APPROPRIATION OF PROFITS

According to section 4 of the Partnership Act, 1932 a Partnership is “the relation between persons
who have agreed to share the profits of a business carried on by all or any one of them acting for all.”
If we analyse the definition we find three basic element of a Partnership :

(1) It arises out of an agreement made by two or more persons;

(2) The agreement is made regarding sharing profits of a business;

(3) Such business is carried on by all or any one of them acting for all.

(a) Partnership is the result of an agreement. It does not arise from status.

(b) The agreement may be either verbal or in writing. There should be some terms and conditions
binding the Partnership.

(c) The existing law does not enforce that the terms of the Partnership must be in writing. If written,
the agreement is known as Deed or Articles of Partnership.

(d) For the formation of a Partnership more than one person is requires. For a banking business the
maximum number of Partners is 10, in other businesses it is 20.

Partnership Deed

Mode of Appropriation : Among other details the deed contains the mode of appropriation of profits
(or losses) specially regarding interest on partners capitals, salary or commission, etc. payable to
partners and the profit-sharing ratio.

In the absence of deed the following guidelines should be followed :

1. Every Partner should share profits equally [Section 13 (b)].

2. No interest is to be allowed on Partners’ capitals [Section 13 (c)].

3. No interest should be charged on the drawings of the Partners.

4. No salary is to be allowed to any partner.

5. Interest on advances made by partners should be provided @ 6% per annum. [Section 13(d)].

6. Every partner should be to have equal share in the property of the Partnership as per Section 14
Some Important Considerations Partners’ Capitals

(a) Where the Partners decide and the agreement provides, the Capitals Accounts of the Partners
remain unchanged over years. In that case the Capital Accounts show the original amounts invested
by the Partners as capitals unless some change (like change in capital Ratio etc.) takes place. The
Capitals are called Fixed Capitals.

Partners’ Current Accounts are opened and used for recording subsequent transactions between the
Partner and the firm for salary/commission to Partners, Interest on Partners Capitals, their drawings
and interests on drawings, share of profit/loss and interest on loans/advances given by Partners to
the firm. Where Capitals are Fixed, Current Accounts serve as the appendix.

(b) Where there is no agreement to keep Capitals fixed over years, entries1 regarding Partners’
drawings, Salary/Commission/Interest on Capital and share profit/loss are recorded through the
Partners’ Capital Accounts. As a result, the Capitals undergo changes from period to period and are
called Fluctuating Capitals.

(c) If any Partner gives any amount as Loan or Advance to the firm separately, Partners Loan Accounts
are opened and maintained. Interest on Loan may be transferred to Loan Account or to Current
Account (if any).

(d) A separate Drawings Account may be maintained to record withdrawals made by the partners from
the firm. On the closing date of a financial period, the balance of the Drawings Account is transferred
to Capital Account or to Current Account (if capitals are fixed).

One must remember also that,

(i) A Capital represents a liability. The balances of fixed capitals should always be credit balances.

The balances of Current Accounts may be credit balances or debit balances (Where a partners’
drawings exceed his share of profits/interests etc).

(ii) The balances of Fluctuating capital may be credit or debit balances.

(iii) Capitals of partners may not be as per their profit sharing ratio.

(iv) A partner may contribute his capitals in cash and also in the form of any other asset including
goodwill. If he brings in any liability his Capital = Assets brought in – Liabilities brought in = Net Assets
brought in.
Appropriation of Profits

Partners become entitled to receive Salary/Commission/Interests/Share of Profit, etc., and also to be

charged with Interest on Drawings/Share of loss, etc. especially by virtue of their becoming partners.
So at the time of preparing the final accounts of a partnership business, the net profit before making
adjustments for the above items is found out. These adjustments are made through the Profit & Loss
Appropriation Account. This Account may be separately opened or may be shown as the concluding
part of the Profit & Loss Account itself. In any case it shows special entitlements of partners and
distribution of profit or loss among them. But before going through illustrations, a student is advised
to note the following:

(a) Interest on Capital: If the Partnership Deed says, provide it at the prescribed rate. If nothing is
stated, do not provide it. If Partnership Deed provides for charging full amount of interest
irrespective of profit/loss, P/L Appr. A/c may show loss. Please remember that as per Section 13(c) of
the Partnership Act, Interest on Capitals should be provided only up to the amount of available
profits where such profits are inadequate to cover up the payment of full amount of interest on
capital. Interest on Capital should be calculated on time basis. Dates of further capital investment or
withdrawal of capitals should be given effect. For interests on Capital, P/L Appr. A/c is debited and
Partners’ Capital or Current Accounts are credited.

(b) Interest on Drawings: Where the partners withdraw, money from the business in anticipation of
profits and the Partnership Deed provides, Interest on Drawings is charged at a fixed rate (of
percentage) from the date of drawings to the closing date of the financial period. Such interest is
credited to P/L Appr. A/c and debited to Partners’ Capital/Current Account. Latter we discuss detail
about the Interest on Drawings.

Calculation of Interest on Drawings

1. If the date of drawings is mentioned, then calculate interest according to the time.

2. If the date of drawings is not mentioned, then calculate interest on the average of the time

period. i.e. if the accounting period is for one-year, then interest for 6 months, and so on.

3. If unequal amounts are drawn at irregular intervals :

Illustration 4 Accounting Period : January – December. Interest @ 12% p.a

Interest = Product × Rate of Interest × 1/12

= 2,50,000 × 12/100 X 1/12 = 2,500

4. If equal amounts are drawn at a fixed date every month, throughout the accounting period :

(a) Drawn at the beginning of every month

(b) Drawn at the middle of every month

(c) Drawn at the end of every month

Interest = Amount Drawn p.m × Rate of Interest × Time

Again, the Accounting Period may be for 12 months; 6 months; 3 months or etc

“How to calculate the time?”

If the Accounting Period is for 12 months : (January – December)

Note : It is a general tendency to learn the time period of 6.5, 6 & 5.5, irrespective of understanding
the rationale behind on such. Refer to the 1st Row (where the amount is drawn at the beginning of
every month and throughout the year), we find 78/12 = 6.5, 72/12 = 6 & 66/12 = 5.5. The rationale is
Rate of interest being mentioned as per annum. But, if the rate of interest is mentioned per month
basis, then interest shall be calculated by considering the time period for 78 months, 72 months & so
on.

(c) Interest on Loan: If the Partnership Deed clearly mentions it, provide interest on loan on time basis
at the given rate. If the Deed does not mention it, provide interest at 6% p.a. Interest on loan is a
general expense of a firm. The Partnership Act considers any payment to any partner, other than rent,
as an appropriation of Profits. By implication the Income Tax Act also treats interest on partner’s loan
at par with Interest on Partner’s Capital. So it should be debited to P/L Appr. A/c and credited to
Partner’s Current A/c (if any) or to Partner’s Loan A/c.
(d) Partners Salaries & Commission: These are to be allowed only if the Deed specifically provides for
these. These are paid to partners for special service rendered by them and are different from staff
salaries or commission. These should be debited to P/L Appr. A/c and Credited to Partners’ Capital or
Current Accounts.

Fixed and Fluctuating Capital Method :

A. Fixed Capital Method

Under this method capital accounts of the partners will remain fixed year after year from the very
beginning except for the introduction of additional capital contributed by the partners. In short, no
entry, like interest on capital, interest on drawings, share of profits etc will appear in the capital
account. Naturally, a separates current account is to be opened where all the adjustments, like interest
on capital, interest on drawings, share of profits, partners’ salaries and commissions, partners’
drawings etc. will appear in this account along with the opening balance of current account (whether
shows a debit or credit balances). The blance of current account will appear in the Balance Sheet. The
Interest on Capital Account and Current Account are under fixed capital method are represented as
under :

N.B : The balance of current account may also show a debit balance. In that case, the same will
appear in the asset side of the Balance Sheet.
B. Fluctuating Capital Method

Under this method, the capital account of the partners will fluctuate year after year. i.e., all the
adjustments, viz, interest on capital, interest on drawings, partners’ salaries and commission, share of
profits, partners’ drawings etc. will appear in this capital account together with the opening balance
of capital accounts. The closing balance of the capital accounts will appear in the liabilities side of the
Balance Sheet.

Distinction between Fixed Capital Method and Fluctuating Capital Method Fixed Capital method and
Fluctuating Capital method in partnership accounts can be distinguished as follows:
*Profit & Loss Appropriation Account should not be prepared since all the charges against the profits
are shown in Profit & Loss Account and all appropriations out of profits are shown in Profit & Lobs
Appropriation Account.
Illustration 1. Prepare the Capital Accounts of the partners X and Y under (a) Fluctuating Capital
Method and (b) Fixed Capital Method from the following particulars :
C. GUARANTEED PARTNERSHIP

In a Partnership, there may be special agreement by virtue of which a Partner may get the guarantee
of earning a minimum amount of profit. This guarantee may be given by one partner in particular or
by the firm. It is given generally to encourage a junior partner or any sincere clerk of the business
inducted to the benefits of Partnership.

(a) Guarantee given by one Partner :

(i) The appropriation of profit should be made in the general course by applying the existing profit
sharing ratio.

(ii) The minimum amount guaranteed is to be decided.

(iii) In case the guaranteed amount (ii) is more, the excess should be deducted from the share of
profit of the Partner given guarantee and calculated under (i) above.

The same amount should be added with the original share of profit of the Partner to whom the
guarantee has been given.

(b) Guarantee given by firm :

(i) The share of profit of the guaranteed Partner is to be calculated according to the profit – sharing
ratio.

(ii) His minimum guaranteed amount is ascertained.

(iii) The higher of (i) and (ii) is given or credited to him.

(iv) The remaining profits are shared among the remaining Partners in their remaining ratio.

If the minimum guaranteed amount is more, the shortfall may be agreed to be in a ratio specially

agreed upon.
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