TRANSACTIONS RELATED TO APPROPRIATION OF PROFIT

ACCOUNTING FOR PARTNERSHIP FIRMS

LESSON - 4

TRANSACTIONS RELATED TO APPROPRIATION OF PROFIT

            We have already discussed in detail in lesson -2 that profit and loss appropriation a/c is prepared to show all the transactions related to the partners. All the appropriations should be debited to profit and loss appropriation account. As per the deed prepared by the partners, they are entitled to receive all the appropriation items in the agreed terms. If in case the partners have made no deed then the INDIAN PARTNERSHIP ACT 1932 will apply. According to this Act, if in case no deed is prepared then the partners are not entitled for any appropriations and the divisible profit will be divided equally among the partners.

TRANSACTIONS RELATED TO APPROPRIATION OF PROFIT ARE:

            - Interest on capital

            - Remuneration/commission to partners

            - Interest on drawings

    

1) INTEREST ON CAPITAL 

            Partners are investing money in the business firm and that money is used in the business for a certain time period so the partners are entitled to receive interest for the capital contributed by them according to the time period it is been used in the business. The rate of interest to be paid will be already decided while preparing the deed. The firm has to pay to the partners as it is an appropriation of

 

profit so it has to be debited in the profit and loss appropriation account. Interest on capital is calculated considering the time period the money had been used in the business. 

            During calculating interest on capital two things are to be kept in mind

                 a) Additional capital introduced by the partner and 

                 b) The amount withdrawn from the capital (drawings out of capital).

NOTE: Interest on capital will be always calculated upon the opening capital not the closing capital.

            FORMULA FOR CALCULATING OPENING CAPITAL

Capital at the end of the year                                                           XXX

ADD :             Drawings                                    XXX

                        Interest on drawings                  XXX

                        Share of loss (if any)                 XXX                      XXX

                                                                        _______        

LESS :             Additional capital                        XXX

                         Remuneration                              XXX

                         Interest on capital                         XXX

                         Share of profit                             XXX                    XXX

                                                                        _______                _________

          OPENING CAPITAL                                                            XXX                                                                                                 

            JOURNAL ENTRIES

                 1) Interest on capital a/c                                 Dr.                  XXX

                                To partners capital/current a/c                                                      XXX

                    (being interest on capital paid to the partners)

                2) Profit and loss appropriation a/c                 Dr.                     XXX

                                 To interest on capital a/c                                                              XXX

                    (being interest on capital paid transferred to profit and loss appropriation a/c)

2) PARTNER'S REMUNERATION (SALARY) / COMMISSION

            The partners may agree to appoint a partner for looking after the business of the firm. The partner who is also working is entitled to receive a salary/commission for his work. The amount payable to the working partner will be mentioned in the deed. The partner's salary is an appropriation of profit so it has to be debited to the profit and loss appropriation account. The working partner receives the payment when the firm's performance is going better and the earning profit.

            - COMMISSION PAYABLE

                

                        Salary will be decided already in amount but commission payable to a partner will be decided as a percentage of profit. The more the firm is earning profit the more the commission to a partner will be. There are two ways to the commission will be provided, they are :

            - A PERCENTAGE OF PROFIT BEFORE CHARGING COMMISSION

                         A certain percentage of commission is calculated from the profit directly as it says before charging such commission, so profit amount is already without any such commission deductions.

            - FORMULA

                

                        Net profit     *               Rate of commission

                                                            ~~~~~~~~~~~~~~~~

                                                                          100

     

            - A PERCENTAGE OF PROFIT AFTER CHARGING COMMISSION

                            A certain percentage of commission is charged from the profit after deducting the commission amount. Not to go deep and confuse, this can be simple found by applying the formula.

            - FORMULA

                        Net profit     *             Rate of commission 

                                                          ~~~~~~~~~~~~~~~~~

                                                        100 + Rate of commission

                 JOURNAL ENTRIES

                 1)       Partners salary/commission a/c                 Dr.               XXX

                                        To partners capital/current a/c                                                XXX

                            (being salary/commission paid to partners)

                 2)       Profit and loss appropriation a/c Dr.                              XXX

                                        To partners salary/commission a/c                                          XXX

                             (being salary/commission paid to partners transferred to profit and loss     appropriation a/c)

3) INTEREST ON DRAWINGS

   

            The partners may withdraw money or money's worth for their personal use form the business it is called drawings. The business has the right to charge interest on that amount for the time period taken by the partners. The interest collected by the firm will add the net profit of the firm so profit and loss appropriation account has to be credited by the interest amount. Here two factors are important to consider AMOUNT and TIME, according to these two factors interest on drawings will be calculated.

            There are two possible ways the partner can take money, he can either take his money invested in the business or he can take the firm's money. If he takes his own money then the firm can't charge any interest but if he takes the money from the firm then the firm charges interest for that amount. When the partner takes his own money it is called 'drawings out of capital', this will reduce the amount of his investment in the business and when he takes the firms money then it is called 'drawings against profit'.

            Partner may withdraw a same amount or different amount at a same time interval or he can withdraw different amount or same amount at different time interval. Time period is given more importance so according to time period we have different situations to calculate interest on drawings.

            Interest on drawings can be calculated in 2 methods, they are:

          - PRODUCT METHOD

                 When different amount is withdrawn at different time period then product method can be used. Under this method interest on drawing is calculated for different amount individually according to the time period it has been used. This method has two ways

                        a) Simple method and

                        b) Product method. (students can use the most convenient method which seems easy for them)

             FORMULA

  Interest on   =   total            Rate of interest        1                            1                            

   drawings       drawings   * ~~~~~~~~~~~~  *  ~~     (for      (or)  ~~~    (for 

                                                         100               12     months)        365    days)

          - AVERAGE METHOD

                        

                    When a same amount is withdrawn at a same time period then average method can be used. Under this method interest on drawings is calculated under many different situations.

            1) WHEN THE PARTNER WITHDRAWS SAME AMOUNT OF MONEY AT EVERY MONTH

                There are 3 more possible situations while withdrawing in a month

                    - Withdrawn at the beginning of the month

                               FORMULA

                                        Total drawings * Rate of drawings           6.5

                                                                    ~~~~~~~~~~~~~   *    ~~~~

                                                                                100                     12

                    - Withdrawn at the middle of the month

                                FORMULA

                

                                          Total drawings * Rate of drawings           6

                                                                    ~~~~~~~~~~~~~   *    ~~~~

                                                                                100                      12

                    - Withdrawn at the end of the month

                                FORMULA

                                              Total drawings * Rate of drawings                5.5

                                                                          ~~~~~~~~~~~~~       *     ~~~~

                                                                                100                                12

            2) WHEN THE PARTNER WITHDRAWS SAME AMOUNT OF MONEY AT EVERY QUARTER (in 3 months)

                There are 3 more possible situations while withdrawing at every quarter

                    - Withdrawn at the beginning of the quarter

                                FORMULA

                                        Total drawings * Rate of drawings           7.5

                                                                    ~~~~~~~~~~~~~   *    ~~~~

                                                                                100                      12

                    - Withdrawn at the middle of the quarter

                                FORMULA

                

                                          Total drawings * Rate of drawings           6

                                                                    ~~~~~~~~~~~~~   *    ~~~~

                                                                                100                       12

                    - Withdrawn at the end of the quarter

                                 FORMULA

                                              Total drawings * Rate of drawings                4.5

                                                                          ~~~~~~~~~~~~~       *     ~~~~

                                                                                100                                 12

            3) WHEN THE PARTNER WITHDRAWS SAME AMOUNT OF MONEY IN HALF YEAR (in 6 months)

                There are 3 more possible situations while withdrawing in half a year

                    - Withdrawn at the beginning of the six month

                                FORMULA

                                        Total drawings * Rate of drawings           3.5

                                                                    ~~~~~~~~~~~~~   *    ~~~~

                                                                                100                       12

                    - Withdrawn at the middle of the six month

                                FORMULA

                

                                          Total drawings * Rate of drawings           3

                                                                    ~~~~~~~~~~~~~   *    ~~~~

                                                                                100                        12

                    - Withdrawn at the end of the six month

                                FORMULA

                                              Total drawings * Rate of drawings                2.5

                                                                          ~~~~~~~~~~~~~       *     ~~~~

                                                                                100                                  12

NOTE : If in case there is no date of drawings mentioned in the question then an average period of 6 months is to be taken for calculation.

                    JOURNAL ENTRIES

                           1)    Partners capital/current a/c             Dr.                       XXX

                                            To interest on drawings a/c                                                        XXX

                                   (being interest on drawings charged from the partners)

                           2)    Interest on drawings a/c                     Dr.                     XXX

                                             To profit and loss appropriation a/c                                          XXX

                                  (being interest on drawings charged transferred to profit and loss appropriation a/c)

NOTE : Narration for each journal entry is very compulsory, narration should start with the word being and sentence can be made according to the student's own understanding and writing.