Partnerships & Companies: Accounting Structures, Profit Sharing, and Financial Reporting

TAKEAWAYS:

• Partnerships are unincorporated businesses with 2+ owners sharing profits/losses per a pre-agreed ratio, while companies are incorporated entities with limited liability and separate legal existence.
• Profit-sharing in partnerships follows explicit agreements (salaries, interest on capital, profit/loss ratios), while companies distribute dividends from retained earnings after tax.
• Goodwill arises in partnerships when existing partners admit new partners at a premium (paid-in capital > book value) or when a business is purchased at a price above net assets.
• Companies issue share capital (equity or preference shares) and maintain reserves (revenue, capital, general) to strengthen financial health, unlike partnerships that rely on capital contributions.
• Dissolution of partnerships involves realization accounts to convert non-cash assets into cash, while companies undergo winding-up via liquidators under the Companies Act.
• Financial statements for partnerships and companies differ in structure (e.g., partners’ capital accounts vs. shareholders’ equity) and disclosure requirements (e.g., partners’ drawings vs. dividends).

1. Partnerships: Formation, Operations, and Dissolution

Partnerships are voluntary associations of 2+ persons (max 20 in Nepal under the Partnership Act, 2034) to carry on a business for profit. They are unincorporated, meaning partners have unlimited liability and the business is not a separate legal entity.

Key Features of Partnerships

classDiagram
    class Partnership {
        +Unincorporated entity
        +2-20 partners (Nepal)
        +Unlimited liability
        +Shared profits/losses
        +No separate tax entity
        +Partnership Deed required
    }
    class PartnershipDeed {
        +Names of partners
        +Profit-sharing ratio
        +Capital contributions
        +Duration
        +Duties/responsibilities
    }
    Partnership "1" --> "1" PartnershipDeed : "Requires"

Formation of a Partnership

A partnership is formed by:

1. Agreement (Partnership Deed): Written or oral, but always recommended to be written to avoid disputes. Key clauses include:

   • Names and addresses of partners.
   • Nature of business.
   • Duration (if not perpetual).
   • Capital contributions.
   • Profit-sharing ratio.
   • Salaries/commissions to partners.
   • Procedure for admission/retirement of partners.
   • Dissolution terms.

2. Registration: Not mandatory in Nepal for all partnerships, but recommended for legal protection (under the Partnership Act, 2034). Unregistered firms cannot sue third parties.

Accounting for Partnerships: Journal Entries

Partnerships use double-entry accounting like sole proprietorships but with additional accounts for partners’ capital, drawings, and profit/loss sharing.

Example: Formation of a Partnership

Scenario: Ram and Shyam form a partnership on 1-4-2023 with the following contributions:

• Ram: Cash Rs 500,000, Furniture Rs 200,000.
• Shyam: Machinery Rs 400,000, Stock Rs 300,000.
• They agree to share profits in the ratio 3:2 and decide to credit the furniture Rs 10,000 (as it is old and depreciated).

Journal Entries:

| Date       | Particulars                          | L.F. | Dr (Rs) | Cr (Rs) |
|------------|--------------------------------------|------|---------|---------|
| 2023-04-01 | Cash A/c                             |      | 500,000 |         |
|            | Furniture A/c                        |      | 200,000 |         |
|            | To Ram’s Capital A/c                 |      |         | 700,000 |
| 2023-04-01 | Machinery A/c                        |      | 400,000 |         |
|            | Stock A/c                            |      | 300,000 |         |
|            | To Shyam’s Capital A/c               |      |         | 700,000 |
| 2023-04-01 | Ram’s Capital A/c                     |      | 10,000  |         |
|            | To Furniture A/c                     |      |         | 10,000  |

Ledger Accounts (T-Accounts):

Profit-Sharing in Partnerships

Profits (or losses) are shared after deducting:

1. Interest on capital (if agreed).
2. Salary/commission to partners (if agreed).
3. Interest on drawings (if agreed).
4. Interest on loans (if partners have loaned money to the business).

Formula:

Net Profit (after all deductions) = Profit before interest on capital/salary/commission.
Profit Share = Net Profit × Partner’s Ratio

Example: Profit-Sharing with Interest on Capital

Scenario: The partnership (Ram:Shyam = 3:2) earns a net profit of Rs 200,000 for the year. They agree to:

• Pay 10% interest on capital (Ram: Rs 690,000; Shyam: Rs 700,000).
• Pay Ram a salary of Rs 30,000 (manager).
• Share remaining profit in 3:2.

Steps:

1. Calculate interest on capital:

   • Ram: 690,000 × 10% = Rs 69,000
   • Shyam: 700,000 × 10% = Rs 70,000
   • Total interest = Rs 139,000

2. Deduct salary and interest from profit:

   • Rs 200,000 (profit) – Rs 30,000 (salary) – Rs 139,000 (interest) = Rs 31,000 (remaining profit).

3. Share remaining profit 3:2:

   • Ram: (3/5) × 31,000 = Rs 18,600
   • Shyam: (2/5) × 31,000 = Rs 12,400

Journal Entry for Profit Sharing:

| Date       | Particulars                          | L.F. | Dr (Rs) | Cr (Rs) |
|------------|--------------------------------------|------|---------|---------|
| 2023-04-30 | Profit & Loss A/c                    |      | 200,000 |         |
|            | To Interest on Capital A/c           |      |         | 139,000 |
|            | To Ram’s Salary A/c                  |      |         | 30,000  |
|            | To Ram’s Current A/c                 |      |         | 18,600  |
|            | To Shyam’s Current A/c               |      |         | 12,400  |

Ledger: Profit & Loss Appropriation Account:

| Particulars                          | Dr (Rs) | Cr (Rs) |
|--------------------------------------|---------|---------|
| To Interest on Capital               |         | 139,000 |
| To Ram’s Salary                      |         | 30,000  |
| To Ram’s Current A/c                 |         | 18,600  |
| To Shyam’s Current A/c               |         | 12,400  |
| **Balance (Transferred to P&L)**      | 200,000 |         |

Goodwill in Partnerships

Goodwill arises when:

1. New partner admitted: Pays more than their book value of capital.
2. Existing business purchased: Buyer pays more than the net assets of the business.

Calculation Methods:

1. Average Profit Method:

   Goodwill = Average Profit × Number of Years’ Purchase
   

   • Example: If average profit is Rs 50,000 and goodwill is valued at 2 years’ purchase, goodwill = Rs 100,000.

2. Super Profit Method:

   Goodwill = Super Profit × Number of Years’ Purchase
   

   • Super Profit = Actual Profit – Normal Profit (based on capital employed).

Example: Admission of a New Partner with Goodwill

Scenario: Ram and Shyam (3:2 ratio) admit Hari as a new partner who contributes Rs 400,000 as capital. The book value of the business is Rs 1,500,000 (capital + reserves). Hari’s share of goodwill is Rs 100,000 (paid in cash).

Steps:

1. Calculate new profit-sharing ratio:

   • Old ratio: Ram:Shyam = 3:2
   • New ratio: Ram:Shyam:Hari = 3:2:1 (assuming equal share for Hari).

2. Goodwill Adjustment:

   • Total goodwill = Rs 100,000 (Hari’s share).
   • Ram’s share of goodwill = (3/6) × 100,000 = Rs 50,000
   • Shyam’s share = (2/6) × 100,000 = Rs 33,333
   • Hari’s share = (1/6) × 100,000 = Rs 16,667 (already paid).

3. Journal Entries:

   | Date       | Particulars                          | L.F. | Dr (Rs) | Cr (Rs) |
   |------------|--------------------------------------|------|---------|---------|
   | 2023-07-01 | Hari’s Capital A/c                   |      | 400,000 |         |
   |            | Goodwill A/c                        |      | 100,000 |         |
   |            | To Ram’s Capital A/c                 |      |         | 50,000  |
   |            | To Shyam’s Capital A/c               |      |         | 33,333  |
   |            | To Hari’s Capital A/c               |      |         | 16,667  |
   |            | To Bank A/c                         |      |         | 416,667 |
   

Dissolution of Partnership

Dissolution means winding up the partnership. Steps:

1. Close all revenue and expense accounts (transfer to P&L A/c).
2. Prepare Realization Account to convert assets into cash and settle liabilities.
3. Distribute remaining cash among partners as per their capital ratios.

Example: Dissolution of Ram, Shyam & Hari

Scenario: The partnership dissolves on 31-12-2023 with the following assets/liabilities:

• Assets:
  • Cash: Rs 100,000
  • Stock: Rs 200,000 (realizable at 90%)
  • Furniture: Rs 150,000 (book value; realizable at 80%)
  • Machinery: Rs 400,000 (book value; realizable at 60%)
• Liabilities: Creditors Rs 150,000
• Partners’ Capital: Ram (Rs 700,000), Shyam (Rs 700,000), Hari (Rs 400,000)

Steps:

1. Prepare Realization Account:

   | Particulars                          | Dr (Rs) | Cr (Rs) |
   |--------------------------------------|---------|---------|
   | Stock A/c                            | 200,000 |         |
   | Furniture A/c                        | 150,000 |         |
   | Machinery A/c                        | 400,000 |         |
   | To Cash A/c                          |         | 180,000 (Stock: 200,000 × 90%) |
   | To Cash A/c                          |         | 120,000 (Furniture: 150,000 × 80%) |
   | To Cash A/c                          |         | 240,000 (Machinery: 400,000 × 60%) |
   | To Creditors A/c                     |         | 150,000 |
   | **Balance (Cash)**                   | 690,000 |         |
   

2. Distribute Cash to Partners:

   • Total capital = Rs 700,000 (Ram) + Rs 700,000 (Shyam) + Rs 400,000 (Hari) = Rs 1,800,000.
   • Ratio: Ram:Shyam:Hari = 7:7:4 (capital ratio).
   • Ram’s share = (7/18) × 690,000 = Rs 269,444
   • Shyam’s share = (7/18) × 690,000 = Rs 269,444
   • Hari’s share = (4/18) × 690,000 = Rs 151,111

Journal Entry:

| Date       | Particulars                          | L.F. | Dr (Rs) | Cr (Rs) |
|------------|--------------------------------------|------|---------|---------|
| 2023-12-31 | Cash A/c                             |      | 690,000 |         |
|            | To Ram’s Capital A/c                 |      |         | 269,444 |
|            | To Shyam’s Capital A/c               |      |         | 269,444 |
|            | To Hari’s Capital A/c                |      |         | 151,111 |

2. Companies: Formation, Share Capital, and Financial Reporting

Companies are incorporated entities with limited liability and separate legal existence. They can be:

• Private Limited (min 2, max 50 shareholders; restricted transfer of shares).
• Public Limited (min 7 shareholders; shares freely transferable).
• One Person Company (OPC) (single shareholder).

Key Features of Companies

classDiagram
    class Company {
        +Incorporated entity
        +Limited liability
        +Separate legal existence
        +Transferable shares
        +Regulated by Companies Act
        +Annual audits mandatory
    }
    class Shareholders {
        +Own equity shares
        +Vote in AGM
        +Receive dividends
        +Limited liability
    }
    class Directors {
        +Manage company
        +Appointed by shareholders
        +Fiduciary duties
    }
    Company "1" --> "many" Shareholders : "Owns"
    Company "1" --> "many" Directors : "Managed by"

Formation of a Company

Steps to form a company in Nepal:

1. Name Approval: From the Office of Company Registrar (OCR).
2. Memorandum of Association (MoA): Defines company’s objectives.
3. Articles of Association (AoA): Rules for internal management.
4. Registered Office: Must be in Nepal.
5. Minimum Paid-Up Capital: Rs 100,000 for private, Rs 2,000,000 for public.
6. Registration: Submit documents to OCR for certificate of incorporation.

Share Capital

Share capital is the fund raised by issuing shares to shareholders. Types:

1. Authorized Capital: Maximum shares a company can issue (stated in MoA).
2. Issued Capital: Shares actually issued to shareholders.
3. Subscribed Capital: Shares applied for by shareholders.
4. Called-Up Capital: Amount shareholders must pay.
5. Paid-Up Capital: Amount actually received.

Types of Shares

Example: Issue of Shares

Scenario: XYZ Ltd. issues 10,000 equity shares of Rs 100 each at a 10% premium. All shares are subscribed and paid.

Journal Entries:

| Date       | Particulars                          | L.F. | Dr (Rs) | Cr (Rs) |
|------------|--------------------------------------|------|---------|---------|
| 2023-01-01 | Bank A/c                             |      | 1,100,000 |         |
|            | To Share Capital A/c                 |      |         | 1,000,000 |
|            | To Securities Premium A/c           |      |         | 100,000  |

Ledger: Share Capital Account:

| Particulars                          | Dr (Rs) | Cr (Rs) |
|--------------------------------------|---------|---------|
| To Bank A/c                          |         | 1,000,000 |
| **Balance (Called-Up)**               |         | 1,000,000 |

Reserves and Surplus

Companies maintain reserves to strengthen financial health. Types:

1. Revenue Reserves:
   • General Reserve: Created from profits.
   • Capital Reserve: From sale of assets, premium on shares, etc.
2. Capital Reserves: From sources other than profit (e.g., revaluation of assets).

Example: Transfer to General Reserve

Scenario: XYZ Ltd. has a net profit of Rs 500,000. The Board decides to:

• Pay dividend of 10% (Rs 100,000).
• Transfer Rs 100,000 to General Reserve.

Journal Entries:

| Date       | Particulars                          | L.F. | Dr (Rs) | Cr (Rs) |
|------------|--------------------------------------|------|---------|---------|
| 2023-03-31 | Profit & Loss A/c                    |      | 500,000 |         |
|            | To Dividend A/c                      |      |         | 100,000 |
|            | To General Reserve A/c               |      |         | 100,000 |
|            | To Retained Earnings A/c             |      |         | 300,000 |

Dividends in Companies

Dividends are distributions of profits to shareholders. Steps:

1. Declare dividend in Board Meeting.
2. Pass dividend resolution in Annual General Meeting (AGM).
3. Record dividend in books (as a liability).
4. Pay dividend (usually within 30 days).

Example: Dividend Accounting

Scenario: XYZ Ltd. declares a 10% dividend on equity shares of Rs 100 (issued and paid-up capital: Rs 1,000,000).

Journal Entries:

| Date       | Particulars                          | L.F. | Dr (Rs) | Cr (Rs) |
|------------|--------------------------------------|------|---------|---------|
| 2023-04-01 | Dividend A/c                         |      | 100,000 |         |
|            | To Dividend Payable A/c              |      |         | 100,000 |
| 2023-05-10 | Dividend Payable A/c                 |      | 100,000 |         |
|            | To Bank A/c                          |      |         | 100,000 |

Financial Statements of Companies vs. Partnerships

## In the Real World

1. Daraz (Nepal):

   • Share Capital & Reserves: Daraz (owned by Alibaba) operates as a private limited company in Nepal. Its share capital is held by Alibaba Group, and it maintains capital reserves from reinvested profits to expand logistics (e.g., Daraz Logistics).
   • Dividends: While Daraz Nepal does not pay dividends (as it reinvests profits), its parent company Alibaba distributes dividends to shareholders based on retained earnings after tax.

2. Ncell (Nepal):

   • Partnership-Like Structure: Ncell’s joint venture with Axiata (Malaysia) resembles a partnership where profits are shared based on agreed ratios (though legally it’s a company). The telecom sector’s high capital requirements make it impractical for a pure partnership.
   • Goodwill Accounting: When Ncell acquired Smart Telecom, it recorded goodwill (difference between purchase price and net assets) on its balance sheet, reflecting the value of Smart’s brand and customer base.

3. Nepal Investment Bank Limited (NIBL):

   • Share Capital & Dividends: As a public limited company, NIBL issues equity and preference shares. In 2022, it declared a 10% dividend on equity shares (Rs 10 per share) from retained earnings, while preference shareholders received a fixed 8% dividend.
   • Reserves: NIBL maintains a general reserve (from past profits) and a capital reserve (from sale of assets like branches) to meet regulatory capital requirements set by Nepal Rastra Bank (NRB).

4. Local Retail Shop (Partnership Example):

   • Profit-Sharing: Imagine a Kathmandu-based grocery shop owned by two partners, Amit and Bimal, with a 3:2 profit-sharing ratio. If the shop earns Rs 500,000 after expenses:
     • Interest on capital (Amit: Rs 800,000; Bimal: Rs 600,000 at 5%) = Rs 70,000.
     • Remaining profit = Rs 500,000 – Rs 70,000 = Rs 430,000.
     • Amit’s share = (3/5) × 430,000 = Rs 258,000.
     • Bimal’s share = (2/5) × 430,000 = Rs 172,000.
   • Goodwill Scenario: If a third partner Sagar joins by paying Rs 500,000 (while his book value is Rs 300,000), the goodwill of Rs 200,000 is shared between Amit and Bimal in their 3:2 ratio.

## Exam Tip

1. Partnerships:

   • Always check the profit-sharing ratio before allocating profits/losses.
   • Goodwill adjustment is a common question—practice calculating partners’ shares of goodwill.
   • Dissolution questions often test realization accounts and cash distribution. Memorize the steps:
     1. Close revenue/expense accounts.
     2. Prepare realization account (asset disposal).
     3. Settle liabilities.
     4. Distribute remaining cash per capital ratio.

2. Companies:

   • Share capital questions often involve premium/discount on issue. Remember:
     • Premium → Credited to Securities Premium A/c (reserve).
     • Discount → Debited to Share Capital A/c (reduces paid-up capital).
   • Dividend accounting is tested frequently. Key points:
     • Dividends are liabilities until paid.
     • Interim dividends can be declared before AGM (but must be approved later).
   • Financial statements: Companies use Statement of Profit and Loss (SPL) and Statement of Financial Position (SFP), while partnerships use Income Statement and Partners’ Capital Accounts.

3. Common Mistakes to Avoid:

   • Ignoring interest on capital/drawings in profit-sharing.
   • Miscounting goodwill shares (always use the sacrificing ratio for existing partners).
   • Forgetting to close the P&L account before distributing profits in partnerships.
   • Mixing up authorized vs. issued capital in company questions.

4. Worked Example for Exam: Question: "A and B are partners sharing profits 3:2. Their capitals are Rs 500,000 and Rs 400,000, respectively. Interest on capital is 10%. The firm earned Rs 200,000 profit. Show the profit distribution." Solution:

   • Interest on A’s capital = 500,000 × 10% = Rs 50,000
   • Interest on B’s capital = 400,000 × 10% = Rs 40,000
   • Total interest = Rs 90,000
   • Remaining profit = Rs 200,000 – Rs 90,000 = Rs 110,000
   • A’s share = (3/5) × 110,000 = Rs 66,000
   • B’s share = (2/5) × 110,000 = Rs 44,000
   • Journal Entry:

     | Date       | Particulars               | Dr (Rs) | Cr (Rs) |
     |------------|---------------------------|---------|---------|
     | 2023-12-31 | P&L A/c                    | 200,000 |         |
     |            | To Interest on Capital A/c |         | 90,000  |
     |            | To A’s Current A/c        |         | 66,000  |
     |            | To B’s Current A/c        |         | 44,000  |
     

## Practice Questions (Exam-Style)

1. Partnership:

   • Ram and Shyam are partners with capitals of Rs 300,000 and Rs 200,000, respectively. They share profits 2:1. Interest on capital is 5%. The firm’s profit is Rs 150,000. Show the profit distribution with journal entries.

2. Company:

   • XYZ Ltd. issues 50,000 equity shares of Rs 100 at a 5% premium. All shares are subscribed and paid. Pass journal entries and show the Share Capital Account.

3. Goodwill:

   • A and B (3:2 ratio) admit C as a new partner who pays Rs 200,000 as capital (book value is Rs 150,000). Calculate goodwill and pass journal entries.

4. Dissolution:

   • A partnership with assets (Cash Rs 50,000; Stock Rs 100,000 realizable at 80%; Furniture Rs 150,000 realizable at 60%) and liabilities of Rs 120,000 dissolves. Partners’ capitals are Rs 200,000 each. Show the realization account and cash distribution.

## Summary Table: Partnerships vs. Companies