Big picture
Every later partnership chapter (goodwill, admission, retirement, dissolution) is built on this one. Here you learn three things: what a partnership legally is, how partners' capital is recorded, and how the year's profit is divided among partners through the Profit and Loss Appropriation Account.
The key idea to hold on to: the ordinary Profit and Loss Account works out how much profit the firm made. The Appropriation Account decides who gets it, and in what form (interest, salary, commission or a share of profit).
Learning goals
State the definition and essential features of a partnership.
List what a partnership deed usually covers, and apply the legal rules that apply when the deed is silent.
Prepare partners' capital and current accounts under the fixed and fluctuating methods.
Calculate interest on capital, including changes in capital during the year and working back from closing capital.
Calculate interest on drawings by the direct, product and average-period methods.
Prepare a Profit and Loss Appropriation Account and pass its journal entries, including insufficient profit, loss years and guarantees of profit.
Correct past errors in appropriation with a single adjusting entry.
Core ideas
1. What a partnership is
Section 4 of the Indian Partnership Act, 1932 defines partnership as the relation between persons who have agreed to share the profits of a business carried on by all or any of them acting for all. Break that definition into its features:
Two or more persons. The upper limit is 50 partners (Companies Act, 2013 read with the Companies (Miscellaneous) Rules, 2014).
An agreement. Partnership arises from a contract, not from birth or status. A Hindu Undivided Family business is not a partnership.
A lawful business carried on for profit. Two friends jointly owning a house for their own use are not partners, because there is no business.
Sharing of profits. Sharing losses is implied, but the agreement is about profits.
Mutual agency. Each partner is both an agent (can bind the firm) and a principal (is bound by the acts of the others). This is the real test of a partnership.
Unlimited liability. Partners are personally liable, jointly and severally, for the firm's debts. A creditor can recover the whole debt from any one partner's private assets.
2. The partnership deed and the rules when it is silent
The partnership deed is the written agreement between partners. It is not compulsory (an oral agreement is valid), but a written deed avoids disputes. It usually records:
the firm's name, address and nature of business, and the date of commencement;
each partner's capital and the profit-sharing ratio;
interest on capital and on drawings, and the rate;
salaries, commission or other remuneration to partners;
interest on loans by partners;
the rules for admission, retirement and death of a partner, and for valuing goodwill;
the method of settling accounts on dissolution, and how disputes are settled.
When the deed is silent on a point, or there is no deed, the Act's provisions apply. Learn this table exactly; it is asked every year.
Matter | Rule when the deed is silent |
|---|---|
Profit-sharing ratio | Equal, whatever the capitals |
Interest on capital | Not allowed |
Interest on drawings | Not charged |
Salary or commission to a partner | Not allowed |
Interest on a partner's loan to the firm | 6% per annum |
Example. Riya and Sahil have no deed. Riya contributed ₹4,00,000 and Sahil ₹1,00,000; Riya also lent the firm ₹50,000. Sahil works full-time and asks for a salary of ₹10,000 per month. The year's profit before any of these items is ₹1,20,000.
Riya gets interest on her loan: 50,000 × 6% = ₹3,000. This is deducted first, leaving ₹1,17,000.
No interest on capital and no salary to Sahil, because the Act allows neither.
The ₹1,17,000 is shared equally: ₹58,500 each, even though Riya's capital is four times Sahil's.
Note. Interest on a partner's loan is a debt of the firm. It is paid whether the firm makes a profit or a loss. Interest on capital is a share of profit, so (unless the deed says otherwise) it can only be paid out of profits.
3. Fixed and fluctuating capital accounts
Fluctuating capital method. Each partner has one account, the Capital Account. Everything goes into it: fresh capital, drawings, interest on capital and drawings, salary, commission, and the share of profit or loss. Its balance changes every year. If nothing is said in a question, assume capitals are fluctuating.
Fixed capital method. Each partner has two accounts:
the Capital Account records only the original capital, plus any fresh capital introduced or capital permanently withdrawn;
the Current Account records everything else (drawings, interest, salary, commission, share of profit or loss).
The capital balance stays the same unless the partners agree to change it. A Current Account can show a debit balance, but a fixed Capital Account always has a credit balance.
Item | Fluctuating method | Fixed method |
|---|---|---|
Interest on capital | Credit Capital A/c | Credit Current A/c |
Salary, commission | Credit Capital A/c | Credit Current A/c |
Share of profit | Credit Capital A/c | Credit Current A/c |
Share of loss | Debit Capital A/c | Debit Current A/c |
Drawings, interest on drawings | Debit Capital A/c | Debit Current A/c |
Additional capital introduced | Credit Capital A/c | Credit Capital A/c |
Capital permanently withdrawn | Debit Capital A/c | Debit Capital A/c |
4. Interest on capital
Interest on capital = Capital × Rate × Time. Use the opening capital. If capital was added or withdrawn during the year, calculate interest on each amount only for the period it stayed in the business.
Example: capital changes during the year. Asha's capital on 1 April was ₹6,00,000. She introduced ₹1,00,000 more on 1 October and permanently withdrew ₹60,000 of capital on 1 January. Interest is 10% p.a.; the year ends on 31 March.
On opening capital 6,00,000 × 10% × 12/12 = 60,000
On addition 1,00,000 × 10% × 6/12 = 5,000
Less on withdrawal 60,000 × 10% × 3/12 = (1,500)
Interest on capital = 63,500Ordinary drawings (against profit) do not reduce capital for interest on capital. Only a permanent withdrawal of capital does.
Example: only the closing capital is given. A very common exam case. Raj's capital on 31 March was ₹3,50,000. During the year his drawings were ₹40,000 and his share of profit was ₹70,000. Interest on capital is 10% p.a. Work backwards: undo everything that happened during the year.
Closing capital 3,50,000
Add: drawings (they reduced it) 40,000
Less: share of profit (it added) (70,000)
Opening capital 3,20,000
Interest on capital = 3,20,000 × 10% = 32,000If additional capital was introduced during the year, deduct it too; if interest on capital or salary had already been credited, deduct those as well.
Interest on capital as a charge. Usually interest on capital is an appropriation (paid only out of profits). If the deed says interest on capital is to be treated as a charge, it is debited to the Profit and Loss Account and allowed in full even if it turns profit into a loss.
5. Interest on drawings
Interest on drawings is charged on each withdrawal for the time from the date of withdrawal to the end of the accounting year. There are four exam situations.
(a) Dates are given, amounts vary: product method. Mohan withdrew ₹10,000 on 1 June, ₹15,000 on 1 September, ₹8,000 on 1 December and ₹12,000 on 1 February. Interest is 12% p.a.; the year ends on 31 March.
Date | Amount (₹) | Months to 31 March | Product (₹) |
|---|---|---|---|
1 June | 10,000 | 10 | 1,00,000 |
1 September | 15,000 | 7 | 1,05,000 |
1 December | 8,000 | 4 | 32,000 |
1 February | 12,000 | 2 | 24,000 |
Total | 45,000 | 2,61,000 |
Interest = Sum of products × Rate ÷ 100 × 1 ÷ 12 = 2,61,000 × 12/100 × 1/12 = ₹2,610.
(b) Equal amounts at regular intervals: average period.
Interest on drawings = Total drawings × Rate ÷ 100 × Average period ÷ 12
Pattern of equal withdrawals (12-month year) | Average period |
|---|---|
Beginning of every month | 6½ months |
Middle of every month | 6 months |
End of every month | 5½ months |
Beginning of every quarter | 7½ months |
Middle of every quarter | 6 months |
End of every quarter | 4½ months |
Example. Kabir withdrew ₹5,000 at the beginning of every month; interest is 8% p.a.
Total drawings = 5,000 × 12 = 60,000
Interest = 60,000 × 8/100 × 6.5/12
= 4,800 × 6.5/12
= 2,600If he had withdrawn at the end of every month, the average period would be 5½ months and the interest would fall to ₹2,200.
(c) Equal amounts for only part of the year. Use the general rule:
Average period = (Months left after the first drawing + Months left after the last drawing) ÷ 2
Example. ₹6,000 drawn at the beginning of each month from 1 October to 1 March (6 withdrawals); year ends 31 March. Months left: 6 after the first (1 October), 1 after the last (1 March). Average period = (6 + 1) ÷ 2 = 3½ months. Interest at 10% p.a. = 36,000 × 10/100 × 3.5/12 = ₹1,050.
(d) Dates are not given.
If the rate is per annum, charge interest for an average of 6 months on the total drawings. Drawings ₹30,000 at 10% p.a. gives 30,000 × 10% × 6/12 = ₹1,500.
If the rate is given as a flat percentage (no "per annum"), charge it on the total without considering time. Drawings ₹30,000 at 10% gives ₹3,000.
6. The Profit and Loss Appropriation Account
Charges against profit (rent paid to a partner, interest on a partner's loan, a manager's commission) go in the Profit and Loss Account. Whatever profit remains is carried to the Appropriation Account and divided.
Debit side (appropriations) | Credit side (sources) |
|---|---|
Interest on capital | Net profit from the P&L Account |
Salary or commission to partners | Interest on drawings |
Transfer to reserve | |
Balance: profit shared in the profit-sharing ratio |
Worked example. Asha and Kabir share profits 3:2. Capitals (fixed): Asha ₹6,00,000, Kabir ₹4,00,000. The deed allows interest on capital at 10% p.a., a salary to Kabir of ₹5,000 per month, and a commission to Asha of 5% of net profit. Drawings: Asha ₹1,00,000, Kabir ₹75,000; interest on drawings: Asha ₹8,000, Kabir ₹6,000. Net profit for the year is ₹2,40,000. Opening current account balances: Asha ₹20,000 Cr, Kabir ₹10,000 Cr.
Profit and Loss Appropriation Account
Particulars | ₹ | Particulars | ₹ |
|---|---|---|---|
Interest on capital: Asha | 60,000 | Net profit b/d | 2,40,000 |
Interest on capital: Kabir | 40,000 | Interest on drawings: Asha | 8,000 |
Salary: Kabir | 60,000 | Interest on drawings: Kabir | 6,000 |
Commission: Asha (5% of 2,40,000) | 12,000 | ||
Profit: Asha (3/5) | 49,200 | ||
Profit: Kabir (2/5) | 32,800 | ||
Total | 2,54,000 | Total | 2,54,000 |
The divisible profit is ₹2,54,000 − ₹1,72,000 = ₹82,000, split 3:2.
Partners' Current Accounts
Dr Particulars | Asha | Kabir | Cr Particulars | Asha | Kabir |
|---|---|---|---|---|---|
Drawings | 1,00,000 | 75,000 | Balance b/d | 20,000 | 10,000 |
Interest on drawings | 8,000 | 6,000 | Interest on capital | 60,000 | 40,000 |
Balance c/d | 33,200 | 61,800 | Salary | – | 60,000 |
Commission | 12,000 | – | |||
P&L Appropriation | 49,200 | 32,800 | |||
Total | 1,41,200 | 1,42,800 | Total | 1,41,200 | 1,42,800 |
The Capital Accounts stay at ₹6,00,000 and ₹4,00,000.
Journal entries for appropriation
Transaction | Debit | Credit |
|---|---|---|
Transfer of net profit | Profit and Loss A/c | P&L Appropriation A/c |
Interest on capital allowed | Interest on Capital A/c | Partners' Capital/Current A/cs |
Closing interest on capital | P&L Appropriation A/c | Interest on Capital A/c |
Interest on drawings charged | Partners' Capital/Current A/cs | Interest on Drawings A/c |
Closing interest on drawings | Interest on Drawings A/c | P&L Appropriation A/c |
Salary or commission credited | Partner's Salary/Commission A/c | Partner's Capital/Current A/c |
Closing salary or commission | P&L Appropriation A/c | Partner's Salary/Commission A/c |
Transfer to reserve | P&L Appropriation A/c | General Reserve A/c |
Share of profit | P&L Appropriation A/c | Partners' Capital/Current A/cs |
Share of loss | Partners' Capital/Current A/cs | P&L Appropriation A/c |
Commission after charging commission. If the commission is a percentage of profit after charging that commission, use Commission = Profit × Rate ÷ (100 + Rate). At 5% on ₹2,52,000, that is 2,52,000 × 5 ÷ 105 = ₹12,000. Check: 2,52,000 − 12,000 = 2,40,000, and 5% of 2,40,000 is 12,000.
7. Insufficient profit and loss years
Insufficient profit for interest on capital. If interest on capital is an appropriation and the profit is smaller than the total interest due, the whole profit is divided in the ratio of the interest amounts (which is the ratio of capitals when the rate is the same). Nothing is left for the profit-sharing ratio.
Example: interest due is P ₹30,000 and Q ₹20,000, but the profit is only ₹45,000. P gets 45,000 × 3/5 = ₹27,000 and Q gets ₹18,000.
Loss year. If the firm makes a loss, no interest on capital is allowed (unless it is a charge). Interest on drawings is still charged; it is credited to the Appropriation Account and reduces the loss to be shared.
Example: loss ₹20,000; interest on drawings P ₹1,000 and Q ₹1,000; ratio 1:1. Loss to be shared = 20,000 − 2,000 = ₹18,000, so ₹9,000 each.
8. Guarantee of minimum profit
A partner, often a new one, may be promised a minimum share. If their actual share falls short, the deficiency is borne by whoever gave the guarantee:
By the firm (all other partners): in their profit-sharing ratio.
By one partner: that partner alone.
By some partners in an agreed ratio: in that ratio.
Example: Ravi, Sana and Meera share 2:2:1 and Meera is guaranteed ₹50,000 by Ravi and Sana equally. Profit is ₹2,00,000. Meera's share is ₹40,000, so the deficiency is ₹10,000.
Partner | Share before guarantee | Deficiency adjustment | Final share |
|---|---|---|---|
Ravi | 80,000 | (5,000) | 75,000 |
Sana | 80,000 | (5,000) | 75,000 |
Meera | 40,000 | 5,000 | 50,000 |
If only Ravi had given the guarantee, Ravi would get ₹70,000 and Sana ₹80,000.
A partner guarantees earnings to the firm. Sometimes a partner promises the firm a minimum amount, say fees of at least ₹60,000 from their clients. If actual fees are ₹45,000, the shortfall of ₹15,000 is debited to that partner's capital account and credited to the Appropriation Account, so it increases the profit shared by everyone.
9. Past adjustments
If last year's accounts were closed with items omitted or wrongly treated, do not reopen the Appropriation Account. Work out what each partner should have received, take back the profit that was wrongly distributed, and pass one adjusting entry for the net effect.
Example: one omission. X and Y share equally. Interest on capital at 10% on X ₹2,00,000 and Y ₹1,00,000 was omitted.
X | Y | Total | |
|---|---|---|---|
Interest that should have been credited | 20,000 | 10,000 | 30,000 |
Profit that must be taken back (1:1) | (15,000) | (15,000) | (30,000) |
Net effect | 5,000 Cr | 5,000 Dr | Nil |
Adjusting entry: Y's Capital A/c Dr ₹5,000, To X's Capital A/c ₹5,000.
Example: several omissions together. P, Q and R share 2:2:1. Their capitals were ₹3,00,000, ₹2,00,000 and ₹1,00,000. After the accounts were closed, it was found that interest on capital at 6% p.a., interest on drawings (P ₹2,000, Q ₹1,500, R ₹500) and a salary of ₹10,000 to R were all omitted.
P | Q | R | Total | |
|---|---|---|---|---|
Interest on capital (Cr) | 18,000 | 12,000 | 6,000 | 36,000 |
Interest on drawings (Dr) | (2,000) | (1,500) | (500) | (4,000) |
Salary (Cr) | – | – | 10,000 | 10,000 |
Should have received | 16,000 | 10,500 | 15,500 | 42,000 |
Take back profit 2:2:1 | (16,800) | (16,800) | (8,400) | (42,000) |
Net effect | 800 Dr | 6,300 Dr | 7,100 Cr | Nil |
Adjusting entry: P's Capital A/c Dr ₹800, Q's Capital A/c Dr ₹6,300, To R's Capital A/c ₹7,100. The net column must always total nil; if it doesn't, recheck.
A reliable problem-solving routine
Read the deed terms and write down every appropriation: interest on capital, salary, commission, reserve, interest on drawings. If the deed is silent on something, apply the Act's rule.
Separate charges (rent to a partner, interest on a partner's loan, interest on capital treated as a charge) from appropriations. Charges reduce the profit before it reaches the Appropriation Account.
Find opening capital (work back from closing capital if needed) and calculate interest on capital for the time each amount was in the business.
Choose the right method for interest on drawings: product method, average period, part-year formula, or 6 months / flat rate when dates are missing.
Check whether the profit is enough to cover interest on capital. If it isn't, divide the profit in the ratio of interest. If there is a loss, allow no interest on capital.
Divide the balance in the profit-sharing ratio, then apply any guarantee.
Post every item to Capital Accounts (fluctuating) or Current Accounts (fixed). Check that the Appropriation Account totals agree.
Connections that matter
Goodwill and change in profit-sharing ratio uses the sacrificing and gaining ratios, built from the profit-sharing ratio you set up here.
Admission, retirement and death all start with closing the old Appropriation Account and adjusting capital accounts. On death, the deceased partner's share of profit up to the date of death uses the same ideas.
Class 11 final accounts prepare the Profit and Loss Account; this chapter continues from its last line, the net profit.
Common mistakes
Putting interest on a partner's loan in the Appropriation Account. It is a charge and goes to the Profit and Loss Account.
Allowing interest on capital or salary when the deed is silent. The Act allows neither.
Sharing profit in the capital ratio when there is no deed. Without a deed, profits are shared equally.
Using 6 months for drawings made at the end of each month. The average period is 5½ months; 6 months applies to the middle of the month.
Reducing capital by ordinary drawings when calculating interest on capital. Only a permanent withdrawal of capital counts.
Using closing capital for interest on capital. Work back to opening capital first.
Crediting salary to the Capital Account under the fixed capital method. It goes to the Current Account.
Paying full interest on capital out of an insufficient profit, then sharing a negative balance. Divide the available profit in the ratio of interest instead.
Making the past-adjustment net column not total nil. The entry only moves amounts between partners.
Revision checklist
I can state the five rules that apply when the deed is silent.
I know which items go to the Capital Account and which to the Current Account under the fixed method.
I can calculate interest on capital with changes during the year, and from closing capital.
I can calculate interest on drawings by the product method, the average-period table and the part-year formula.
I can prepare an Appropriation Account, pass its journal entries and check that both sides agree.
I can handle insufficient profit, a loss year and a guarantee of profit.
I can correct several omitted items with one adjusting entry.