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Topic Nine. Partnership. Partnership. A business carried out by people in agreement to share profits and losses Each partner is a partner of the others Business has unlimited liability Partners property could be attached for a firm’s debts
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Topic Nine Partnership
Partnership • A business carried out by people in agreement to share profits and losses • Each partner is a partner of the others • Business has unlimited liability • Partners property could be attached for a firm’s debts • We shall learn how to account for a partnership’s capital
Learning outcomes • After this lesson you should be in a position to, • Describe partnership business • Explain the contents of a partnership agreement • Differentiate between fixed and fluctuating partnership capital accounts • Value partnership goodwill using different methods as might be agreed upon by partners • Value goodwill as a result of change in profit-sharing ratios of existing partners • Value goodwill as a result of introduction of a new partner • Value goodwill as a result of a partner leaving the business either through retirement or death
Partnership agreement • An agreement between partners contain items such as; • The period of time that the business will be carried out. • Partners’ names and addresses • Amount of capital contributed by each partner • Interest on capital • Interest on loans and drawings
Partnership agreement • Salaries and commissions • The profit and loss sharing ratios for the partners • Method of valuing goodwill • The place where a firm’s accounts will be held • Management partners • Admission of a new partner • Withdrawal/retirement of a partner • How to solve a dispute, if any arises between the partners • Procedure to be followed in dissolving the business
Partnership agreement • In absence of a written agreement the following will be implied as agreed upon by the partners; • Partners will share profits equally • Partners will have equal participation in the business • No interest on capital and drawings • Admissions will be after agreement by old partners • Partners will not be entitled to a salary or commission • Books of account will be kept at the firm’s head office
Fixed and fluctuating capital accounts • Capital accounts could either be fluctuating or fixed • Where capital accounts are fluctuating they will be affected by transactions between the business and the partner • If fixed, dealings between a partner and the business will be shown in a different account, current account, while the capital account will only be affected by capital injection.
Methods of valuing goodwill • Average of profits • Computation of super profits • Capitalization
Average profits • Goodwill is estimated at the average profits earned in the past years. • Goodwill assumed to be worth a factor of these profits. • For instance if profits of $725,000 are earned over 5 years; average profits will be $145,000 • Goodwill could be agreed at 4 years average profits that is, $580,000
Super Profit Method • Using the super profits method, the partners charge goodwill based on the firm’s profits in excess of the normal profits • This requires calculation of the firm’s capital and then multiplying this with the normal rate of returns agreed upon
Illustration • Using the illustration of Abacha Partnership above, assume the normal rate of return for their capital is 15 percent. • Normal profits are15 percent of total capital $90,000 (0.15*600,000). • Supernormal profits are difference between the average returns, $145,000 and normal profits, $90,000. • Goodwill is then based on a multiple of the supernormal profits, in this case assume 6 years, $330,000 (145,000-90,000)*6).
Capitalization method • Profits are capitalized using the market rate cost of capital. • In this case, assume average profits of $145,000 are capitalized at 20 percent. • Value = Average profits/ interest rate = $145,000/.20 = $725,000 • Goodwill is difference between capitalized profits and capital contribution. That is, $125,000 ($725,000-$600,000).
Goodwill and partnerships • We have learnt that goodwill is shared by old partners and charged to new partners. • The following are illustrations where; • profit-sharing ratios change, • a new partner is introduced, or • a partner leaves We shall illustrate the three scenarios using Abacha partnership reviewed earlier assuming a goodwill of $300,000
Change in profit ratios • Suppose partners have decided to change their profit sharing ratios as follows; Old New Astra 5/12 1/2 Baker 1/3 1/4 Charlie 1/4 1/4
Change in profit ratios • Goodwill will be shared using the old ratios as follows:- • Astra $137,500 (5/12*330,000) • Baker $110,000 (1/3*330,000) • Charlie $82,500 (1/4*330,000) • Goodwill should be written off as follows:- • Astra $165,000 (1/2*330,000) • Baker $82,500 (1/4*330,000) • Charlie $82,500 (1/4*330,000) • Partners’ capital will be as noted in the next slide
Introduction of a new partner • New joiners will be charged goodwill • Use the case of Abacha Partnership • Mr. Dakar has been accepted in the firm subject to contribution of capital of $180,000 • Change in profit sharing ratios Old New Astra 5/12 4/10 Baker 1/3 3/10 Charlie 1/4 2/10 Dakar - 1/10
Withdrawal of a partner • Partner may be expelled, retire or die • Goodwill and capital should be paid • Suppose that Charlie retires and paid his capital including his share of goodwill. • After his exit the remaining partners, Astra and Baker will share profits in the ratio of 3/5 and 2/5 respectively
Conclusion • Partnerships accounts prepared just like sole proprietorship or company accounts as learnt in lesson 3 • Differences are in disclosure of capital accounts • We have learnt how to prepare capital accounts and how to value goodwill
