Lets say, two friends decide to start a small café together. One brings in money, the other brings in his culinary skills. They agree to share profits equally. That simple agreement gives birth to a partnership. But how do we formalize it? How do we distribute profits fairly? And what happens if one partner wants to leave? These are the questions that Partnership Accounting answers with clarity.
Source: Pixabay
Definition of Partnership
According to Section 4 of the Indian Partnership Act, 1932,
Partnership is 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.
Notice three key elements here – Agreement, Profit-sharing, and Mutual agency. Without any of these, you don’t have a partnership, just a casual arrangement.
Essential Features of Partnership
- Agreement: Partnership must arise from an agreement (written or oral). It cannot be created by status or inheritance.
- Business: There must be a lawful business activity. Joint ownership of property without business does not constitute partnership.
- Profit-Sharing: Partners must agree to share profits. Sharing losses may or may not be explicitly stated, but generally implied.
- Mutual Agency: Each partner acts as both agent and principal for others. This is the heart of partnership law – any partner’s action binds the firm.
- Unlimited Liability: Partners have joint and several liability. If business assets are insufficient, partners’ personal assets may be used to pay debts.
Types of Partners
Partnership is flexible, and so are the roles partners play. Here are the main types:
| Type | Meaning |
|---|---|
| Active (Managing) Partner | Participates in daily business activities and decision-making. |
| Sleeping (Dormant) Partner | Invests capital but does not take active part in management. Shares profits and bears losses. |
| Nominal Partner | Lends his name and reputation but does not invest or share profits. Liable to third parties for firm’s acts. |
| Partner by Estoppel | By words or conduct leads others to believe he is a partner. Liable as if he were one. |
| Partner in Profits Only | Agrees to share only profits but not losses. |
Partnership Deed
A Partnership Deed is a written document that governs the rights, duties, and obligations of partners. While not mandatory, it is strongly recommended to avoid disputes.
Key Clauses of Partnership Deed
- Capital contribution of each partner.
- Profit-sharing ratio.
- Interest on capital, interest on drawings.
- Partners’ salaries, commission, or remuneration.
- Rules for admission, retirement, or death of a partner.
- Dispute resolution methods (arbitration, court jurisdiction).
- Maintenance of accounts and audit procedure.
Remember: If the deed is silent on any matter, provisions of the Indian Partnership Act, 1932 will apply. For instance, no interest on capital is allowed unless agreed in deed.
Profit-Sharing Ratios
Profit-sharing ratio determines how profits or losses are divided among partners. This is one of the most crucial clauses in the deed.
a. Equal Division (Deed Silent)
If no specific ratio is mentioned in the deed, profits and losses are divided equally among partners, irrespective of their capital contributions.
b. Ratio Based on Deed
If deed specifies ratio, profits are divided accordingly. This may be equal or unequal, depending on partners’ agreement.
Problem: A and B share profits in the ratio 3:2. Net profit for the year is ₹60,000. Find each partner’s share.
Solution:
- Total ratio = 3+2 = 5 parts
- Share of A = 60,000 × 3/5 = ₹36,000
- Share of B = 60,000 × 2/5 = ₹24,000
Journal Entry:
Profit & Loss Appropriation A/c Dr. 60,000
To A’s Capital A/c 36,000
To B’s Capital A/c 24,000
Why Profit-Sharing Ratios Matter
They directly affect partner’s remuneration and capital accounts. A small error in ratio calculation may lead to disputes. That’s why exam questions often test this concept with adjustments (e.g., interest on capital, salary, guarantee of minimum profit).
Partnerships are built on trust, but trust alone is not enough for smooth functioning. Clear agreements, well-defined profit-sharing ratios, and awareness of rights and liabilities are essential.