profit for the year ended 31 March 20X3 [9 marks] b. Write up the partners' current accounts for the year ended 31 March 20X3
[3 marks] [12 marks in total].
- Discussion
This is quite a simple question, but care is needed on several points: - The drawings figures are given. They go into the current accounts and do not appear in theincome statement or statement of division of profit.
Note 3 gives details of receivables. The charge in the income statement is:
| $ | $ | |
| Debts written off | 2,400 | |
| Movement in allowance | ||
| Original allowance | 3,800 | |
| New allowance required 5% x [68,400 - 2,400 | 3,300 | [500] |
| 1,900 |
3. Note 4 explains the rent. $30,000 is the cost for nine months. That means $10,000 per quarter. The fourth quarter must therefore be $11,000, giving a total of $41,000.
| a Alumute and Brador | |||
| Income statement for the year ended 31 March 20X3 | $ | $ | |
| Sales revenue | 448,700 | ||
| Cost of sales: | opening inventory | 15,600 | |
| purchases | 184,600 200,200 | ||
| less: closing inventory | 21,400 | [178,800] | |
| Gross profit | 269,900 | ||
| Less: | expenses salaries | 88,000 | |
| rent [30,000 + 11,000] | 41,000 | ||
| insurance | 2,500 | ||
| sundry expenses | 39,400 | ||
| depreciation [35,500 x 20%] | 7,100 | ||
| receivables expense [2,400 - 500] | 1,900 | ||
| --- | [179,900] | ||
| Net profit | 90,000 |
| Statement of division of profit | ||||||
| Alamute | Brador | Total | ||||
| $ | $ | $ | ||||
| Net profit | 90,000 | |||||
| Interest on capital | 2,500 | 2,500 | [5,000] | |||
| 85,000 | ||||||
| Balance of profit 60:40 | 51,000 | 34,000 | [85,000] | |||
| 53,500 | 36,500 | -- | ||||
| b current accounts | ||||||
| Alamute | Brador | Alamute | Brador | |||
| $ | $ | $ | $ | |||
| Balance | -- | 2,600 | Balance | 3,800 | -- | |
| Drawings | 48,400 | 36,900 | Share of profit | 53,500 | 36,500 | |
| Balance | 8,900 | -- | Balance | -- | 3,000 | |
| 57,300 | 39,500 | 57,300 | 39,500 |