Capital and current accounts
The partnership agreement provides for a fixed amount of capital to be contributed by each partner, it is preferable for the amounts therefore to be credited to the respective partners’ capital accounts, and for partners’ drawings, salaries, interests on capital and shares of profits to be dealt with the current account.
This enables a clear distinction to be made in the accounts between fixed capital and not drawn profits.
Partners’ loan accounts
Where a partner makes an advance to the firm as distinct from capital, the amount therefore should be credited to a separate loan account and not to the partners’ capital account.
Interest on a partners’ advance or loan at the agreed rate or, in absence of agreement, at 5% per annul should be credited to his current account and debited to profit and loss account as an expense of the business in arriving at net profit.
Allocation of partnership profits
The formula for allocation of partnership profits between the partners will usually be set out in the partnership agreement. The formula may take account of some or all of the following adjustments:
- Interest on capital
- Interest on drawings
- Partners’’ salaries
- Profit-sharing ratios
Interest on capital
By making notional charge against profits for this expense at a fair commercial rate on the capital employed in a business, it can be seen whether the balance of profit remaining is sufficient to satisfy the continuance of the firm with unlimited liability, since the interest charged may be regarded as approximately the income the partners would have derived from the interest of their capital in securities involving little or no risk. Apart from this, however, where there are two or more partners with unequal capitals, the effect of charging interest on capital is to adjust the rights of the partners as between themselves as regards capital, giving each a reasonable return on his capital before dividing the balance of profit in the agreed proportions.
Interest on drawings
Where that is charged, it is usually calculated at a fixed rate per annul from the date of each drawing to the date the accounts are closed and taken account of in the statement of allocation of net profit in a similar way to interest on capital.
In the absence of agreement no partner is entitled before arriving at the amount of divisible profits to remuneration for his services to the firm.
Where the agreement provides for the payment of salaries to partners, it should be appreciated that such payments, although designated salaries are, like above expenses, merely in the nature of preferential shares of the divisible profit. The amounts such salaries should therefore be taken into account in the statement of allocation of net profit.