TOPIC :

AUDIT OF
PARTNERSHIP FIRM
INDIA SILICATE
WORKS

DEFINATION OF PARTNERSHIP :
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.
Persons who have entered into partnership with one another are called individually "partners"
and collectively a "firm", and the name under which their business is carried on is called the
"firm name".

ESSENTIAL ELEMENTS OF PARTNERSHIP :

From the statutory definition of partnership, the essential elements of partnership can be
understood as
"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.

persons
There should be at least two persons to form a partnership or partnership firm.
Restrictions on the number of persons
The maximum number of members that can exist in partnership is 10 in case of a
firm carrying on banking business and 20 in case of any other business.
This restriction is placed by the companies act and not the partnership act.
Companies Act, 1956 show

who have agreed

There should be an agreement between those persons who are forming the
partnership. The agreement is the foundation for the partnership. Partnerships can
arise only from a contract and not status.
Indian Partnership Act, 1932 show

the profits of a business

There should be a business carried on by the partnership and that too with an
intention to make and share profits of that business.
Therefore we can say

No Business, No Partnership and

No intention to share profits, No Partnership

Though, no specific mention of sharing of losses is made, we assume that Sharing

profits implies Sharing Losses also.
Indian Partnership Act, 1932 show

carried on by all or any of them acting for all

The business may be carried on by any one or more of the partners.
Acting for all
This implies that a partner conducting the business should be understood as
conducting the business on behalf of all the partners. Each partner would be
responsible for the acts of every other partner in relation to the firm.
As far as the outsiders are concerned, the partners and the firm are one and the same.
Mutual Agency [Principal Agent relationship]

Concerning each of two or more persons or things; especially given or done in

return

reciprocal
In his/her role as a partner, a person acts both as a principal as well as an agent.

A partner is an agent of the firm for the acts that the he/she does on behalf of the
firm, whereby he/she can bind the other partners for such acts. The other partners
would be in the position of a principal for such acts.
With regard to the acts of the other partners, he/she will be in the position of a
principal (since he as a partner is bound by the acts of the other partners on behalf of
the firm)
Where a partner cannot be made responsible for the acts of one or more other
partners we cannot say they together form a partnership. This mutual agency is what
really decides whether there is a partnership or not.
Thus it is said the "Mutual Agency" is the real test of partnership.

TYPES OF PARTNERSHIP :

Following are the important types of partnerships.

* Active or actual partnership
* Dormant or sleeping partnership
* Nominal partnership
* Sub partnership
* Partnership in profit only

ACTIVE/ACTUAL PARTNERSHIP

In this type of partnership the partners are actively involved in the business and business
relations and other aspects of the partnership firms.

DORMANT/SLEEPING PARTNERSHIP

In a dormant or a sleeping partnership, the partner will lend his name to the business but neither
interested in the business nor the profit sharing from the business.

NOMINAL PARTNERSHIP
These type of partners are known to the outsiders only. They will not actually involve in the
business.

SUB PARTNERSHIP
If a partner wants to share his profits to others he can enter into the partnership with others
stating the profit sharing levels or ratio. This is sometime referred to as parnership marketing.

PARTNERSHIP IN PROFIT ONLY

Partners who does not like loss bearing can enter into partnership sharing only the profit.
Such a parnership is called as partnership in profit only.

PARTNERSHIP - A FORM OF BUSINESS ORGANISATION :

Partnership is a form of business organisation. A business and its ownership are independent
entities. The idea that the actual business and the form of organisation that is owning it are
different would help you in creating an understanding on the difference in accounting for
partnership firms and other forms of business organizations.
The same business may be owned by a

sole proprietor,

partnership firm,

co-operative society,

company or any other form of business organisation.

Ascertaining the profit or loss is a task related to the business. The process of profit
ascertainment (final accounting) for a business would be more or less the same whatever may be
the form of business organisation that is owning the business.
What's different?
How the profit made is dealt with in distributing it among ownership is an idea related to the
form of business organisation. The way the profits made by an organisation are shared is what is
different from organisation to organisation.

PROFIT AND LOSS APPROPRIATION :

Income Distribution
Appropriation

Give or assign a resource to a particular person or cause

Setting aside Money for a specific purpose

reserve

set aside
In a partnership firm, the act of distributing profits among the partners is identified as
Appropriation of profits.
Factors of Production and Returns
In economic terms, the four basic factors of production are Land, Labour, Capital and
Organisation. Each of these factors would be compensated by sharing a part of the income
earned. What a factor gets as its share is what is called the return for the factor.

Rent is the return for Land;

Wages are the returns for Labour/Labor;

Interest is the return for Capital; and

Profits are the returns for the Organisation.

Thus profit earned by the partnership firm can be said to be the returns earned by the
Organisation.
In case of a sole proprietary concern, there is only a single person who contributes the capital of
the organisation (the sole proprietor) and as such all the organisation's returns belong to the
owner. For this reason the net profit is generally transferred to the Capital a/c in total.
In case of a partnership firm there would be two or more persons contributing the capital of the
organisation and as such the organisation's returns have to be equitably distributed among them.
Organisation - Partnership Firm
Land, Labour and Capital are factors of production which we see or feel.

Organisation is an intangible factor that combines these three factors to achieve the intended
objective. Organisation in one way can be understood as, the efforts made by those who have
contributed capital in conducting the affairs of the organisation to achieve its objectives. These
efforts may take many different forms.
What constitutes Organisation in a Partnership Firm
In a partnership firm partners contribute capital. They also make contributions to the organisation
in many other forms. All the contributions other than capital that partners contribute to the firm
constitute the factor we call Organisation.
Partners contribution to the firm takes many different forms which may be tangible or intangible.
Some of them are

Time
Partners spend their time and efforts in working for the firm by looking after the day to
day affairs of the firm. This contribution may be full time, part time or intermittent.

Business Relations
Partners through their personal contacts in the society bring in customers which may
result in more sales.

Intelligence
Partners use their intelligence and abilities in various situations like in solving problems
faced by the firm, tiding over tough situations, overcoming competitions etc.

Why is not Capital included

We do not consider the Capital contributed by the partners as a part of the factor organisation,
since Capital itself is considered a distinct factor.
Varied Contributions of Partners towards the Organisation
Since no two beings can be having with the same capabilities, the contributions made by the
partners for the factor called organisation varies from partner to partner. Each partner contributes
according to his/her abilities and possibilities.

REMUNERATING THE FACTORS OF PRODUCTION IN A

PARTNERSHIP FIRM
We are limiting our discussion to remunerating the two factors of production Capital and
Organisation only.
Judicious Distribution of the Firms Profits
A, B and C are partners in a firm. The firm has made a profit of 3,00,000. What would be the
judicious share of profit to be distributed to each partner A, B and C.
Share Equally
A, B and C sharing 1,00,000 each.
This sounds prudent if the contributions of A, B and C towards the firm is the same in all
respects.
Say, A, B and C

are of the same intelligence level,

work for the same time for the firm,

have contributed the same amount of Capital for the firm,

are having more or less the same contacts outside through which sales are generated,

have all withdrawn the same amounts of money for their personal uses (drawings)

In such a situation it would be appropriate to give each an equal share.

when equal Share is not Judicious
Practically, contributions of all the partners being equal in all respects being a no possibility,
sharing the profits of the firm equally amongst partners would not be the judicious way. In such
cases we would try to adjust for the differences in the following ways.

UNEQUAL CAPITAL CONTRIBUTIONS

The Capital Contributed by A, B and C is 2,00,000, 75,000 and 1,00,000 respectively. Now, since
A, B and C have contributed varied amounts of Capital towards the firm, it would not be
appropriate to share the profits equally among them.
Compensate by paying Interest on Capital.
Compensate for the uneven contributions towards capital by paying interest on their capital
contributions. Greater the Capital contributed, greater the interest earned. This would set right
the difference in contributions in the form of capital.
Profit equal to the total "Interest on Capital" on all the capital of the firm is set aside and is
distributed to the partners in the ratio of their capitals.
Rest of the profits can be shared equally if all other contributions are equal.
Unequal time and efforts
B works full time in the firm and A and C are passive partners. Now, since A, B and C have
contributed varied amounts of time and efforts in conduce of the affairs of the firm, it would not
be appropriate to share the profits equally among them.
Compensate by paying Salary to Partner.
Compensate for the uneven contributions of time and efforts towards the firm by paying salary to
partner. The salary paid to B would be compensation for his greater contribution.
Profit equal to the total "Salary to Partners" to all the partners who have made a contribution in
this respect is set aside and is distributed to them in proportion to the value of their contributions
as agreed upon between partners.
Rest of the profits can be shared equally if all other contributions are equal.

PUBLIC RELATIONS/CONTACTS
C has greater contacts in the outside world, a lot of customers are C's contacts. Now, the
contribution of C towards the sales of the firm through his contacts is greater than that of A and
B. Therefore, it would not be appropriate to share the profits equally among them.
Compensate by paying Commission to Partner.
Compensate C for providing more customers to the business by paying commission on sales. The
commission paid to C for sales made to customers who are his contacts would be compensation
for his greater contribution.
Profit equal to the total "Commission to Partners" to all the partners who have made a
contribution in this respect is set aside and is distributed to them in proportion to the value of
their contributions as agreed upon between partners.
Rest of the profits can be shared equally if all other contributions are equal.
Drawings
The Drawings of A, B and C are respectively, 2,000, 15,000 and 5,000 respectively.
Assume that drawings are being recorded using the 'Drawings a/c' which is the general
convention. Therefore, the Capital a/c balances are not affected by drawings made by partners.
The net capital contribution at any time can be obtained by setting off the Capital a/c and
Drawings a/c balances.
The net capital account balances of the partners are not in proportion to their capital account
balances. Therefore paying interest on capital based on capital account balances would be unjust.
Remedy - charge Interest on Drawings.

Greater the drawings greater the interest payable by the partners. This would compensate the
unevenness in drawings made by the partners.
Remunerating Organisation = distributing Profits
As can be seen, Interest on Capital, Salary to Partners, Commission to Partners, etc., are all paid
out of profits made and as such form appropriations of profits. All these appropriations are
intended to ensure an equitable distribution of profits among the partners based on their
contributions for the firm.
All the contributions other than capital together are identified as 'organisation' and it is rightly
said that remuneration for organisation is profit.
Distribution of Profits among Partners
Partners profit sharing ratio
A:B:C

1:1:1

The only conclusion that can be drawn straight away reading the postings would be that there is a
transfer to or from the Profit and Loss a/c.
Charge Against Profits Vs. Appropriation of Profits
Classification of Debits to Profit and Loss account
If we consider a single profit and loss account in use, we can classify all the debits being made to
the account into two as
Charge on/against Profits

Impose a Financial liability

encumbrance

A charge can be interpreted as a debit to the profit and loss account which represent an
expenditure or loss. A charge will result in reduction of profits. All expenses and losses
are a charge against profits.
Salaries, Wages, Rent, Depreciation, Loss on Sale of Assets etc., are all charges against
profits.
Appropriation of Profit

Give or assign profits for a particular person or cause

Setting aside profits for a specific purpose

reserve

set aside
Profit appropriated is profit set aside for being used in the future for some purpose
specified or unspecified. It is not for the purpose of an expenditure that has already been
committed or incurred. For this reason, appropriation of profits does not result in a
reduction of profits.
Creation of reserves is an example of profit appropriation.

Using Profit & Loss Appropriation a/c

Interest on Capital, Salary, Commission etc., to Partners - Appropriations
Distribution of profit to partners is appropriation of profits. It can be understood as profit being
kept aside to be given to the owners as a return for their contributions.
"Interest on Capital", "Salary to Partners", 'commission to partners' etc., paid to partners are
different methods adopted to compensate their varied contributions to ensure equitable
distribution of profits. Therefore all these payments made to partners would also be
appropriations of profits and do not constitute a charge against profits.

Segregating charges and appropriations

To segregate charges and appropriations of profits being made to the profit and loss account, the
P/L a/c is divided into two by creating a new account by name "Profit and Loss Appropriation
a/c".

PARTNERSHIP DEED : RELATIONSHIP BETWEEN PARTNERS :

Agreement between Partners is the basis for Partnership
"Partnership" is the relation betweenpersons who have agreed to share the profits of a
business carried on by all or any of them acting for all.
who have agreed
There should be an agreement between the persons who are forming the partnership. The
agreement is the foundation for the partnership. Partnerships can arise only from a contract
created out of an agreement and not just by status.
Indian Partnership Act, 1932 show
Agreement may be Written or Oral
The contract based on the agreement between the partners forms the basis of the relationship
between the partners. It specifies the terms and conditions that bind the partners into the
relationship. This agreement may be written or oral.

Written Agreement Partnership Deed

The agreement between the partners put down in writing forms the Partnership Deed. It is a
document containing the various aspects agreed upon by the partners. It is also called
a Partnership Agreement orArticles of Partnership.
Contents of the Partnership Deed
The partnership deed generally covers/includes the following aspects

Names of the partners of the firm and their addresses

Duration of Partnership

Capital contribution of each Partner and aspects relevant to it like introduction of

additional capital, drawings that can be made etc.

Interest to be paid on Capital, Loans given by partners to the firm, interest to be

charged on Drawings and the relevant rates of interest

Aspects relating to salaries, commissions, etc., to be paid to partners

The ratio in which the profits and losses are to be shared among partners

Goodwill valuation methodology at the time of incorporating changes in the

partnership.

Rights and Duties of Partners inter se among themselves.

Name of the Bank/Banks where the business banking accounts should be maintained
and the person/persons who are vested with the power to operate the accounts.

The person/persons responsible for accounting for the business transactions and the
place where the books of accounts are to be kept generally.

Everything that is relevant to the relationship between the partners forms part of the agreement.
Even aspects relating to Arbitration (in case of disputes among themselves) etc., will be part of
the agreement.
Role of Partnership Deed in Accounting
Any and every aspect relating to the partnership may be included in the "Partnership Deed". This
deed forms the basis of any transaction involving the partners. Even accounting for partnership
firms is a function that is to be carried on in accordance with the provisions in the "Partnership
Deed".

Salary to be paid to partners, profits to be shared among partners, interest on capital, interest on
drawings, etc., are all to be decided based on the agreement between the partners (i.e. based on
the partnership deed).
Thus in accounting for transactions involving these, compliance with what is agreed upon should
be ensured.

Where the Partnership Deed is silent

Where the partnership deed or the agreement between the partners is silent on any aspect that is
to be decided based on that agreement, the provisions in the "Indian Partnership Act, 1932"
apply.
Role of Partnership Act in Accounting
The following provisions affect the accounting treatments in the absence of an agreement in that
respect.
Partners Share of Profits
In the absence of an agreement between the partners, they would share profits and losses equally
among themselves (and not in the ratio of their capital contributions).
If there is an agreement between the partners then the shares would be decided based on the
agreement.
Separate Ratios for Profits and Losses
The partners may agree that profits be shared in a certain ratio and losses in another ratio.
Share in Profits Only
The partners may agree that one or more partners would share profits only and will not have to
share losses at all.

Share in Losses Only!!!

There is no provision for one or more partners agreeing to share only losses and not sharing any
profits. Partnership would exist only where there is a business and the partners have agreed to
share the profits of the business. Since the fundamental characteristic of sharing profits would be
missing if they agree to share only losses, this is not a possibility.

Indian Partnership Act, 1932 show

Remuneration to Partners
In the absence of an agreement between the partners, a partner is not entitled to receive any
remuneration (salary, commission, brokerage etc.,) for the services rendered by him to the firm.
If there is an agreement between the partners then the partner may receive such remuneration as
agreed upon.
Indian Partnership Act, 1932 show
Interest on Capital
In the absence of an agreement between the partners, a partner is not entitled to receive any
interest on Capital even if there is a variation in the profit sharing ratio and the capital
contribution.
If there is an agreement between the partners then interest is to be paid at the rates agreed upon.
Interest to be paid only out of Profits
Even where the agreement provides for payment of interest on capital, it will not be paid if there
are losses.
Indian Partnership Act, 1932 show

Interest on Drawings
No specific mention is made about drawings in the act. Therefore, it is assumed that the
provisions that are applicable for Capital would also be applicable for Drawings.
In the absence of an agreement between the partners, a partner is not entitled to pay any interest
on Drawings.
If there is an agreement between the partners then interest is to be charged at the rates agreed
upon.
Interest on Partners Loans or Advances
In the absence of an agreement between the partners, a partner is entitled to receive interest at the
rate of 6% p.a. on any payment or advance made beyond the amount of Capital he has to
contribute.
If there is an agreement between the partners then interest is to be paid at the rates agreed upon, .

PROFIT SHARING RATIO, INTEREST ON CAPITAL AND

DRAWINGS, COMMISSION BEFORE AND AFTER CHARGING :
Profit Sharing Ratio
By profit sharing ratio in a partnership firm, we mean the ratio in which the profits and losses of
the firm are to be distributed amongst the partners.
The basis for arriving at the ratio is the agreement between the partners. If there is a partnership
deed, the ratio should be ascertained from the provisions in the partnership deed. In the absence
of a partnership deed and where there is no indication as to the agreement between the partners
in this aspect, it should be considered as equal share for all partners.
The ratio may be specified in terms of absolute values or it may be expressed as the ratio of their
Capital account balances or it may be based on anything else as agreed upon by the partners.
Deriving this ratio (if it is not given) would be one important requirement in problem solving.
Different Ratios for Profit Sharing and Loss Sharing
If the partners so agree, the Profit Sharing Ratio and the Loss Sharing Ratio may be different.
There may be a partner who has a share in profits only but not a partner who has a share in
losses only.

Expressing the Profit Sharing Ratio

The profit sharing ratio may be expressed in a number of different forms. Whatever may be the
form in which the ratio is expressed it can always be converted to a form convenient to us for
being used in problem solving.
Simple Ratio
May, Day and Way are partners sharing profits in the in the ratio 1 : 3 : 4.
Simple Ratio [Fractions represent shares]
Where the shares are represented by fractional numbers, one should always check to see if the
sum of the fractional parts representing shares add up to 1.
Interest on Capital
Interest on Capital is to be paid

Only when agreed upon

Interest on Capital is to be paid to partners only if it is specifically agreed upon. If there is
no mention regarding this, in the partnership agreement (deed), then no interest need be
paid.

Only out of profits

Interest is to be paid only out of profits. Where there is a loss, no interest should be paid
on capital, even if the partnership agreement provides for the same.

@ 6% if rate is not mentioned

Where the partnership deed provides for payment of interest on capital and it does not
mention the rate of interest to be paid, it is a convention to pay interest @ 6% p.a.

On What Balance is Interest calculated

Interest is paid on capital for the reason that it has been used for the purpose of the partnership
business.

The balance in Capital account unless where it is maintained under Fixed Capital Method, keeps
fluctuating on account of a number of reasons, thus making it difficult to assess the amount of
capital employed in the business. There would be a change on account of appropriations made at
the end of the accounting period like salary to partners, commission to partners, etc. Even during
the course of the accounting period, the balances may change on account of additional capital
introduced, capital withdrawn, etc.,
In the absence of appropriate information, it is a convention that interest is paid on the opening
balances in Capital Accounts on the assumption that it has been employed for the full length of
the accounting period and all other changes to the capital account have been done towards the
end of the accounting period.
In problem solving we will come across these situations.

Opening Balance known

Where Capital a/c balances at the beginning of the accounting period are known and there
is no change in the balance through out the period, interest is calculated on the opening
balance.

Closing Balance and Appropriations at the end known

Where Capital a/c balances at the end are known and the changes at the end of the
accounting period that have affected the account are also known, the opening balance in
capital accounts is ascertained using the information relating to the changes and interest
is calculated thereon.

Closing balance and all transactions known

Where the Capital a/c balances at the end are known and the changes over the accounting
period as well as those at the end of the accounting period are known, the capital account
balances at various points of time (when changes take place) and the period for which the
capital has been utilised is ascertained and interest is calculated thereon.

Closing balance known

Where the Capital a/c balances at the end are known and no other information is
available, or where the information relating to transactions affecting the capital account
are known without the information relating to the date/period of occurrence, we calculate
the interest based on the closing balance.
Interest on Drawings

Interest on Drawings is to be charged

Only when agreed upon

Interest on Drawings is to be charged to partners only if it is specifically agreed upon. If
there is no mention in the partnership agreement regarding this, no interest need be
charged.

@ 6% if rate is not mentioned

Where the partnership deed provides for charging interest on drawings and it does not
mention the rate of interest to be charged, it is a convention to charge interest @ 6% p.a.

Calculating Interest on Drawings

Interest is charged on drawings for the reason that the amount has been withdrawn by the
partners without allowing it for being used for the purpose of the business.
In the absence of appropriate information, it is a convention that the interest on drawings is
calculated on the "Drawings a/c" balance at the end.
In problem solving we will come across these variations.

Closing Balance known

Where the Drawings a/c balances at the end of the accounting period are known and there
is no information relating to the time of drawing, interest is calculated on the closing
balance.

Amount and dates of Drawings are known

Where drawings made during the period and the dates on which the drawings have been
made are known, interest is calculated based on the amount drawn and the period of use,
since the period for which the withdrawn amounts are used can be ascertained.

Drawings made at regular intervals

Where the Drawings are made at regular intervals, all the drawings are converted to an
equivalent of drawings for a specified period and interest is calculated thereon.
The information available is the same as the information available in the case of amount
and dates of drawing known. However, since the drawings are made at regular intervals,
converting them to an equivalent amount would make it easier to calculate interest.

Salary to Partners
Salary is to be paid to partners only if it is specifically agreed upon.
If there is no mention in the partnership agreement then no salary need be paid.
Commission to Partners
Commission is to be paid to partners only if it is specifically agreed upon.
If there is no mention in the partnership agreement then no commission need be paid.
Expressing Commission
Commission payable to partners may be expressed in a number of different ways. It may be

Specified amount

Per unit of sales relatable to the partner

Per days of activity of the partner

As a % of Sales, NetProfit, Purchases or any other value.

What method is employed for expressing and calculating commission is dependent on the reason
for which the commission is being offered and the agreement between the partners.
There are two ways commission as a % of a value can be expressed. How it is expressed decides
how the commission is calculated mathematically.
Consider Commission being calculated as a % of Net Profit as an example.

Before charging such commission

Where there is no specific mention we assume that the commission is being expressed as
a % of value before charging such commission. Calculation is straight forward.
Commission = Value % of Commission.

After charging such commission

Under this method, commission is expressed as a % of value after charging such
commission.
The commission should work out to 8% of the value remaining after charging or
deducting commission.

Partners Capital Accounts

The first difference we can notice, between accounting for sole proprietary form of business
organisation and partnership form of business organisation is with regard to capital and its
related aspects.
Partners Capital Accounts

Interest on Capital, Salaries to Partners, Interest on Drawings, Commission to Partners are

appropriations of profits to ensure equitable distribution of profits based on the various
contributions made by partners to the firm. Along with the Partners Share of Profits, these
amounts conventionally are credited or debited to the Partner's capital accounts which would
result in the balance in the Partners Capital accounts getting altered.
Fluctuating Capital Accounts
Fluctuate

Having unpredictable ups and downs

waver
Since the capital account balances changes (fluctuates) with the regular transactions relating to
capital, the Capitals accounts maintained under this method are known as "Fluctuating Capital
Accounts".
Fixed Capital Accounts
Purpose
Profits (revenue) increase capital. By profits we mean all the appropriations of profits that find
their way into the capital account, like interest on capital, salary to partner, commission to
partner, share of profits. Capital also increases when additional capital is brought in by the
partner which is a Capital natured transaction.
Under the fluctuating capital account system, since we use only a single capital account, it gets
affected by transactions of both capital and revenue nature.
If the organisation intends to obtain the information relating to the Capital account balance on
account of Capital natured transactions and Revenue Natured transactions separately, a separate
Capital accounts needs to be maintained to record the revenue natured transactions.
The basic purpose of accounting is derivation of information. The more information we need, the
more accounting heads we need to maintain.

Fixed Capital Accounts

Two ledger accounts are maintained for collecting information relating to capital. The
transactions that affect partners capital accounts are classified as capital and current natured.

Calculation of Interest on Capital

The capital account balance considered for calculation of interest on capital is dependent on the
method adopted for maintaining the capital accounts.

Fixed Capital Accounts

Where the Capital Accounts are being maintained under "Fixed Capital Accounts"
method, interest on capital is to be calculated on the balances in the capital accounts.
Interest on Current account balances is not considered unless there is a specific
instruction regarding the same.

Fluctuating Capital Accounts

Where the Capital Accounts are being maintained under "Fluctuating Capital Accounts"
method, interest on capital is to be calculated on the balances in the capital accounts as
that is the only account that is related to capital.

In both cases any specific agreement between partners has to be considered in arriving at the
balances and calculation of interests. Say if they agree to consider only the balance at the end for
calculating interest, only that balance would be considered even if the partners have brought in
additional capital or withdrawn capital during the accounting period.

GURANTEES MADE BY / TO ONE OR MORE PARTNERS.

Opportunity Cost/Loss
Any decision that involves a choice between two or more mutually exclusive alternatives has an
opportunity cost or loss involved.
Opportunity Cost
Opportunity Cost is the value or utility that is foregone by taking up a particular alternative. It is
the value of the utility that would have been derived had the best of threst of the alternatives been
chosen.
Opportunity Loss
Opportunity Loss is the value or utility that is foregone by taking up a particular alternative. It is
the difference between the value of the utility and its opportunity cost.
Partners in a Firm Opportunity Loss
The contributions made by partners to the firm take various forms like contribution of assets
(cash, Motor Vehicles, Buildings etc) towards capital, their time and energy by working in the
firm, their personal contacts by generating sales through them, their selling abilities etc.,

In contributing these assets or services to the firm, the partners personally incur an opportunity
cost/loss which they will consider before employing them for the firm.

where the partner is investing capital he/she would be thinking of the earnings they might
get if that capital is employed elsewhere;

where he/she is employing his/her time as a working partner, he/she would be thinking of
his/her earning if he/she employs the same time elsewhere.

Each and every contribution of the partner has an opportunity cost loss attached to it unless they
are sitting idle.

Need for Guarantee

In situations of the sort mentioned here, partners may ask for a guarantee from one or more other
partners so that they would not be at loss by employing their resources for the firm.

Where a partner is participating in a partnership firm, he/she needs to be compensated at

the minimum, to the extent of his/her opportunity loss for the contribution made to the
firm. Otherwise he/she may be desisted from contributing to the firm.

Where a partner is very much sure that he can employ what he/she is contributing to the
firm elsewhere in a more profitable manner, why should he/she invest them for the firm,
unless there is some sort of assurance for the returns they get by contributing to the firm?

When a person is getting into a partnership agreement, he/she will be conscious of his/her
own abilities as well as the limitations of his/her other partners. Moreover, he/she would
be measuring his/her opportunity cost/loss in becoming a partner.

All Partners Cannot be the Guaranteed

In the context of a particular guarantee, one or more partners can be given the guarantee. Since,
there should be at least one partner who is giving the guarantee, not all the partners can be the
guaranteed.
All Partners Cannot be the Guarantors
In the context of a particular guarantee, one or more partners can give the guarantee. Since, there
should be at least one partner who is being guaranteed, not all the partners can be the guarantors.
There should be at least one who is giving and one who is guaranteed, thus eliminating the
chance of all the partners being either guarantors or the guaranteed in such cases.
A Partner can be a guarantor and a guaranteed
One or more partners can be both the guarantor and guaranteed at the same time. A partner may
guarantee one or more other partners and at the same time get a guarantee from one or more
other partners
Guarantee to Partners
Guarantee to One Partner
A, B and C are partners in a firm sharing profits and losses in the ratio 5 : 3 : 2. They now decide
to admit Mr. M as a partner giving him 110th share and taking among
themselves 510th,310thand110th respectively. Mr. M was willing to join as a partner only if he is
guaranteed that his annual share of profits would be not less than 20,000.
Effect of the Guarantee
If Mr. M is to get his guaranteed annual share, the firm would have to make an annual profit of at
least 2,00,000 ( 110th of 2,00,000 = 20,000). If the profit is lesser, then the existing partners
should forego their share to ensure that Mr. M gets his guaranteed share of profits. If the profit is
more than 2,00,000, the guarantee does not affect the share of other partners.
The guarantee may be given by one or more partners.

Guarantee by one Partner

On admitting Mr. M, the firm would benefit in a number of ways. Specifically Mr. A
would be getting a major relief on Mr. M sharing some of his responsibilities.
Mr. B and Mr. C were reluctant to agree to the guarantee proposal put forward by Mr. M.
Mr. A, since he would be benefiting directly and being confident that the firm would
make enough profits to ensure the minimum share asked for by Mr. M, has agreed to
guarantee Mr. M on his own.
Thus Mr. A guarantees Mr. M's minimum share. The burden of guarantee has to be borne
by Mr. A.

Guarantee by two Partners

Mr. B is reluctant to agree to the guarantee proposal put forward by Mr. M. Mr. A and Mr.
C being confident that Mr. M's admission is beneficial to the firm in every way, together
agree to guarantee Mr. M.
The burden of guarantee has to be borne by Mr. A and Mr. B together.

Guarantee by the Firm

Since all partners feel that admitting Mr. M would be benefiting the firm in all ways, they
all agree to the minimum guarantee asked for by Mr. M.
The burden of guarantee has to be borne by all the partners together. In such a situation,
Mr. M is said to have been guaranteed by the firm.

Guarantee to two or more Partners

Guarantee to two or more partners would have be viewed similarly. The guarantee may be given
by

only one partner

two or more partners

the firm, i.e. all the partners together.

Appropriation Guarantee - Shortfall

All appropriations as we see in partnership accounting are arrangements made to ensure an
equitable distribution of profits based on the various contributions made by partners to the firm.
As such the amount guaranteed may relate to

Distributable Profits only

Distributable Profits and other Appropriations

The guaranteed amount, apart from share of profits, may consist of other profit
appropriations like salary to partner, commission to partner etc.

Shortfall
The difference between the amount guaranteed and the amount that a guaranteed partner would
get if the guarantee is not brought into force, is what we call the shortfall.
The terms of guarantee enable us to understand what constitutes the guaranteed amount and
thereby calculate the guaranteed amount and the shortfall that has to be made good if any.
Who bears the shortfall and in what proportion?
Who bears the burden of shortfall is dependent on who has given the guarantee.
Where there is only one partner who has given the guarantee, the total burden inevitably has to
be borne by that partner only.
Where two are more partners have given the guarantee or the firm has given the guarantee, the
proportion in which the burden of shortfall is borne by the partners is dependent on the

agreement between them. In problem solving, where there is no mention of the proportion, we
assume that they share the burden in proportion to the profit sharing ratio inter se between them.
REFERENCES:
(1) http://www.futureaccountant.com/partnership-accounts/study-notes/#.Vg649NKqqkr.