1. Meaning & characteristics of NPO

NON-PROFIT ORGANISATION

MEANING & CHARACTERISTICS

Organizations are of two types: - profit-making & non-profit making. Profit-making organizations operate with the main objective of earning profit. But there are organizations whose objective is not to earn profit but to render services. These organizations are called non-profit making organizations. The services are rendered to its own members or to the society at large. The main objective of such organizations may be social, educational, religious, or charitable. The surplus arising from rendering services is not distributed among its members by way of dividends or share of profit but utilized for the furtherance of the objective of the organization—examples of non-profit making organizations are clubs, societies, schools, colleges, hospitals, charitable trusts etc.

Features of non-profit making ORGANISATIONS:

The features of non-profit making organizations are as follows:

1.         Service motive – Unlike profit-making organizations, the non-profit making organization operates with the motive to serve the people of the society.

2.         Separate identity – The non-profit making organizations have separate legal entities.

3.         Form of organization – Such organizations function in the form of schools, colleges, hospitals, clubs, societies, charitable trusts etc.

4.         Utilisation of surplus – The excess revenue earned over the cost incurred in the process of rendering services is not distributed among its members. Rather it is utilized for achieving the objective of serving society.

5.         Financing – Non-profit making organizations cannot financially operate only by receiving revenue from rendering services. Therefore, it receives donations either from members or outsiders to finance the cost of rendering services.

6.         Budget – Each non-profit organization prepares an annual budget. The budget gives information about the anticipated receipt and expenditure for the ensuing year.

7.         Management – Such organizations are managed by elected representatives of the members.

8.         Accounting – Non-profit making organizations are required to prepare their annual accounts and these accounts are submitted to the members of the government departments. The accounts are prepared on an accrual basis.

1. Meaning & characteristics of NPO

CHAPTER – 1

ACCOUNTING FOR NOT-FOR-PROFIT ORGANISATION

Meaning & characteristics of NPO
There are certain organisations which are set up for providing service to its members and the public in general. Such organisations include clubs, charitable institutions,  schools,  religious organisations, trade unions, welfare societies and societies for the promotion of art and culture. These organisations have service as the main objective and not the profit as is the case of organisations in business. Normally, these organisations do not undertake any business activity, and are managed by trustees who are fully accountable to their members and the society for the utilization of the funds raised for meeting the objectives of the organisation. Hence, they also have to maintain proper accounts and prepare the financial statement which take the form of Receipt and Payment Account; Income and Expenditure Account; and Balance Sheet. at the end of for every accounting period (normally a financial year).
This is also a legal requirement and helps them to keep track of their income and expenditure, the nature of which is different from those of the business organisations. In this chapter we shall learn about the accounting aspects relating to not-for-profit organisation.

Meaning and Characteristics of Not-for- Profit Organisation
Not-for -Profit Organisations refer to the organisations that are for used for the welfare of the society and are set up as charitable institutions which function without any profit motive. Their main aim is to provide service to a specific group or the public at large. Normally, they do not manufacture, purchase or sell goods and may not have credit transactions. Hence they need not maintain many books of account (as the trading concerns do) and Trading and Profit and Loss Account. The funds raised by such organisations are credited to capital fund or general fund. The major sources of their income usually are subscriptions from their members donations, grants-in-aid, income from investments, etc. The main objective of keeping records in such organisations is to meet the statutory requirement and help them in exercising control over utilisation of their funds. They also have to prepare the financial statements at the end of each accounting period (usually a financial year) and ascertain their income and expenditure and the financial position, and submit them to the statutory authority called Registrar of Societies.

The main characteristics of such organisations are:

1. Such organisations are formed for providing service to a specific group or public at large such as education, health care, recreation, sports and so on without any consideration of caste, creed and colour. Its sole aim is to provide service either free of cost or at nominal cost, and not to earn profit.

2. These are organised as charitable trusts/societies and subscribers to such organisation are called members.

3. Their affairs are usually managed by a managing/executive committee elected by its members.

4. The main sources of income of such organisations are: (i) subscriptions from members, (ii) donations (general). (iii) legacies(general). (iv) grant- in-aid, (v) income from investments, etc.

5. The funds raised by such organisations through various sources are credited to capital fund or general fund.

6. The surplus generated in the form of excess of income over expenditure is not distributed amongst the members. It is simply added in the capital fund.

7. The Not-for-Profit Organisations earn their reputation on the basis of their contributions to the welfare of the society rather than on the customers’ or owners’ satisfaction.

8. The accounting information provided by such organisations is meant for the present and potential contributors and to meet the statutory requirement.

1. Nature of partnership, Partnership Deed, Maintenance of Partnership accounts,

Chapter - 2

Accounting for Partnership  : Basic Concepts

You have learnt about the preparation of financial statements for a sole proprietary concern. As the business expands, one needs more capital and larger number of people to manage the business and share its risks. In such a situation, people usually adopt the partnership form of organisation. Accounting for partnership firms has it’s own peculiarities, as the partnership firm comes into existence when two or more persons come together to establish business and share its profits. On many issues affecting distribution of profits, there may not be any specific agreement between the partners. In such a situation the provisions of the Indian Partnership Act 1932 apply. Similarly, calculation of interest on capital, interest on drawings and maintenance of partners capital accounts have their own peculiarities. Not only that a variety of adjustments are required on the death of a partner or when a new partner is admitted and so on. These peculiar situations need specific treatment in accounting that need to be clarified.

The present chapter discusses some basic aspects of partnership such as distribution of profit, maintenance of capital accounts, etc. The treatment of situations like admission of partner, retirement, death and dissolution have been taken up in the subsequent chapters.

Nature of Partnership

When two or more persons join hands to set up a business and share its profits and losses, they are said to be in partnership. Section 4 of the Indian Partnership Act 1932 defines partnership as 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 individually called ‘partners’ and collectively called ‘firm’. The name under which the business is carried is called the ‘firm’s name’. A partnership firm has no separate legal entity, apart from the partners constituting it. Thus, the essential features of partnership are:

  1. Two or More Persons: In order to form partnership, there should be at least two persons coming together for a common goal. In other words, the minimum number of partners in a firm can be two. There is however, a limit on their maximum number. By virtue of Section 464 of the Companies Act 2013, the Central Government is empowered to prescribe maximum number of partners in a firm but the number of partners can not be more than 100. The Central government has prescribed the maximum number of partness in a firm to be 50.
  1. Agreement: Partnership is the result of an agreement between two or more persons to do business and share its profits and losses. The agreement becomes the basis of relationship between the partners. It is not necessary that such agreement is in written form. An oral agreement is equally valid. But in order to avoid disputes, it is preferred that the partners have a written agreement.
  1. Business: The agreement should be to carry on some business. Mere co- ownership of a property does not amount to partnership. For example, if Rohit and Sachin jointly purchase a plot of land, they become the joint owners of the property and not the partners. But if they are in the business of purchase and sale of land for the purpose of making profit, they will be called partners.
  1. Mutual Agency: The business of a partnership concern may be carried on by all the partners or any of them acting for all. This statement has two important implications. First, every partner is entitled to participate in the conduct of the affairs of its business. Second, that there exists a relationship of mutual agency between all the partners. Each partner carrying on the business is the principal as well as the agent for all the other partners. He can bind other partners by his acts and also is bound by the acts of other partners with regard to business of the firm. Relationship of mutual agency is so important that one can say that there would be no partnership, if the element of mutual agency is absent.
  1. Sharing of Profit: Another important element of partnership is that, the agreement between partners must be to share profits and losses of a business. Though the definition contained in the Partnership Act describes partnership as relation between people who agree to share the profits of a business, the sharing of loss is implied. Thus, sharing of profits and losses is important. If some persons join hands for the purpose of some charitable activity, it will not be termed as partnership.
  1. Liability of Partners: Each partner is liable jointly with all the other partners and also severally to the third party for all the acts of the firm done while he is a partner. Not only that the liability of a partner for acts of the firm is also unlimited. This implies that his private assets can also be used for paying off the firm’s debts. 

Partnership Deed

Partnership comes into existence as a result of agreement among the partners. The agreement can be either oral or written. The Partnership Act does not require that the agreement must be in writing. But wherever it is in writing, the document, which contains terms of the agreement is called ‘Partnership Deed’. It generally contains the details about all the aspects affecting the relationship between the partners including the objective of business, contribution of capital by each partner, ratio in which the profits and the losses will be shared by the partners and entitlement of partners to interest on capital, interest on loan, etc.

The clauses of partnership deed can be altered with the consent of all the partners. The deed should be properly drafted and prepared as per the provisions of the ‘Stamp Actand preferably registered with the Registrar of Firms.

Contents of the Partnership Deed

The Partnership Deed usually contains the following details:
•    Names and Addresses of the firm and its main business;
•    Names and Addresses of all partners;
•    Amount of capital to be contributed by each partner;
•    The accounting period of the firm;
•    The date of commencement of partnership;
•    Rules regarding operation of Bank Accounts;
•    Profit and loss sharing ratio;
•    Rate of interest on capital, loan, drawings, etc;
•    Mode of auditor’s appointment, if any;
•    Salaries, commission, etc, if payable to any partner;
•    The rights, duties and liabilities of each partner;
•    Treatment of loss arising out of insolvency of one or more partners
•    Settlement of accounts on dissolution of the firm;
•    Method of settlement of disputes among the partners;
•    Rules to be followed in case of admission, retirement, death of a partner
•    Any other matter relating to the conduct of business.
Normally, the partnership deed covers all matters affecting relationship of partners amongst themselves. However, if there is no express agreement on certain matters, the provisions of the Indian Partnership Act, 1932 shall apply.

Provisions of Partnership Act Relevant for Accounting

The important provisions affecting partnership accounts are as follows:

(a) Profit Sharing Ratio: If the partnership deed is silent about the profit sharing ratio, the profits and losses of the firm are to be shared equally by partners, irrespective of their capital contribution in the firm.

(b) Interest on Capital: No partner is entitled to claim any interest on the amount of capital contributed by him in the firm as a matter of right. However, interest can be allowed when it is expressly agreed to by the partners. Thus, no interest on capital is payable if the partnership deed is silent on the issue.

(c) Interest on Drawings: No interest is to be charged on the drawings made by the partners, if there is no mention in the Deed.

(d) Interest on Loan: If any partner has advanced loan to the firm for the purpose of business, he/she shall be entitled to get an interest on the loan amount at the rate of 6 per cent per annum.

(e) Remuneration for Firm’s Work: No partner is entitled to get salary or other remuneration for taking part in the conduct of the business of the firm unless there is a provision for the same in the Partnership Deed.

Apart from the above, the Indian Partnership Act specifies that subject to contract between the partners:

(i) If a partner derives any profit for him/her self from any transaction of the firm or from the use of the property or business connection of the firm or the firm name, he/she shall account for the profit and pay it to the firm.

(ii) If a partner carries on any business of the same nature as and competing with that of the firm, he/she shall account for and pay to the firm, all profit made by him/her in that business.

Special  Aspects  of Partnership  Accounts

Accounting treatment for partnership firm is similar to that of a sole proprietorship business with the exception of the following aspects:

•   Maintenance of Partners’ Capital Accounts;

•   Distribution of Profit and Loss among the partners;

•   Adjustments for Wrong Appropriation of Profits in the Past;

•   Reconstitution of the Partnership Firm; and

•   Dissolution of Partnership Firm.

The first three aspects mentioned above have been taken up in the following sections of this chapter. The remaining aspects have been covered in the subsequent chapters.

1. Nature of partnership, Partnership Deed, Maintenance of Partnership accounts,

Meaning

 Partnership business is an association between two or more persons who agree to do business & share profits & losses. The partners act as both agents & principals of the firm.

“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.” Section 4 of Indian Partnership Act, 1932.

Nature & Essential features of Partnership

Partnership is a separate business entity from the accounting viewpoint. However, from the legal viewpoint, a partnership firm is not separate from its partners. In case the business assets are not enough to meet the liabilities, the partner’s personal assets would also be liable to meet the debts.

Features

  1. Two or more persons – In a partnership business, the minimum number of partners is two & the maximum number of partners allowed is 50.
  2. Agreement – The relationship between partners is based on an agreement & that agreement is known as Partnership Deed.
  3. Profit-sharing – A partnership business is formed to do lawful business.
  4. Business of partnership can be carried on by all or any of them acting for all.

Partnership Deed

Partnership comes into existence by an oral or written agreement between the partners which contains all the terms & conditions of partnership. This agreement defines the relationship between partners. It is a legal document which is signed by all the partners. This document helps in avoiding any kind of dispute in future among the partners. This document is known as Partnership Deed.

A partnership deed, we can say, is the most important document in partnership business & it consists of the following clauses;

  1. Description of partners – Name, description & address of partners.
  2. Description of the firm – Name & address of the firm.
  3. Principal place of business – Address of the principal place of business
  4. Nature of business – What type of business is it - Trading or manufacturing? The nature of business is mentioned here.
  5. Commencement of Business – Date of commencement of partnership is mentioned here.
  6. Capital Contribution – The amount of capital to be contributed by each partner & whether the capital accounts are fixed or fluctuating.
  7. Interest on Capital – Rate of interest, if allowed, on capital
  8. Interest on Drawings – Rate of interest, if to be charged, on drawings
  9. Profit-Sharing Ratio – Ratio in which profits & losses are to be shared by partners.
  10. Interest on Loan – Rate of interest on loan given by a partner to a firm.
  11. Salary – Amount of salary, and commission to be paid to the partners
  12. Settlement of accounts – The manner in which the accounts of the partners are to be settled in case of his retirement, death or dissolution of partnership.
  13. Accounting period – The date on which accounts shall be closed every year.
  14. Rights & duties of partners – The rights & duties of partners are defined here.
  15. Duration of partnership – The period of partnership for which it has been started.
  16. Bank account operation – How shall the bank accounts be operated? Whether it shall be operated by any partner or jointly.
  17. Valuation of Assets – The manner in which the assets & liabilities of the firm are to be valued.
  18. Death of a partner – Whether the firm will continue or dissolve after the death of a partner.
  19. Settlement of Disputes – If there is any dispute among the partners then how it’ll be settled.

SPECIAL ASPECTS OF A PARTNERSHIP ACCOUNT

When the partnership deed is silent or does not have any clause in respect of the following matters or no partnership deed has been prepared by the partners, the following provisions of the Indian Partnership Act, 1932, shall apply:-

  1. Sharing of profit & losses – Profit & losses to be shared equally by all the partners.
  2. Interest on Capital – Interest on capital is not paid to any partner.
  3. Interest on Drawings – Interest on drawings is not charged to any partner.
  4. Interest on loan or advance/ loans by partners – Interest on loans is paid @ 6% pa. Interest is payable even if there is a loss.
  5. Remuneration to partners – Remuneration (salary, commission etc.) is not paid or allowed to any partner.

Some other important points:-

  1. A minor may be admitted for the benefit of partnership.
  2. A partner may retire from partnership with the consent of other partners or as per the agreement.
  3. Registration of firm is optional & not compulsory.
  4. Unless otherwise agreed by the partners, a firm is dissolved on the death of a partner.

Note – These provisions are applicable even if the partnership deed does not have a clause to this effect.

Maintenance of Partnership Accounts

This is how partnership accounts are maintained

After the determination of net profit by preparing Profit & Loss A/c, we have to prepare Profit & Loss Appropriation A/c.  Profit & Loss Appropriation A/c is an extension of Profit & Loss A/c. It is credited with the Net Profit taken from the Profit & Loss A/c & interest on drawings & debited with interest on capital, partner’s salaries & commissions. If the partners decide to transfer a certain part of the profit to Reserves, then it is also shown in the Dr side& the balance profit is distributed among the partners in their profit sharing ratio.

 

2. Accounting records

Accounting Records of Not-for-Profit Organisations

As stated earlier, normally such organisations are not engaged in any trading or business activities. The main sources of their income are subscriptions from members, donations, financial assistance from government and income from investments. Most of their transactions are in cash  or through the bank. These institutions are required by law to keep proper accounting records and keep proper control over the utilization of their funds. This is why they usually keep a cash book in which all receipts and payments are duly recorded. They also maintain a ledger containing the accounts of all incomes, expenses, assets and liabilities which facilitates the preparation of financial statements at the end of the accounting period. In addition, they are required to maintain a stock register to keep complete record of all fixed assets and the consumables.

They do not maintain any capital account. Instead they maintain capital fund which is also called general fund that goes on accumulating due to surpluses generated, life membership fee, etc., received from year to year. In fact, a proper system of accounting is desirable to avoid or minimise the chances of misappropriations or embezzlement of the funds contributed by the members and other donors.

Final Accounts or Financial Statements

The Not-for-Profit Organisations are also required to prepare financial statements at the end of the each accounting period. Although these organisations are non-profit making entities and they are not required to make Trading and Profit & Loss Account but it is necessary to know whether the income during the year was sufficient to meet the expenses or not. Not only that they have to provide the necessary financial information to members, donors, and contributors and also to the Registrar of Societies. For this purpose, they have to prepare their final accounts at the end of the accounting period and the general principles of accounting are fully applicable in their preparation as stated earlier, the final accounts of a ‘not-for-profit organization’ consist of the following:

a. Receipt and Payment Account

b. Income and Expenditure Account

c. Balance Sheet.

The Receipt and Payment Account is the summary of cash and bank transactions which helps in the preparation of Income and Expenditure Account and the Balance Sheet. Besides, it is a legal requirement as the Receipts and Payments Account has also to be submitted to the Registrar of Societies along with the Income and Expenditure Account, and the Balance Sheet.

Income and Expenditure Account is akin to Profit and Loss Account. The Not-for-Profit Organisations usually prepare the Income and Expenditure Account and a Balance Sheet with the help of Receipt and Payment Account. However, this does not imply that they do not make a trial balance. In order to check the accuracy of the ledger accounts, they also prepare a trial balance which facilitates the preparation of accurate Receipt and Payment Account as well as the Income and Expenditure Account and the Balance Sheet.

In fact, if an organisation has followed the double entry system they must prepare a trial balance for checking the accuracy of the ledger accounts and it will also facilitate the preparation of Receipt and Payment account. Income and Expenditure Account and the Balance Sheet.

Receipt and Payment Account

It is prepared at the end of the accounting year on the basis of cash receipts and cash payments recorded in the cash book. It is a summary of cash and bank transactions under various heads. For example, subscriptions received from the members on different dates which appear on the debit side of the cash book, shall be shown on the receipts side of the Receipt and Payment Account as one item with its total amount. Similarly, salary, rent, electricity charges paid from time to time as recorded on the credit side of the cash book but the total salary paid, total rent paid, total electricity charges paid during the year appear on the payment side of the Receipt and Payment Account. Thus, Receipt and Payment Account gives  summarized  picture of various receipts  and payments, irrespective of whether they pertain to the current period, previous period or succeeding period or whether they are of capital or revenue nature. It may be noted that this account does not show any non cash item like depreciation. The opening balance in Receipt and Payment Account represents cash in hand/cash at bank which is shown on its receipts side and the closing balance of this account represents cash in hand and bank balance as at the end of the year, which appear on the credit side of the Receipt and Payment Account. However, if it is bank overdraft at the end it shall be shown on its debit side as the last item. Let us look at the cash book of Golden Cricket Club given in the example to show how the total amount of each item of receipt and payment has been worked out.

Example 1

Golden Cricket Club Cash Book (Columnar)

Part A

Item wise Aggregation of various Receipts :

Subscriptions (2014–2015)

   Subscriptions (2013–14)

   Subscription (2015–16)

Entrance Fees

Locker Rent

Life Membership fee

Donation for Buildings

Interest on Government securities

    Part B

Item wise Aggregation of various Payments

Insurance Premium

Printing and Stationery

Lighting

Telephone Expenses

Rates and Taxes

Government Securities

Wages and Salaries

Postage and Courier Service

The above data can also be shown in the form of the respective accounts in the ledger. A detailed illustrative list of items of receipts and payments is given in figure 1.

Figure 1

Receipt and Payment Account is given below:

Receipt and Payment Account for the year ending ————

Fig. 1.1: Format of Receipt and Payment Account

There will be either of the two amounts i.e., each at bank or bank overdraft, not both.

It may be noted that the receipts side of the Receipt and Payment Account gives a list of revenue receipts (for past, current and future periods) as well as capital receipts. Similarly, the payments side of the Receipts and Payments Account lists the Revenue Payments (for past, current and future periods) as well as Capital Payments.

Features

    1. It is a summary of the cash book. Its form is identical with that of simple cash book (without discount and bank columns) with debit and credit sides. Receipts are recorded on the debit side while payments are entered on the credit side.
    2. It shows the total amounts of all receipts and payments irrespective of the period to which they  pertain . For example, in the Receipt and Payment account for the year ending on March 31, 2016, we record the total subscriptions received during 2015–16 including the amounts related to the years 2014–2015 and 2016-2017. Similarly, taxes paid during 2015–16 even if they relate to the years 2014–15 and 2016–2017.
    3. It includes all receipts and payments whether they are of capital nature or of revenue nature.
    4. No distinction is made in receipts/payments made in cash or through bank. With the exception of the opening and closing balances, the total amount of each receipt and payment is shown in this account.
    5. No non-cash items such as depreciation outstanding expenses accrued income, etc. are shown in this account.
    6. It begins with opening balance of cash in hand and cash at bank (or bank overdraft) and closes with the year end balance of cash in hand/ cash at bank or bank overdraft. In fact, the closing balance in this account (difference between the total amount of receipts and payments) which is usually a debit balance reflects cash in hand and cash at bank unless there is a bank overdraft.

Steps in the Preparation of Receipt and Payment Account

  1. Take the opening balances of cash in hand and cash at bank and enter them on the debit side. In case there is bank overdraft at the begining of the year, enter the same on the credit side of this account.
  2. Show the total amounts of all receipts on its debit side irrespective of their nature (whether capital or revenue) and whether they pertain to past, current and future periods.
  3. Show the total amounts of all payments on its credit side irrespective of their nature (whether capital or revenue) and whether they pertain to past, current and future periods.
  4. None of the receivable income and payable expense is to be entered in this account as they do not involve inflow or outflow of cash.
  5. Find out the difference between the total of debit side and the total of credit side of the account and enter the same on the credit side as the closing balance of cash/bank. In case, however, the total of the credit side is more than that of the total of the debit side, show the difference on the debit as bank overdraft and close the account.

From the following information based on the data assimilated from the cash book given in example 1, at page 4, the Receipt and Payment Account of Golden Cricket Club for the year ended on March 31, 2015 will be prepared as follows:

Summary of Cash Book

 

   Receipt and Payment Account for the year ending March 31, 2015

Revision 1

From the following particulars relating to Silver Point, prepare a Receipt and Payment account for the year ending March 31, 2017.

Solution

Books of Silver Point Receipt and Payment Account for the year ending March 31, 2017

2. Accounting records

financial statements of non-profit making organizations

Like trading organizations, non-profit making organizations also prepare their financial statements at the end of each accounting period. Their financial statements comprise the following:

             1.         Receipts and Payments Account (Cash Book)

             2.         Income and Expenditure Account (Profit & Loss A/c)

             3.         Balance Sheet.

1. Receipts and Payments ACCOUNT:

 The following points are noteworthy relating to Receipts and Payments A/C:

a. Receipts and Payments Account is a summary of cash transactions.

b. It shows the opening and closing balance of cash and bank, receipts and payments (both cash and cheque) and the closing cash and bank balance at the end of the accounting period.

c. The left-hand side records all receipts and the right-hand side all payments (whether revenue or capital or relating to current years past or future accounting years).

d. It shows a classified summary of cash transactions during a given period.

For example, fees may be received from the members of a club on different dates and appear on different pages of the Cash Book as it is a chronological record. But the total fees received during the accounting period is shown in the Receipts and Payments Account.

Keypoints OF RECEIPTS and Payments Account

1.         It is similar to a Cash Book of a trading concern.

2.         It is a real account. Receipts are recorded on the receipt side and payments are recorded on the payment side.

3.         It starts with the opening cash and bank balance and closes with the closing cash and bank balance.

4.         Both cash and bank transactions are merged in the same column.

5.         All types of receipts are recorded on its receipts side irrespective of the nature of receipts (i.e. both capital and revenue receipts and receipts relating to past, present and future years).

6.        All types of payments are recorded on the credit side irrespective of the nature of payments (i.e. both capital and revenue payments and payments relating to past, present and future years).

Format of Receipts and Payments Account:

Name of the Non-Profit Making Organisation:-

Receipts and Payments Account for the year ended **********

Income and Expenditure Account

Important Facts about Income & Expenditure A/C:

  • Income and Expenditure Account is similar to Profit and Loss Account of a trading concern
  • Since non-profit making organizations do not operate on profit objectives, income and Expenditure Account is prepared instead of preparing Profit and Loss Account.
  • On the debit side, it shows all revenue expenses relating to the current year whether paid or not. 
  • On the credit side, it shows all revenue incomes and gains relating to the current year whether received or not.
  • It is a nominal account and its preparation procedure is the same as that of a Profit and Loss Account of a trading concern.
  • The balancing figure of this account is called surplus/excess of income over expenditure or deficit/excess of expenditure over income.

Key points of Income and Expenditure Account

1.         It is similar to the Profit and Loss Account of a trading concern.

2.         It is a nominal account. Expenses and losses are recorded on the debit side and incomes and gains are recorded on the credit side. The expenses are matched with revenues of the concerned period.

3.         All revenue incomes relating to the current year whether received or due are recorded on the credit side.

4.         All revenue expenses relating to the current year whether paid or outstanding are recorded on the debit side.

5.         Capital expenditures and capital receipts are not recorded in this account.

6.         It records both cash and non-cash items such as depreciation.

Format of Income and Expenditure Account

 (Name of the Non-Profit Making Organisation)

Income and Expenditure Account

For the year ended on *********

The distinction between Receipts and Payments Account and Income and Expenditure A/c

3. Balance Sheet

           The balance sheet of a non-profit making organization is prepared on the same line as that of a trading concern. Assets including accrued income and prepaid expenses are shown on the assets side and the liabilities side shows all liabilities including outstanding expenses. Capital Fund (same as Capital Account in case of trading concerns) appears on the liabilities side. The surplus during the period is added to the Capital Fund and the deficit is subtracted.

             Note: When no information regarding Capital Fund is available, it can be ascertained by preparing the Balance Sheet at the beginning of the year i.e. Opening Balance Sheet.

3. Preparation of opening & closing Balance Sheet, Some peculiar items, Incidental Trading Activity

  Income and Expenditure Account

It is the summary of income and expenditure for the accounting year. It is just like a profit and loss account prepared on accrual basis in case of the business organisations. It includes only revenue items and the balance at the end represents surplus or deficit. The Income and Expenditure Account serves the same purpose as the profit and loss account of a business organisation does. All the revenue items relating to the current period are shown in this account, the expenses and losses on the expenditure side and incomes and gains on the income side of the account. It shows the net operating result in the form of surplus (i.e. excess of income over expenditure) or deficit (i.e. excess of expenditure over income), which is transferred to the capital fund shown in the balance sheet.

The Income and Expenditure Account is prepared on accrual basis with the help of Receipts and Payments Account along with additional information regarding outstanding and prepaid expenses and depreciation etc. Hence, many items appearing in the Receipts and Payments need to be adjusted. For example, as shown in Example 1, (Page No. 10) subscription amount of Rs.2, 65,000 received during the year 2014-15 appearing on the receipts side of the Receipt and Payment Account includes receipts for the periods other than the current period. But the subscription amount of Rs. 2,25,000 pertaining to the current year only will be shown as income in Income and Expenditure Account for the year 2014-15.

Steps in the Preparation of Income and Expenditure Account

Following steps may be helpful in preparing an Income and Expenditure Account from a given Receipt and Payment Account:

1.  Persue the Receipt and Payment Account thoroughly.

2. Exclude the opening and closing balances of cash and bank as they are not an income.

3. Exclude the capital receipts and capital payments as these are to be shown in the Balance Sheet.

4. Consider only the revenue receipts to be shown on the income side of Income and Expenditure Account. Some of these need to be adjusted by excluding the amounts relating to the preceding and the succeeding periods and including the amounts relating to the current year not yet received.

5. Take the revenue expenses to the expenditure side of the Income and Expenditure Account with due adjustments as per the additional information provided relating to the amounts received in advance and those not yet received.

6. Consider the following items not appearing in the Receipt and Payment Account that need to be taken into account for determining the surplus/ deficit for the current year :

    a. Depreciation of fixed assets.

    b. Provision for doubtful debts, if required.

    c. Profit or loss on sale of fixed assets.

Now you will observe how the income and expenditure account is prepared from the receipts and payments account given in example 1, on page 10.

Income and Expenditure Account for the year ending on March 31, 2015

Note that-

  1.    Opening and closing cash/bank balances have been excluded.
  2.    Payment for purchase of Government securities being capital expenditure has been excluded.
  3.    Amount of subscriptions received for the year 2013-14 and 2015-16 have been excluded.
  4.    Life membership fee is an item of capital receipt and so excluded.
  5.    Donation for building is a receipt for a specific purpose and so excluded.

   Revision 2

   From the Receipt and Payment Account given below, prepare the Income and Expenditure Account of Clean Delhi Club for the year ended March 31, 2017.

   Receipt and Payment Account for the year ending March 31, 2017

Solution

Books of Clean Delhi Club

Income and Expenditure Account for the year ending March 31, 2017

Revision3

From the following Receipt and Payment Account for the year ending March 31, 2015 of Negi's Club, prepare Income and Expenditure Account for the same period:

Receipt and Payment Account for the year ending March 31, 2015

The following additional information is available:

  1. Salaries outstanding – Rs. 1,500;
  2. Entertainment expenses outstanding – Rs. 500;
  3. Bank interest receivable – Rs. 150;
  4. Subscriptions accrued – Rs. 400;
  5. 50 per cent of entrance fees is to be capitalised;
  6. Furniture is to be depreciated at 10 per cent per annum.

Solution

  Books of Negi's Club

Income and Expenditure Account for the year ending 31.3.2015

Distinction between Income and Expenditure Account and Receipt and Payment Account

Based upon discussion made in regard to the Receipts and Payments Account and the Income and Expenditure Account we make the distinction between Income and Expenditure Account and Receipts and Payments Account in the tabular form:

 Balance Sheet

‘Not-for-Profit’ Organisations prepare Balance Sheet for ascertaining the financial position of the organisation. The preparation of their Balance Sheet is on the same pattern as that of the business entities. It shows assets and liabilities as at the end of the year. Assets are shown on the right hand side and the liabilities on the left hand side. However, there will be a Capital Fund or General Fund in place of the Capital and the surplus or deficit as per Income and Expenditure Account which is either added to/deducted from the capital fund, as the case may be. It is also a common practice to add some of the capitalised items like legacies, entrance fees and life membership fees directly in the capital fund.

Besides the Capital or General Fund, there may be other funds created for specific purposes or to meet the requirements of the contributors/donors such as building fund, sports fund, etc. Such funds are shown separately in the liabilities side of the balance sheet.

Some times it becomes necessary to prepare Balance Sheet as at the beginning of the year in order to find out the opening balance of the capital/general fund.

Preparation of Balance Sheet

The following procedure is adopted to prepare the Balance Sheet:

1. Take the Capital/General Fund as per the opening balance sheet and add surplus from the Income and Expenditure Account. Further, add entrance fees, legacies, life membership fees, etc. received during the year.

2. Take all the fixed assets (not sold/discarded/or destroyed during the year) with additions (from the Receipts and Payments account) after charging depreciation (as per Income and Expenditure account) and show them on the assets side.

3. Compare items on the receipts side of the Receipts and Payments Account with income side of the Income and Expenditure Account. This is to ascertain the amounts of: (a) subscriptions due but not yet received: (b) incomes received in advance; (c) sale of fixed assets made during the year; (d) items to be capitalised (i.e. taken directly to the Balance Sheet) e.g. legacies, interest on specific fund investment and so on.

4. Similarly compare, items on the payments side of the Receipt and Payment Account with expenditure side of the Income and Expenditure Account. This is to ascertain the amounts if: (a) outstanding expenses; (b) prepaid expenses; (c) purchase of a fixed asset during the year; (d) depreciation on fixed assets; (e) stock of consumable items like stationery in hand; (f) Closing balance of cash in hand and cash at bank as, and so on.

A proforma Balance Sheet is given for the proper understanding of preparing the balance sheet.

Balance Sheet of as on ...............

Fig. 1.2: Proforma Balance Sheet

Revision4

From the following Receipt and Payment Account and additional information relating to Excellent Cricket Club, prepare Income and Expenditure Account for the year ended March 31, 2015 and Balance Sheet as on date.

 

  Donations and Surplus on account of tournament are to be kept in Reserve for a permanent pavilion. Subscriptions due on March 31, 2015 were Rs. 42,000. Write-off fifty per cent of sports materials and thirty per cent of printing and stationery.

  Solution

  Books of Excellent Cricket Club Income and Expenditure Account for the year ending on March 31, 2015

   Note:  Since the opening balance of the capital fund is not given, the same has been ascertained by preparing opening balance sheet.

     Balance Sheet of Excellent Cricket Club as on March 31, 2015

   

Balance Sheet of Excellent Cricket Club as on March 31, 2014

   Some Peculiar Items

  Final accounts of the Not-for-Profit organisations are prepared on the similar pattern as that of a business orgnisation. However, a few items of income and expenses of such orgnisations are somewhat different in nature and need special attention in their treatment in final accounts. They        are peculiar to these orgnisations. Some of the common peculiar items are explained as under:

  Subscriptions:

 Subscription is a membership fee paid by the member on annual basis. This is the main source of income of such orgnisations. Subscription paid by the members is shown as receipt in the Receipt and Payment Account and as income in the Income and Expenditure Account. It may be noted   that Receipt and Payment Account shows the total amount of subscription actually received during the year while the amount shown in Income and Expenditure Account is confined to the figure related to the current period only irrespective of the fact whether it has been received or not.   For example, a club received Rs. 20,000 as subscriptions during the year 2016-17 of which Rs.3,000 relate to year 2015-16 and Rs.2,000 to 2017-18, and at the end of the year 2016-17 Rs.6,000 are still receivable. In this case, the Receipt and Payment Account will show Rs.20,000 as   receipt from subscriptions. But the Income and Expenditure Account will show Rs. 21,000 as income from subscriptions for the year 2016-17, the calculation of which is given as below:    

The above amount of subscriptions to be shown as income can also be ascertained by preparing the subscription account as follows:

Subscription Account

Revision 5

As per Receipt and Payment Account for the year ended on March 31, 2017, the subscriptions received were Rs. 2,50,000. Additional Information given is as follows:

  1.  Subscriptions Outstanding on 1.4.2016 Rs. 50,000
  2. Subscriptions Outstanding on 31.3.2017 Rs.35,000
  3. Subscriptions Received in Advance as on 1.4.2016 Rs.25,000
  4. Subscriptions Received in Advance as on 31.3.2017 Rs.30,000

Ascertain the amount of income from subscriptions for the year 2016–17 and show how relevant items of subscriptions appear in opening and closing balance sheets.

Solution

Alternately, income received from subscriptions can be calculated by preparing a Subscriptions account as under.

Subscription Account

Relevant items of subscription can be shown in the opening and closing balance sheet as under:

Balance Sheet as on March 31, 2014

Relevant data only

Balance Sheet as on March 31, 2015

Relevant data only

 

Revision 6

Extracts of Receipt and Payment Account for the year ended March 31, 2017 are given below:

Receipt                                                                          Subscriptions (Rs.)

2015-16                                                                                 2,500

2016-17                                                                                 26,750

2017-18                                                                                 1,000

       30,250

Additional Information:

Total number of members: 230. Annual membership fee: Rs. 125.

Subscriptions outstandings on April 1, 2016: Rs. 2,750.

Prepare a statement showing all relevant items of subscriptions viz., income, advance, outstandings, etc.

Solution

Amount of subscription due for the year 2016-17 irrespective of cash Rs. 28,750 (i.e. Rs. 125 × Rs. 230).

Note:  The amount of subscriptions outstanding as on 01-04-2017 has been ascertained as follows:

Revision 7

From the following extract of Receipt and Payment Account and the additional information, compute the amount of income from subscriptions and show as how they would appear in the Income and Expenditure Account for the year ending March 31, 2015 and the Balance Sheet.

Receipt and Payment  Account  for the year ending  March 31, 2015

Additional Information:

 

Solution

Income and expenditure account for the year ending on march 31, 2015

Note:  Total amount of subscriptions outstanding as on 31-3-2015 are Rs. 18,500. This, includes Rs. 1,500 (Rs. 8,500 - Rs. 7,000) for subscriptions still outstanding for 2013-14.  Hence, the subscriptions outstanding for 2014-15 are Rs. 17,000 (Rs. 18,500 - Rs. 1,500)

Balance Sheet (Relevant Data) as on  March 31, 2015

 Relevant data only

Donations:

It is a sort of gift in cash or property received from some person or organisation. It appears on the receipts side of the Receipts and Payments Account. Donation can be for specific purposes or for general purposes.

(i) Specific Donations: If donation received is to be utilised to achieve specified

purpose, it is called Specific Donation. The specific purpose can be an extension of the existing building, construction of new computer laboratory, creation of a book bank, etc. Such donation is to be capitalised and shown on the liabilities side of the Balance Sheet irrespective of the fact whether the amount is big or small. The intention is to utilise the amount for the specified purpose only.

(ii) General Donations: Such donations are to be utilised to promote the general purpose of the organisation. These are treated as revenue receipts as it is a regular source of income hence, it is taken to the income side of the Income and Expenditure Account of the current year.

Legacies:

 It is the amount received as per the will of a deceased person who may or may not specify the use of the amount. Legacies, use of which is specified are specific legacy and is shown in the balance sheet as liability. If the use is not specified it is considered as revenue nature and credited to income and expenditure account.

Life Membership Fees:

Some members prefer to pay lump sum amount as life membership fee instead of paying periodic subscription. Such amount is treated as capital receipt and credited directly to the capital/general fund.

Entrance Fees: 

Entrance fee also known as admission fee is paid only once by the member at the time of becoming a member. In case of organisations like clubs and some charitable institutions, is limited and the amount of entrance fees is quite high. Hence, it is treated as non-recurring item and credited directly to capital/general fund.

Sale of old asset:

 Receipts from the sale of an old asset appear in the Receipts and Payments Account of the year in which it is sold. But any gain or loss on the sale of asset is taken to the Income and Expenditure Account of the year. For example, if an item furniture with a book value of Rs. 800 is sold for Rs. 700, this amount of Rs. 700 will be shown as receipt in Receipts and Payments Account and Rs. 100 on the expenditure side of the Income and Expenditure Account as a loss on sale of old asset and while showing furniture in the balance sheet Rs. 800 will be deducted from its total book value.

Sale of Periodicals:

It is an item of recurring nature and shown as the income side of the Income and Expenditure Account.

Sale of Sports Materials:

 Sale of sports materials (used materials like old balls, bats, nets, etc) is the regular feature with any Sports Club. It is usually shown as an income in the Income and Expenditure Account.

Payments of Honorarium:

It is the amount paid to the person who is not the regular employee of the institution. Payment to an artist for giving performance at the club is an example of honorarium. This payment of honorarium is shown on the expenditure side of the Income and Expenditure Account.

Endowment Fund:

It is a fund arising from a bequest or gift, the income of which is devoted for a specific purpose. Hence, it is a capital receipt and shown on the Liabilities side of the Balance Sheet as an item of a specific purpose fund.

Government Grant:

Schools, colleges, public hospitals, etc. depend upon government grant for their activities. The recurring grants in the form of maintenance grant is treated as revenue receipt (i.e. income of the current year) and credited to Income and Expenditure account. However, grants such as building grant are treated as capital receipt and transferred to the building fund account. It may be noted that some Not-for-Profit organisations receive cash subsidy from the government or government agencies. This subsidy is also treated as revenue income for the year in which it is received.

Special Funds

The Not-for-Profit Organisations office create special funds for certain purposes/activities such as 'prize funds', 'match fund' and 'sports fund', etc. Such funds are invested in securities and the income earned on such investments is added to the respective fund, not credited to Income and Expenditure Account. Similarly, the expenses incurred on such specific purposes are also deducted from the special fund. For example, a club may maintain a special fund for sports activities. In such a situation, the interest income on sports fund investments is added to the sports fund and all expenses on sports deducted there from. The special funds are shown in balance sheet. However, if, after adjustment of income and expenses the balance in specific or special fund is negative, it is transferred to the debit side of the Income and Expenditure Account or adjusted as per prescribed directions. (see Illustrations 8 and 9.)

Revision 8

Show how you would deal with the following items in the financial statements of a Club:

Solution

Revision 9

(a) Show the following information in financial statements of a ' Not-for-Profit' Organisation:

(b) What will be the effect, if match expenses go up by Rs. 6,000 other things remaining the same?

Solution

(a)  Balance Sheet as on………..*

Only relevant data.

(b) If match expenses go up by Rs. 6,000, the net balance of the match fund becomes negative i.e. Debit exceeds the Credit, and the resultant debit balance of Rs. 2,000 shall be charged to the Income and Expenditure Account of that year.

Revision 10

Extract of a Receipt and Payment Account for the year ended on March 31, 2015:

Payments:  Stationery Rs. 23,000

Additional Information:

Solution

Stationery:

Normally expenses incurred on stationary, a consumable items are charged to Income and Expenditure Account. But in case stock of stationery (opening and/or closing) is given, the approach would be make necessary adjustments in purchases of stationery and work out cost of stationery consumed and show that amount in Income and Expenditure Account and its stock in the balance sheet. For example, the Receipt and Payment Account shows a payment for stationery amounting to Rs. 40,000 and there is an opening and closing stationery amounting to Rs. 12,000 and Rs. 15,000. The amount of expense on stationery will be worked out as follows:

In case stationery is also purchased on credit, the amount of its consumption will be worked out as given in Revision12.

Revision 11

Following is the Receipt and Payment Account of an Entertainment Club for the period April 1, 2016 to March 31, 2017.

Receipt and Payment  Account for the year ending March 31, 2017

Additional Information

  1. The club had 225 members, each paying an annual subscription of Rs. 500. Subscription outstanding as on 31 March 2016 Rs. 15,000.
  2. Telephone bill outstanding for the year 2016-2017 is Rs. 2,000.
  3. Locker Rent Rs. 3,050 outstanding for the year 2015-16 and Rs. 1,500 for 2016-17.
  4. Salary outstanding for the year 2016-17 Rs. 4,000.
  5. Opening Stock of Printing and stationery Rs. 2,000 and closing stock of printing and stationery is Rs. 3,000 for the year 2016-17.
  6. On 1st April 2016 other balances were as under:
  7. Depreciation Furniture and Building @ 12.5% and 5% respectively assuming that it is on reducing balance for the year ending March 31,2017

Prepare  Income  and  Expenditure  account  and  Balance  Sheet as  on that date.

Book of entertainment club

Income and expenditure account for the year ending on march 31, 2017

Solution

Balance Sheet of Entertainment Club as on March 31, 2016

 

Balance Sheet of Entertainment Club as on March 31, 2017

Revision 12

 

Prepare Income and Expenditure Account and Balance Sheet for the year ended

March 31, 2015 from the following information.

Receipt and Payment  Account for the year ending March 31, 2015

The following additional information is provided to you:

1. There are 1800 members each paying an annual subscription of

Rs. 200, Rs. 8,000 were in arrears for 2013-14 as on April 1, 2014.

2. On March 31, 2015 the rates were prepaid to June 2015; the charge paid every year being Rs. 24,000.

3. There was an outstanding telephone bill for Rs. 1,400 on March 31, 2015.

4. Outstanding sundry expenses as on March 31, 2014 totaled Rs. 2,800.

5. Stock of stationery as on March 31, 2014 was Rs. 2000; on March 31, 2015, it was Rs. 3,600.

6. On March 31, 2014 Building stood at Rs. 4,00,000 and it was subject to depreciation @ 2.5% p. a.

7. Investment on March 31, 2014 stood at Rs. 8,00,000.

8. On March 31, 2015, income accrued on investments purchased during the year amounted to Rs. 1,500.

 

Solution

Income  and Expenditure  Account for the year ending on March 31, 2015

Balance Sheet as on March 31, 2015

Balance Sheet as on March 31, 2014

 Working Note :

Subscription Account 

Revision 13

Following is the Receipt and Payment Account of Friendship Club in respect of the Year on 31.3.2016

Receipt and Payment  Account for the year ending March 31, 2016.

Additional Information :

1.  There are 500 members, each paying an annual subscription of Rs. 50, Rs. 17,500 being in arrears for 2014-15 at the beginning of 2015-16. During 2014-15, subscriptions were paid in advance by 40 members for 2015-16.

2.  Stock of stationery on March 31, 2015, was Rs. 1,500 and on March 31, 2016, Rs. 2,000.

3.  On March 31, 2016, the rates and taxes were prepaid to the following January 31, the annual charge being Rs. 1,500.

4.  Telephone bill unpaid as on March 31, 2015 Rs. 3,000 and on March 31, 2016 Rs. 1,500.

5.  Sundry expenses accruing at 31.3.2015 were Rs. 250 and at March 31, 2016 Rs. 300.

6.  On March 31, 2015 Building stood in the books at Rs. 2,00,000 and it is required to write off depreciation @ 10% p.a.

7.  Value of 8% Government Securities on March 31, 2015 was Rs. 75,000 which were purchased at that date at Par. Additional Government Securities worth Rs. 25,000 are purchased on March 31, 2016.

 You are required to prepare:

(a)  An Income and Expenditure Account for the year ended on 31.3.2016 (b)  A Balance Sheet on that date.

Solution

Books of Friendship Club 

Balance sheet as on march 31, 2015

 

Income  and Expenditure  Account for the year ending on March 31, 2015

Verification: 500 x 50 = 25000.

Balance Sheet of Friendship Club as on March 31, 2016

Income and Expenditure  Account based on Trial Balance

In case of not-for-profit organisations, normally the Income and Expenditure Account and Balance Sheet is prepared based on the Receipts and Payments Account and the additional information given. But, sometimes, the trial balance along with some additional information is given for this purpose. See Revision 14.

Revision 14

From the trial balance and other information given below for a school, prepare Income and Expenditure Account for the year ended on 31.3.2017 and a Balance Sheet as on that date:

Additional Information:

(i)  Tution fee yet to be received for the year are Rs. 25,000.
(ii)  Salaries yet to be paid amount to Rs.30,000.

(iii)  Furniture costing Rs. 40000 was purchased on October 1, 2016 was sold for Rs. 20,000.
(iv)  The book value of the furniture sold was Rs. 50,000 on April 1, 2016 was sold for 
Rs. 20,000.
(v)  Depreciation is to be charged @ 10% p.a. on furniture, 15% p.a. on Library books, and 5% p.a. on building.

Solution

Income  and Expenditure  Account for the year ending on March 31, 2017

 Working Notes: 

1.  As admission fee is a regular income of a school, so it has been taken as a revenue income of the school.

2.  Depreciation on furniture has been computed as following on the assumption that furniture was sold on April 1, 2016.

Balance Sheet as on March 31, 2017

Revision 15

Prepare Income and Expenditure Account of Entertainment Club for the year ending March 31, 2017 and Balance Sheet as on that date from the following information:

Receipt and Payment Account For the year ending on March 31, 2017

Additional Information:

Solution

Books of Entertainment Club Income and Expenditure  Account for the year ending March 31, 2017

Balance Sheet of Entertainment Club as on March 31, 2016

Balance Sheet of Entertainment as on March 31, 2017

Note:  Interest on Prize Fund Investments @ 5% amounts to Rs. 3,000 whereas only Rs. 1,500 have been received; so the balance is treated as Accrued interest.

It is preferable to prepare separate accounts of various items involving many transactions. In this case Account for Subscription, Miscellaneous Expenses, and Sports Materials may be made as a Classroom activity.

Revision 16

Shiv-e-Narain Education Trust provides the information in regard to Receipt and Payment Account and Income and Expenditure Account for the year ended March 31st 2017:

Receipt and Payment  Account for the year ending March 31, 2017

On March 31, 2016 the following balances appeared:

Investments Rs.1, 60,000; Furniture Rs.40, 000; and Books Rs.20, 000.

Income  and Expenditure  Account for the year ending on March 31, 2017

Prepare opening and closing balance sheet

Solution

Shiv-e-Narain Education Trust Balance Sheet as on March 31, 2016

Balance Sheet of Shiv-e-Narain Education Trust as on March 31, 2017

Note:

1Income and Expenditure Account for the current year shows interest on investment income Rs.6,800 while Receipts and Payments Account shows the receipts of   Rs.6,000 the difference of Rs.800 means interest on investment has become due but not yet receivable  during the year.

2.  Income and Expenditure Account shows Rs.90,000 as income from Tuition fees. However, the Receipts and Payments Account shows Rs.10,000 as tuition fees received for the year 2017-18 and Rs.80,000 for 2015-16. It implies that Rs.10,000 on account of tuition fees for the year 2016-17 are still receivable (i.e. Tuition fees are outstanding).

3Receipt and Payment Account shows a payment of Rs.85,000 on account of staff salaries, but the Income and Expenditure Account shows expenditure of Rs.84,000 on account of staff salaries. It means the excess of Rs.1,000 shown in the Receipt and Payment Account may either belong to the pervious year or the next year. Their  is no evidence that staff salaries of Rs.1,000 was outstanding at the end of the  previous year  2013-14. This is why this payment of Rs.1,000 has been considered  as an advance salaries to the staff.

Summary

  1. Difference between Profit Seeking Entities and Not-for-Profit Entities: Profit- seeking entities undertake activities such as manufacturing trading, banking and insurance to bring financial gain to the owners. Not-for-Profit entities exist to provide services to the member or to the society at large. Such entities might sometimes carry on trading activities but the profits arising therefrom are used for further the service objectives.
  2. Appreciation of the need for separate Accounting Treatment for Not-for-Profit Organisations: Since not-for-profit entities are guided primarily by a service motive, the decisions made by their managers are different from those made by their counterparts in profit-seeking entities. Differences in the nature of decisions implies that the financial information on which they are based, must also be different in content and presentation.
  3. Explanation of the nature of the Principal Financial Statements prepare by Not-for- Profit enterprises: Not-for-Profit Organisations that maintain accounts based on the double-entry system of accounting, generally prepare three principal statements to fulfil their information needs. These include Receipts and Payments Account, Income and Expenditure Account, and a Balance Sheet. The Receipts and Payments Account is summarised under relevant heads, cash book which records all cash Receipts and cash Payments without distinguishing between capital and revenue items, and between items relating to the current year and those relating to previous or future years. The Income and Expenditure Account is an income statement which is prepared to ascertain the excess of revenue income over revenue expenditure or vice versa, for a particular accounting year, as a result of the entity's overall activities. Although it is considered to be a substitute for the Trading and Profit and Loss Account of a profit-seeking entity, there are certain conceptual differences between the two statements. The Balance Sheet is prepared at the end of the entity's accounting year to depict the financial position on that date. It includes the Capital Fund or Accumulated Fund, special purpose funds, and current liabilities on the left hand or liabilities side, and fixed assets and current assets on the right hand or assets side.
  4. Difference between the Receipt and Payment Account and the Income and Expenditure Account: Many differences exist between the Receipt and Payment Account and the Income and Expenditure Account which is evident from the nature and purpose of two statements. While the former records both capital and revenue receipts and payments relating to any accounting year, the latter records only revenue items relating to the current accounting year. Non-cash expenses such as depreciation on fixed assets and outstanding incomes and expenses are shown in the latter but omitted in the former. The Receipt and Payment Account has an opening balance while the Income and Expenditure Account does not. The closing balance of the former account represents cash and bank balances on the closing date while in the latter account it indicates surplus or deficit from the activities of the enterprise.
  5. Conversion of a Receipt and Payment Account into an Income and Expenditure Account: This essentially involves five steps namely, (i) adjusting the revenue receipts on the debit side to include accrued incomes and incomes relating to the current year received earlier and to exclude amounts received in arrears or in advance; (ii) adjusting revenue payments on the credit side; (iii) identifying and showing non-cash expenses and losses on the debit side of the Income and Expenditure Account; (iv) computing and showing profits/losses from trading and/or social activities on the credit/debit side of the Income and Expenditure Account; and (v) ascertaining the surplus or deficit as the closing balance of the Income and Expenditure Account.

3. Preparation of opening & closing Balance Sheet, Some peculiar items, Incidental Trading Activity

How to Prepare Opening & Closing Balance Sheet?

Step 1 – Take into account the closing balances of assets & liabilities of the previous year & the opening balances of the Receipts & Payments A/c will be the cash in hand & cash at the bank as of that date. The Balancing Figure will be Capital Fund

Step 2 – After the preparation of the opening Balance Sheet, we shall proceed towards the preparation of the Closing Balance Sheet& for this purpose, the assets will be then adjusted for any sale or purchase during the year. Any gain or loss on the sale of assets will be taken to Income & Expenditure A/c. Any depreciation will also be taken to Income & Expenditure A/c. Only the net assets will appear on the Balance Sheet& the payments made for the purchase of new assets in the Receipts & Payments A/c shall appear as the new asset or added to the old assets.

Step 3 – From the Receipts side, any capital receipts like contributions to Building Fund & specific funds like specific donations will be recorded on the liabilities side.

Step 4 – Adjustments for prepaid & outstanding expenses will be made to the relevant expenses. Outstanding expenses & advance subscriptions will appear on the liabilities side whereas prepaid expenses & outstanding subscriptions will appear on the asset side.

Step 5 – The liabilities appearing in the previous year’s Balance Sheet should be checked with the payments made during the year. If some liabilities have been paid, then these liabilities will not appear in the new Balance Sheet to the extent they are paid. Only the net unpaid amount if any will appear on the Balance Sheet.

Step 6 – Finally, the Capital Fund balance from Opening Balance Sheet shall be adjusted with surplus or deficit from the Income & Expenditure A/c & also any specific fund which is not required anymore will be added to the Capital fund.

AN EXAMPLE OF CLOSING A BALANCE SHEET

Meaning and Treatment of Special Items

             The meaning and treatment of the special items in the financial statements of non-profit making organizations are as follows:

1.         Capital Fund

             Non-profit organizations follow FUND BASED ACCOUNTING method. In this method, the fund is of two types i.e. General Fund or Capital Fund & Specific Fund.  The capital introduced is known as the General Fund or Capital Fund. It is an unrestricted fund that can be used to achieve the objectives of society. All the recurring expenses like salary and rent are charged to General Fund through Income & Expenditure A/c similarly all the revenues are added to the General Fund through Income & Expenditure A/c. If the fund money is invested somewhere then the interest earned will be directly added to the General Fund/Capital Fund.

             On the other hand, Specific Fund is a restricted fund set up for a specific purpose. The money can be used only for the achievement & realization of that particular purpose. The restriction on the use of this fund is either put by the donor or by the management. If the fund money is invested somewhere then the interest earned will be directly added to the specific Fund. It is again classified into two types;

  1. Specific Asset Building – Funds used for building some fixed assets like Building or Pavilion.
  2. Revenue Funds – Funds used for maintaining certain recurring expenses such as Tournament fund, Scholarship Fund, Sports Fund etc.

2.         Subscriptions

             Subscriptions are collected by non-profit making organizations from their members regularly. It is revenue in nature. It is the main source of income for any non-profit making organization. Subscriptions related to the current year shall be recorded in Income & Expenditure A/c whether received or not. Subscriptions due for the current year shall also be shown in the asset side of the Balance Sheet. Subscriptions received in advance for next year shall not appear in the Income & Expenditure A/c as it is not a current year item but the amount received in advance shall be recorded as a liability in the Balance sheet as it is a prepaid income.

Explanation:-

Income& Expenditure A/c is nothing but P/L A/c with a different name. Since the purpose of preparing P/L A/c is to find out the current year's profit or loss, therefore, only current items of revenue nature is recorded in P/L A/c. In the same way, Income & Expenditure A/c also records only the current year items & items of the previous year & next year are excluded.

  • Outstanding at the end shall be added as it is a current year item.
  • Outstanding at the beginning shall be deducted as it is a previous year's item (last year’s closing outstanding is this year’s opening outstanding)
  • Advance at the End is not a current year item. It is the membership fees received for next year in advance so it’ll be deducted from the total subscriptions received.
  • Advance at the beginning is this year’s income because it represents last year’s closing advance i.e. membership fees for the current year received in advance during the previous year.

3.         Donations

             A non-profit making organization may receive donations from time to time. Donations received for a particular purpose like the development of a pavilion, construction of a building, awarding prizes etc. are called specific donations. A donation received not for a specific purpose is called a general donation.

             Accounting Treatment: All specific donations are to be capitalized i.e. put in the liabilities side of the Balance Sheet.

             If the general donation is a big amount it is to be capitalized i.e. added to the Capital Fund in the liabilities side of the Balance sheet.

             In case the general donation is a small amount it is treated as income and put in the credit side of the Income and Expenditure Account.

             Note: Whether the amount of general donation is big or small, it is judged by considering the nature of the activities of the non-profit making organizations.

4.         Entrance Fees

             This is the fee collected from the new entrants on admission to the clubs or societies etc. It is also known as admission fees.

             Accounting Treatment: The entrance fees may be treated as revenue or capital depending upon the rule and by-laws of the organizations.

5.         Legacies

             It is a kind of gift received by a non-profit making organisation as per the will of a deceased person.

             Accounting Treatment: If legacy is a small amount, it is treated as an income and is to be taken in the credit side of Income and Expenditure Account.

             In case of a big amount, it should be capitalised i.e. added to Capital Fund in the liabilities side of Balance Sheet.

             Note:Whether the amount of legacy is big or small, it is judged by considering the nature of activities of non-profit making organisation.

6.         Life Membership Fees

             Membership fees for the whole life collected from members is known as life membership fees. In this case the member is to pay a lump-sum amount instead of periodic payments and enjoys the benefits of the organisation till the end of his life.

             Accounting Treatment: Life membership fees is treated as capital item and hence added to the Capital fund.

             Note: However, there is another way of treatment.

             It is credited to a separate fund (Life Membership Fees Account) and an amount equal to the annual membership fee (subscription) is transferred to the Income and Expenditure Account. The balance in the separate fund is shown in the liabilities side of the Balance Sheet. If a life member dies, then the balance lying in the special fund is transferred to the Capital Fund of the organization.

7.         Special Fund

            Sometimes a non-profit making organisation may create funds for some special purposes. For example, a sports club may create Tournament Fund for meeting tournaments expenses or a building fund for the construction of building etc.

             Accounting Treatment: The fund may be invested in banks or in Govt. securities.

  • Any income relating to such special fund is added to this fund.
  • Any expenditure on account of this fund is subtracted from such fund.
  • Such special fund appears in the liabilities side of Balance Sheet.
  • If there is deficit (the expenditure on account of fund is more than the amount of fund) it is recorded in the expenditure side of Income and Expenditure Account.

8.       Calculation of Cost of Consumable Goods – Consumable goods are the items that are used or consumed during the year such as sports material, stationery, books, medicines, and food items. In the Income & Expenditure A/c, only the amount of such items consumed will during the year be shown. Therefore, it is necessary to find out the cost of consumption of such goods.

STEPS TO PREPARE INCOME & EXPENDITURE A/C FROM RECEIPTS & PAYMENTS A/C

  1. Prepare the Opening Balance Sheet to find out the opening balance of Capital Fund (if it is not given).
  2. Identify the revenue receipts from the receipts side of Receipts & Payment A/c & show them in the Income side of the Income & Expenditure A/c. Capital receipts will be shown in the Balance sheet.
  3. Identify the Capital expenditure from the payment side of Receipts & Payment A/c & show it in the Balance sheet. Capital items won’t appear in Income & Expenditure A/c.
  4. Certain items do not appear in Receipts & Payment A/c but shall be recorded in Income & Expenditure A/c such as depreciation of fixed assets, loss on sale of fixed assets, and profit on the sale of fixed assets. Depreciation & loss shall be shown in the Expenditure side whereas profit on the sale of fixed assets shall be shown in the Income side.
  5. Finally, find out the surplus or deficit i.e. if the income side is higher it is surplus & if the expenditure side is higher then it is a deficit.
  6. Prepare Closing Balance Sheet by taking into consideration the opening balance of assets & liabilities, surplus/deficit, purchase & sale of assets during the year & depreciation on fixed assets. The surplus shall be added to the Capital whereas the Deficit shall be deducted from the Capital.

INCIDENTAL TRADING ACTIVITY

This Incidental Trading activity is also known as incidentals, these are the gratuities and the fees or costs which are incurred in addition to the main item, service or event paid for during the trading pursuits.

Trading pursuits like a hospital or a chemist shop or even a beauty parlor or canteen, all these places can also in use to furnish certain provisions to the members or public. In this scenario, the trading A/c has to be drawn to determine the outcome of this incidental pursuit. The profit from these trading pursuits is solicited to accomplish the primary objectives which satisfy the cause for which the establishment was set up, then it is transferred to the Income and Expenditure A/c. 

In Relation to the Above, the following are the Details:

  • The trading A/c has to be outlined to ascertain either profit or loss due to incidental commercial pursuit. All these costs and revenues in a straight way and principally are associated with such pursuits, are documented in the trading A/c. After this, the Balance of the trading A/c is being transferred to the Income and Expenditure A/c
  • Income and Expenditure A/c documents, also the trading profit (or loss), and all other incomes and expenses are not documented in the Trading A/c. Surfeit or deficit is disclosed by the Income and Expenditure A/c as is being transferred to the capital or general fund.

2. Maintenance of capital accounts, Distribution of profit among the partners

Maintenance  of Capital Accounts of Partners

All transactions relating to partners of the firm are recorded in the books of the firm through their capital accounts. This includes the amount of money brought in as capital, withdrawal of capital, share of profit, interest on capital, interest on drawings, partner’s salary, commission to partners, etc.
There are two methods by which the capital accounts of partners can be maintained. These are: (i) fixed capital method, and (ii) fluctuating capital method. The difference between the two lies in whether or not the transactions other than addition/withdrawal of capital are recorded in the capital accounts of the partners.

Fixed Capital Method: Under the fixed capital method, the capitals of the partners shall remain fixed unless additional capital is introduced or a part of the capital is withdrawn as per the agreement among the partners. All items like share of profit or loss, interest on capital, drawings, interest on drawings, etc. are recorded in a separate accounts, called Partner’s Current Account. The partners’ capital accounts will always show a credit balance, which shall remain the same (fixed) year after year unless there is any addition or withdrawal of capital. The partners’ current account on the other hand, may show a debit or a credit balance. Thus under this method, two accounts are maintained for each partner viz., capital account and current account, While the partners’ capital accounts shall always appear on the liabilities side in the balance sheet, the partners’ current account’s balance shall be shown on the liabilities side, if they have credit balance and on the assets side, if they have debit balance. The partner’s capital account and the current account under the fixed capital method would appear as shown below:

Partner’s  Capital  Account

Partner’s  Current  Account

                                                                                                                                           Fig. 2.1: Proforma of Partner’s Capital and Current Account under Fixed Capital Method.

Fluctuating Capital Method: Under the fluctuating capital method, only one account, i.e. capital account is maintained for each partner. All the adjustments such as share of profit and loss, interest on capital, drawings, interest on drawings, salary or commission to partners, etc are recorded directly in the capital accounts of the partners. This makes the balance in the capital account to fluctuate from time to time. That’s the reason why this method is called fluctuating capital method. In the absence of any instruction, the capital account should be prepared by this method. The proforma of capital accounts prepared under the fluctuating capital method is given below:

Partner’s  Capital  Account

                                                                                                                                                          Fig. 2.2: Proforma of Partner’s Capital Account under Fluctuating capital Method.

Distinction between Fixed and Fluctuating Capital Accounts

The main points of differences between the fixed and fluctuating capital methods can be summed up as follows:

Distribution of Profit among Partners

 The profits and losses of the firm are distributed among the partners in an agreed ratio. However, if the partnership deed is silent, the firm’s profits and losses are to be shared equally by all the partners.

You know that in the case of sole partnership the profit or loss, as ascertained by the profit and loss account is transferred to the capital account of the proprietor. In case of partnership, however, certain adjustments such as interest on drawings, interest on capital, salary to partners, and commission to partners are required to be made. For this purpose, it is customary to prepare a Profit and Loss Appropriation Account of the firm and ascertain the final figure of profit and loss to be distributed among the partners, in their profit sharing ratio.

Profit and Loss Appropriation Account

Profit and Loss Appropriation Account is merely an extension of the Profit and Loss Account of the firm. It shows how the profits are appropriated or distributed among the partners. All adjustments in respect of partner’s salary, partner’s commission, interest on capital, interest on drawings, etc. are made through this account. It starts with the net profit/net loss as per Profit and Loss Account. The journal entries for preparation of Profit and Loss Appropriation Account and making various adjustments through it are given as follows:

Journal Entries

1. Transfer of the balance of Profit and Loss Account to Profit and Loss Appropriation Account:

(a)     If Profit and Loss Account shows a credit balance (net profit): Profit and Loss A/c                                           Dr.

To Profit and Loss Appropriation A/c

(b)     If Profit and Loss Account shows a debit balance (net loss) Profit and Loss Appropriation A/c                        Dr.

To Profit and Loss A/c

2.  Interest on Capital:

(a)    For Allowing interest on capital:

Interest on Capital A/c                            Dr.

To Partner’s Capital/Current A/cs (individually)

(b)     For transferring interest on capital to Profit and Loss Appropriation Account: Profit and Loss Appropriation A/c                 Dr.

To Interest on Capital A/c

3.  Interest on Drawings:

(a)     For charging interest on drawings to partnerscapital accounts: Partners Capital/Current A/c’s (individually)                      Dr.

To Interest on Drawings A/c

(b)     For transferring interest on drawings to Profit and Loss Appropriation Account: Interest on Drawings A/c                          Dr.

To Profit and Loss Appropriation A/c

4.  Partner’s Salary:

(a)     For Allowing partner’s salary to partner’s capital account: Salary to Partner A/c                                      Dr.

To Partner’s Capital/Current A/c’s (individually)

(b)     For transferring partner’s salary to Profit and Loss Appropriation Account: Profit and Loss Appropriation A/c                Dr.

To Salary to Partner’s A/c

5.  Partner’s Commission:

(a)     For crediting commission allowed to a partner, to partner’s capital account: Commission to Partner A/c                             Dr.

To Partner’s Capital/Current A/c’s (individually)

(b)     For transferring commission allowed to partners to Profit and Loss Appropriation Account.

Profit and Loss Appropriation A/c                           Dr.

To Commission to Partners Capital/Current A/c

              6.  Share of Profit or Loss after appropriations:

      (a   If Profit:

Profit and Loss Appropriation A/c                       Dr.
To Partner’s Capital/Current A/c’s (individually)

(b  If Loss:

Partner’s Capital/Current A/c (individually) To Profit and Loss Appropriation A/c

Note: In case firm suffers a loss, no interest on capital, salary, remuneration is to be allowed to partners. The Proforma of Profit and Loss Appropriation Account is given as follows:

Profit  and Loss Appropriation Account

                                                                                                                                                    Fig. 2.3: Proforma of Profit and Loss Appropriation Account

Revision 1

Sameer and Yasmin are partners with capitals of Rs.15,00,000 and Rs. 10,00,000 respectively. They agreed to share profits in the ratio of 3:2. Show how the following transactions will be recorded in the capital accounts of the partners in case: (i) the capitals are fixed, and (ii) the capitals are fluctuating. The books are closed on March 31, every year.

Solution

Fixed Capital Method
Partner’s  Capital  Accounts

Partner’s  Current  Accounts

Fluctuating Capital Method

Partner’s  Capital Accounts

Revision 2

Amit, Babu and Charu set up a partnership firm on April 1, 2019. They contributed Rs. 50,000, Rs. 40,000 and Rs. 30,000, respectively as their capitals and agreed to share profits and losses in the ratio of 3 : 2 :1. Amit is to be paid a salary of Rs. 1,000 per month and Babu, a Commission of Rs. 5,000. It is also provided that interest to be allowed on capital at 6% p.a. The drawings for the year were Amit Rs. 6,000, Babu Rs. 4,000 and Charu Rs. 2,000. Interest on drawings of Rs. 270 was charged on Amit’s drawings, Rs. 180 on Babu’s drawings and Rs. 90, on Charu’s drawings. The net profit as per Profit and Loss Account for the year ending March 31, 2020 was Rs. 35,660. Prepare the Profit and Loss Appropriation Account to show the distribution of profit among the partners.

Solution

Profit  and Loss Appropriation Account

Revision 3

Yadu, Madhu and Vidu are partners sharing profits and losses in the ratio of 2:2:1. There fixed capitals on April 01, 2019 were; Yadu Rs. 5,00,000, Madhu Rs. 4,00,000 and Vidhu Rs. 3,50,000. As per the partnership deed, partners are entitled to interest on capital @ 5% p.a., and Yadu has to be paid a salary of Rs. 2,000 per month while Vidu would be receiving a commission of Rs. 18,000. Net loss of the firm as per profit and loss account for the year ending March 31, 2019 amounted to Rs. 75,000 on the basis of above information prepare profit and loss appropriation account. Prepare profit and loss appropriation account for the year ending March 31, 2019.

Solution

Books of Yadu, Madhu and Vidu Profit and Loss

Appropriation Account for the year ending March 31, 2019

Revision  4

Amitabh and Babul are partners sharing profits in the ratio of 3:2, with capitals of Rs. 50,000 and Rs. 30,000 respectively. Interest on capital is agreed @ 6% p.a. Babul is to be allowed an annual salary of Rs. 2,500. Manager is to be allowed commission Rs. 5,000. Amitabh has also given a Loan on April 01, 2019 of Rs. 50,000 to the firm without any agreement. During the year 2019-20, the profits earned is Rs. 22,250. Prepare Profit and Loss Appropriation account showing the distribution of profit and the partners’ capital accounts for the year ending March 31, 2020.

Solution

Profit  and Loss Appropriation Account

Amitabh’s  Capital Account

Babul’s Capital Account

Working Notes:

Profit  and Loss Account

Interest on Capital

No interest is allowed on partners’ capitals unless it is expressly agreed among the partners. When the Deed specifically provides for it, interest on capital is credited to the partners at the agreed rate with reference to the time period for which the capital remained in business during a financial year. Interest on capital is generally provided for in two situations: (i) when the partners contribute unequal amounts of capitals but share profits equally, and (ii) where the capital contribution is same but profit sharing is unequal. Interest on capital is calculated with due allowance for any addition or withdrawal of capital during the accounting period. For example, Mohini, Rashmi and Navin entered into partnership, bringing in Rs. 3,00,000, Rs. 2,00,000 and Rs. 1,00,000 respectively into the business. They decided to share profits and losses equally and agreed that interest on capital will be provided to the partners @10 per cent per annum. There was no addition or withdrawal of capital by any partner during the year. The interest on capital works out to Rs. 30,000 (10% on 30,000) for Mohini, Rs. 20,000 (10% on 2,00,000) for Rashmi, and Rs.10,000 (10% on 1,00,000) for Navin.

Take another case of Mansoor and Reshma who are partners in a firm and their capital accounts showed the balance of Rs. 2,00,000 and Rs. 1,50,000 respectively on April 1, 2019. Mansoor introduced additional capital of Rs. 1,00,000 on August 1, 2019 and Reshma brought in further capital of Rs. 1,50,000 on October 1, 2019. Interest is to be allowed @ 6% p.a. on the capitals. It shall be worked as follows:

Rs. 2,00,000 ×   6/100   +   Rs. 1,00,000 ×   6/100   ×  8 

For Mansoor

= Rs. 12,000 + Rs. 4,000 = Rs. 16,000

For Reshma

= Rs. 1,50,000  ×  6/100   +  Rs. 1,50,000 ×   6/100 ×  6/12

= Rs. 9,000+Rs. 4,500= Rs. 13,500

When there are both addition and withdrawal of capital by the partners during a financial year, the interest on capital is calculated as follows:

(i)  On the opening balance of the capital accounts of partners, interest is calculated for the whole year;

(ii)  On the additional capital brought in by any partner during the year, interest is

calculated from the date of introduction of additional capital to the last day of the financial year.

(iii)  In case of withdrawal of capital, interest on capital will be calculated as:

On opening capital from the beginning of the year till date of capital withdrawn and then on the reduced capital for the remaining time period. Alternatively, it can be calculated with respect of amount remained in business for the relevant period.

Revision 5

Saloni and Srishti are partners in a firm. Their capital accounts as on April 01. 2019 showed a balance of Rs. 2,00,000 and Rs. 3,00,000 respectively. On July 01, 2019, Saloni introduced additional capital of Rs. 50,000 and Srishti, Rs. 60,000. On October 01 Saloni withdrew Rs.

30,000, and on January 01, 2020 Srishti withdraw, Rs. 15,000 from their capitals. Interest is allowed @ 8% p.a. Calculate interest payable on capital to both the partners during the financial year 2019–2020.

Solution

Statement Showing Calculation of Interest on Capital :

 For Saloni

                                                                                                                           (Rs.)

Interest on Rs. 2,00,000 for 3 months = Rs.2, 00, 000 × 8 × 3/100 × 12             = 4,000

Add : Interest on Rs. 2,50,000 for 3 months = Rs.2, 50, 000 × 8 × 3/100 × 12  = 5, 000

Add : Interest on Rs. 2,20,000 for 6 months = Rs.2, 20, 000 ×  6/12  ×  8/100   = 8,800

 

      Total - 17,800

 For Srishti

                                                                                                                (Rs.)

Interest on Rs. 3,00,000 for 3 months = Rs.3, 00, 000 ×  3/12  ×   8/100               = 6,000

Add : Interest on Rs. 3,60,000 for 6 months  = Rs.3, 60, 000 ×  8/100  ×  6/12  = 14, 400

Add : Interest on Rs. 2,20,000 for 3 months = Rs.3, 45, 000 × 8/100  ×  3/12          = 300 

Sometimes opening capitals of partners may not be given. In such a situation before calculation of interest on capital the opening capitals will have to be worked out with the help of partners’ closing capitals by marking necessary adjustments for the additions and withdrawal of capital, drawings, share of profit or loss, if already shown in the capital accounts the partners.

Revision 6

Josh and Krish are partners sharing profits and losses in the ratio of 3:1. Their capitals at the end of the financial year 2015-2016 were Rs. 1,50,000 and Rs. 75,000. During the year 2015-2016, Josh’s drawings were Rs. 20,000 and the drawings of Krish were Rs. 5,000, which had been duly debited to partner’s capital accounts. Profit before charging interest on capital for the year was Rs. 16,000. The same had also been debited in their profit sharing ratio. Krish had brought additional capital of Rs. 16,000 on October 1, 2015. Calculate interest on capital @ 12% p.a. for the year 2015-2016.

Solution

Statement Showing  Calculation  of Capital at the Beginning

Interest on capital will be as 18,960 (12% of Rs. 1,58,000) for Josh and Rs. 960 for krish calculated as follows:

(Rs. 60,000 ×  12/ 100) + ( Rs. 16,000 ×  12/100  ×  6/12) = Rs. 7,200 + Rs. 960 = Rs. 8,160.

As clarified earlier, the interest on capital is allowed only when the firm has earned profit during the accounting year. Hence, no interest will be allowed during the year the firm has incurred net loss and if in a year, the profit of the firm is less than the amount due to the partners as interest on capital, the payment of interest will be restricted to the amount of profits. In that case, the profit will be effectively distributed in the ratio of interest on capital of each partner.

Revision 7

Anupam and Abhishek are partners sharing profits and losses in the ratio of 3 : 2. Their capital accounts showed balances of Rs. 1,50,000 and Rs. 2,00,000 respectively on April 01, 2019. Show the calculation of interest on capital for the year ending  December 31, 2020 in each of the following alternatives:

(a) If the partnership deed is silent as to the payment of interest on capital and the profit for the year is Rs. 50,000;

(b) If partnership deed provides for interest on capital @ 8% p.a. and the

firm incurred a loss of Rs. 10,000 during the year;

(c) If partnership deed provides for interest on capital @ 8% p.a. and the firm earned a profit of Rs. 50,000 during the year;

(d) If the partnership deed provides for interest on capital @ 8% p.a. and the firm earned a profit of Rs. 14,000 during the year.

Solution

(a)  In the absence of a specific provision in the Deed, no interest will be paid on the capital to the partners. The whole amount of profit will however be distributed among the partners in their profit sharing ratio.

(b) As the firm has incurred losses during the accounting year, no interest on capital

will be allowed to any partner. The firm’s loss will however be shared by the partners in their profit sharing ratio.

     Rs.

(c)  Interest to Anupam @ 8% on Rs. 1,50,000       =   12,000

Interest to Abhishek @ 8% on Rs. 2,00,000            =   16,000

                                                                       = 28,000

As the profit is sufficient to pay interest at agreed rate, the whole amount of interest on capital shall be allowed and the remaining profit amounting to Rs. 22,000 (Rs. 50,000 – Rs. 28,000) shall be shared by the partners in their profit sharing ratio.

(d) As the profit for the year is Rs. 14,000, which is less than the amount of interest on capital due to partners, i.e. Rs. 28,000 (Rs. 12,000 for Anupam and Rs. 16,000 for Abhishek), interest will be paid to the extent of available profit i.e., Rs. 14,000. Anupam and Abhishek will be credited with Rs. 6,000 and Rs. 8,000, respectively. Effectively this amounts to sharing the firm’s profit in the ratio of interest on capital, i.e., 3:4.

Interest on Drawings

The partnership agreement may also provide for charging of interest on money withdrawn out of the firm by the partners for their personal use. As stated earlier, no interest is charged on the drawings if there is no express agreement among the partners about it. However if the partnership deed so provides for it, the interest is charged at an agreed rate, for the period for which drawings have been made. Remained outstanding from the partners during an accounting year. Charging interest on drawings discourages excessive amounts of drawings by the partners. The calculation of interest on drawings under different situations is shown as here under.

When Fixed Amounts was Withdrawn Every Month

Many a time, a fixed amount of money is withdrawn by the partners, at equal time interval, say each month or each quarter. While calculating the time period, attention must be paid to whether the fixed amount was withdrawn at the beginning (first day) of the month, middle of the month or at the end (last day) of the month. If withdrawn on the first day of every month, interest on total amount will be calculated for 6½ months; if withdrawn at the end at every month, it will be calculated for 5½ months, and if withdrawn during the middle of the month, it will be calculated for 6 months.

Suppose, Aashish withdrew Rs. 10,000 per month from the firm for his personal use during the year ending March 31, 2017. The calculation of average period and the interest on drawings, in different situations would be as follows:

(a) When the amount is withdrawn at the beginning of each month:

(c)  When money is withdrawn in the middle of the month

When money is withdrawn in the middle of the month, nothing is added or deduced from the total period.

When Fixed Amount is withdrawn Quarterly

When fixed amount of money is withdrawn quarterly by partners, in such a situation, for the purpose of calculation of interest, the total period of time is ascertained depending on whether the money was withdrawn at the beginning or at the end of each quarter. If the amount is withdrawn at the beginning of each quarter, the interest is calculated on the total money withdrawn during the year, for a period of seven and half months i.e., 12 + 3/ 2 and if withdrawn at the  and of each quarter it will be calculated for a period of 4½ months, i.e., 9 + 0/2.

Suppose Satish and Tilak are partners in a firm, sharing profits and losses equally. During financial year 2016–2017, Satish withdrew Rs. 30,000 quarterly. If interest is to be charged on drawings @ 8% per annum, the calculation of average period and interest on drawings will be as follows:

(a) If the amount is withdrawn at the beginning of each quarter

Statement Showing Calculation  of Interest  on Drawings

 

Alternatively, the interest can be calculated on the total amount withdrawn during the accounting year, i.e. Rs. 1,20,000 for a period of 7½ months (12+9+6+3)/4. as follows:

Rs. 1,20,000 ×  8/100 × 15/2 × 1/12 = Rs 6, 000

(b)   If the amount is withdrawn at the end of each quarter

Statement Showing Calculation  of Interest  on Drawings

Alternatively, the interest can be calculated on the total amount withdrawn during the accounting year, i.e., Rs. 1,20,000 for a period of 4½ months

(9 + 6 + 3 + 0)/4 months as follows: = Rs. 1,20,000 ×  8/100 × 9/2 × 1/12 = 3, 600.

When Varying Amounts are Withdrawn at Different Intervals

When the partners withdraw different amounts of money at different time intervals, the interest is calculated using the product method. Under the product method, for each withdrawal, the money withdrawn is multiplied by the period (usually expressed in months) for which it remained withdrawn during the financial year. The period is calculated from the date of the withdrawal to the last day of the accounting year. The products so calculated are totalled on the total of the products interest at the specified rate is calculated as under:

Total of products × Rate × 1/12

For example, Shahnaz withdrew the following amounts from her firm, for personal use during the year ending March 31, 2017. Calculate interest on drawings by product method, if the rate of interest to be charged is 7 per cent per annum

Calculation of interest on drawings will be as follows:

Statement Showing Calculation  of Interest  on Drawings

​​​​​​Interest = Sum of Products ×  Rate × 1/12 = 4, 50, 000 × 7/100 × 1/12 = 30100/12 = Rs 2, 508 (approx).

Revision 8

John Ibrahm, a partner in Modern Tours and Travels withdrew money during the year ending March 31, 2020 from his capital account, for his personal use. Calculate interest in drawings in each of the following alternative situations, if rate of interest is 9 per cent per annum.

(a) If he withdrew Rs. 3,000 per month at the beginning of the month.
(b) If an amount of Rs. 3,000 per month was withdrawn by him at the end of each month.
(c) If the amounts withdrawn were : Rs. 12,000 on   June 01, 2019, Rs. 8,000; on August 31, 2019, Rs. 3,000; on September 30, 2019, Rs. 7,000, on November 30, 2019, and Rs. 6,000 on January 31, 2020.

Solution

(aAs a fixed amount of Rs. 3,000 per month is withdrawn at the beginning of the month, interest on drawings will be calculated for an average period of 6 1/2 months. Interest on drawings = Rs. 36, 000 × 9 × 13 × 1/100 × 2 × 12 = Rs 1. 755.

(b) As the fixed amount of Rs. 3,000 per month is withdrawn at the end of each month, interest on drawings will be calculated for an average period of 5 1/2 months.

Rs.36,000 ×9 ×11×1 = Rs. 1,485

      100×2×12

(c) Statements showing Calculation  of Interest  on Drawings

 Revision  9

Manu, Harry and Ali are partners in a firm sharing profits and losses equally. Harry and Ali withdrew the following amounts from the firm, for their personal use during 2019-2020. 

Calculate interest on drawings if the rate of interest to be charged is 10 per cent, and the books are closed on December 31 every year.

Statement Showing  Calculation  of Interest  on Drawings

Amount of Interest
Mannu  = Rs 1,56,000 x 10 x 1/100 x 12 = Rs 1, 300
Ali = Rs 1, 50, 000 x 10 x 1/ 100 x 12 = Rs 1, 250

When Dates of Withdrawal are not specified

When the total amount withdrawn is given but the dates of withdrawals are not specified, it is assumed that the amount was withdrawn evenly throughout the year. For example; Shakila withdrew Rs. 60,000 from partnership firm during the year ending March 31, 2020 and the interest on drawings is to be charged at the rate of 8 per cent per annum. For calculation of interest, the period would be taken as six months, which is the average period assuming, that amount is withdrawn evenly in the middle of the month, throughout the year. The amount of interest on drawings works out to be Rs. 2,400 as follows:

Rs 60, 000 x 8 x 6/100 x 12 = Rs 2, 400

When the total amount withdrawn is given but the dates of withdrawals are not specified, it is assumed that the amount was withdrawn evenly throughout the year. For example; Shakila withdrew Rs. 60,000 from partnership firm during the year ending March 31, 2020 and the interest on drawings is to be charged at the rate of 8 per cent per annum. For calculation of interest, the period would be taken as six months, which is the average period assuming, that amount is withdrawn evenly in the middle of the month, throughout the year. The amount of interest on drawings works out to be Rs. 2,400 as follows:

Rs 60, 000 × 8 × 6/100 × 12 = Rs 2, 400

 

2. Maintenance of capital accounts, Distribution of profit among the partners

MAINTENANCE OF CAPITAL ACCOUNTS& DISTRIBUTION OF PROFITS AMONG THE PARTNERS

To record the changes in Capital A/c of each partner, we prepare individual capital accounts for each partner. The capital accounts of partners can be maintained in two methods :

Fixed Capital Method

Fluctuating Capital Method

 

  1. Fixed Capital Method – In this method, the capital A/c of partners remains unaltered or fixed. When this method is followed, two accounts i.e. Capital A/c & Current A/c for each partner are maintained.
  • Capital A/c – The capital account remains unaltered i.e. fixed unless additional capital is introduced or withdrawal is made from the existing capital. If there is no fresh capital introduced or any withdrawals, the capital account of the partner show the same balance year after year.
  • Current A/c – It is prepared to record transactions other than introduction & withdrawal of capital such as interest on capital, interest on drawings, salary or commission to a partner, and share of profits/losses. The balance of current account always keeps fluctuating because of these adjustments.

Current A/c is debited with;

  • Drawings made by partner
  • Interest on drawings
  • Share of loss
  • Transfer of amount to any capital account permanently

Current A/c is credited with;

  • Interest on capital
  • Salary or commission
  • Share of profits
  • Transfer of any amount from capital account permanently

  1. Fluctuating Capital A/c – Under Fluctuating Capital method, only one account namely Capital A/c is maintained for each partner. All the transactions of a partner like salary, commissions, interest on capital are recorded in this account. As a result of this, the capital a/c fluctuates with every transaction. The debit balance of capital account is shown in the liabilities side & the credit balance is shown in the asset side.

INTEREST ON DRAWNGS

  • Drawings refers to the amount withdrawn by the owner in cash or in kind.
  • Interest on drawings is charged only when it is mentioned in the partnership deed.
  • When it is charged, it is debited to Profit & Loss Appropriation A/c.
  • It is either debited to Partner’s Capital A/c or Current A/c depending on whether Fixed Capital or Fluctuating Capital method is being followed

INTEREST ON DRAWINGS : - HOW IT IS CALCULATED?

  • The computation of Interest on Drawings depends upon various factors like when the amount is withdrawn & the time period for which it remains withdrawn etc.
  • So, the situations can be as follows;
  1. Fixed amount is withdrawn at the BEGINNING of every Month

If a partner withdraws fixed amount in the beginning of every month, interest is charged on the whole amount for 6 ½ months

Interest on Drawings = Total Drawings X Rate of Interest X 6 ½                                                                                          100                              12

6 ½ months = Average Period

Average Period Formula = Time left after first drawings + Time left after last drawings                                                              2

  • Average period should be used only when the amount of Drawings is uniform & the time interval between the two consecutive drawings is also uniform.
  1. Fixed amount is withdrawn at the END of every Month.

If a partner withdraws a fixed amount at the end of every month, interest is charged for  5 ½ months.

Interest on Drawings = Total Drawings X Rate of Interest X 5 ½                                                                                               100                              12

  1. Fixed amount is withdrawn in the MIDDLE of every Month

Interest on Drawings = Total Drawings X Rate of Interest X 6                                                                                                      100                        12

  1. Fixed amount is withdrawn at the BEGINNING of every QUARTER

Interest on Drawings = Total Drawings X Rate of Interest X 7 ½                                                                                                        100                       12

  1. Fixed amount is withdrawn in the MIDDLE of every QUARTER

Interest on Drawings = Total Drawings X Rate of Interest X 6                                                                                               100                        12

  1. Fixed amount is withdrawn at the END of every QUARTER

Interest on Drawings = Total Drawings X Rate of Interest X 4 ½                                                                                              100                             12

  1.  Fixed amount is withdrawn during 6 MONTHS
  1. At the BEGINNING OF EACH MONTH

Interest on Drawings = Total Drawings X Rate X 3 ½ 
                                                                                     100      12

  1. In the MIDDLE OF EACH MONTH

Interest on Drawings = Total Drawings X Rate X 3 
                                                                                100      12

  1. At the END OF EACH MONTH

Interest on Drawings = Total Drawings X Rate X 3 ½ 
                                                                                     100      12

  1. If Unequal amount is withdrawn at DIFFERENT DATES, interest on drawings is calculated on the basis of the Simple Method or Product Method

Interest on Drawings = Total of Product X Rate of Interest x 1 or 1                                                                                                                         100                12     365

  1. When the date of withdrawal IS NOT GIVEN, the interest on drawings is calculated for six months on an average basis.
  2. When Rate of Interest is given without the word PER ANNUM, interest is charged without considering the time factor

Journal Entries to Record Interest on Drawings

Salary or Commission to Partners

  • Salary or commission to partners is paid only when it is allowed in Partnership Deed
  • It is an appropriation of profit & not charge against the profit so it should be allowed only when profit is earned
  • Commission may be allowed to the partners either
  • As a percentage of profit before charging such commission

Net Profit (before Commission) x Rate of commission
                                                                           100

or

  • As a percentage of profit after charging such commission

Net profit (before commission) x Rate of Commission
                                                                100+Rate of Commission

Accounting Treatment:-

Partner’s Salaries/ Commission A/c      Dr

        To Partner’s Current A/c                                     (When capitals are fixed)

        To Partner’s Capital A/c                                      (When capitals are fluctuating)

Profit & Loss Appropriation A/c              Dr

         To Partner’s salaries/commission A/c

Interest on Partner’s Loan to the Firm

  • If a partner apart from investing share capital, advances any loan to the firm then he is entitled to receive interest even in the absence of an agreement/deed.
  • In the absence of an agreement/deed, the minimum rate of interest on loan to be paid to the partner is 6% p.a.
  • Interest on loan is a charge against profit & it is transferred to the debit of Profit/Loss A/c & not to the debit of Profit/Loss Appropriation A/c
  • Journal Entries
  • Interest on partner’s loan A/c      Dr

 To Partner’s Loan A/c

  • Profit & Loss A/c                                Dr

To Interest on partner’s loan A/c     

3. Guarantee of profit to a partner, Past adjustments, Final accounts

Guarantee of Profit  to a Partner

Sometimes a partner is admitted into the firm with a guarantee of certain minimum amount by way of his share of profits of the firm. Such assurance may be given by all the old partners  in a certain ratio or by any of the old partners, individually to the new partner. The minimum guaranteed amount shall be paid to such new partner when his share of profit as per the profit sharing ratio is less than the guarnteed amount. For example, Madhulika and Rakshita, who are partners in a firm decide to admit Kanishka into their firm, giving her the guarantee of a minimum of Rs.25,000 as her share in firm’s profits. The firm earned a profit of Rs.1,20,000 during the year and the agreed profit sharing ratio between the partners is decided as 2:3:1. As per this ratio, Madhulika’s share in profit comes to Rs.40,000 (2/6 of Rs. 1,20,000); Rakshita, Rs. 60,000 (3/6 of Rs. 1,20,000) and Kanishka Rs. 20,000 (1/6 of Rs. 1,20,000). The share of Kanishka works out to be Rs.5,000 short of the guaranteed amount. This shall be borne by the guaranteeing partners Madhulika and Rakshita in their profit sharing ratio, which in this case is 2:3, Madhulika’s share in the deficiency comes to Rs.2,000 (2/5 of Rs. 5,000), and that of Rakshita Rs.3,000. The total profit of the firm will be distributed among the partners as follows Madhulika will get Rs.38,000 (her share 40,000 minus share in deficiency Rs.2,000); Rakshita Rs.57,000 (60,000–3,000) and Kanishka Rs. 25,000 (Rs. 20,000 + Rs. 2,000 + Rs. 3,000).

If only one partner gives the guarantee, say in the above case, only Rakshita gives the guarantee, the whole amount of deficiency (Rs.5,000) will be borne by her only. In that case profit distribution will be Madhulika Rs.40,000, Rakshita Rs. 55,000 (60,000–5,000) and Kanishka Rs. 25,000 (Rs. 20,000 + Rs. 5,000).

Revision 10

Mohit and Rohan share profits and losses in the ratio of 2:1. They admit Rahul as partner with 1/4 share in profits with a guarantee that his share of profit shall be at least Rs. 50,000.  The net profit of the firm for the year ending March 31, 2015 was Rs. 1,60,000. Prepare Profit and Loss Appropriation Account.

Solution

Books of Mohit, Rohit and Rahul Profit and Loss Appropriation Account for the year ending .....

Working Notes:

The new profit sharing ratio after admission of Rahul comes to 2:1:1. As per this ratio the share of partners in the profit comes to:

 But, since Rahul has been given a guarantee of minimum of Rs. 50,000 as his share of profit. The deficiency of Rs. 10,000 (Rs. 50,000 – Rs. 40,000) shall be borne by Mohit and Rohan in the ratio in which they share profits and losses between themselves, viz. 2:1 as follows:

Mohit’s share in deficiency comes to 2/3 × Rs. 10,000 = Rs. 6,667

 

Rohan’s share in deficiency comes to 1/3 × Rs. 10,000 = Rs. 3,333

 

Thus Mohit will get Rs. 80,000 – Rs. 6,667 = Rs. 73,333, Rohan will get Rs. 40,000–Rs. 3,333 = Rs. 36,667 and Rahul will get Rs. 40,000 + Rs. 6,667 + Rs. 3,333 = Rs. 50,000 in the profit of the firm.

 

 

Calculation of new profit sharing ratio:

The new partner Rahul’s share is  1/4  The remaining profit is 1 – 1/4  = 3/4, to be shared between Mohit and Rohan in the ratio of 2:1.

Mohit’s new share = 3/4 × 2/3 = 2/4

Rohan’s new share = 3/4 × 1/3 = 1/4

Thus, New profit sharing ratio comes to be  2/4 : 1/4 : 1/4 or 2 : 1: 1

Revision 11

(i) Arun, Varun and Tarun were partners of a law firm sharing profits in the ratio of 5:3:2. Their partnership deed provided the following: (i) Interest on partners' capital @ 5% p.a.

(ii) Arun guaranteed that he would earn a minimum annual fee of Rs.6,00,000 for the firm.

(iii) Tarun was guaranteed a profit of Rs. 2,50,000 (excluding interest on capital) and any deficiency on account of this was to be borne by Arun and Varun in the ratio of 2:3.

During the year ending March 31, 2019, Arun earned a fee of Rs. 3,20,000 and net profits earned by the firm were Rs. 8,60,000. Partner's capital on April 01, 2018 were Arun - Rs. 30,00,000; Varun - Rs. 3,00,000 and Tarun- Rs. 2,00,000.

Prepare Profit and  Loss Appropriation account and show your workings clearly.

Solution

Books of Arun, Varun and Tarun Profit  and   Loss Appropriation Account for the year ending  March 31, 2019 

 Working Notes :- 

Rs. 30,000 to be borne by Arun & Varun in the ratio of 2:3 i.e. Rs. 12,000

and Rs. 18,000 respectively.

Revision 12

John and Mathew share profits and losses in the ratio of 3:2. They admit Mohanty into their firm to 1/6 share in profits. John personally guaranteed that Mohanty’s share of profit, after charging interest on capital @ 10 per cent per annum would not be less than Rs. 30,000 in any year. The capital provided was as follows: John Rs. 2,50,000, Mathew Rs. 2,00,000 and Mohanty Rs. 1,50,000. The profit for the year ending March 31,2015 amounted to Rs. 1,50,000 before providing interest on capital. Show the Profit & Loss Appropriation Account if new profit sharing ratio is 3:2:1.

Solution

Books of John and Mathew

Profit  and Loss Appropriation Account for the year ending....

Working Notes:

Profit after interest on capital is Rs. 90,000, which is to be distributed in the ratio of 3:2:1 as follows: John gets Rs. 45,000 (3/6 × Rs. 90,000), Mathew Rs. 30,000, Mohanty Rs. 15,000. Deficiency of Mohanty from the guaranteed profit of Rs. 15,000 will be borne by John. John will therefore get Rs. 45,000 – Rs. 15,000 = Rs. 30,000, Mathew Rs. 30,000 and Mohanty Rs. 30,000.

Revision 13

Mahesh and Dinesh share profits and losses in the ratio of 2:1. From January 01, 2014 they admit Rakesh into their firm who is to be given a share of 1/10 of the profits with a guaranteed minimum of Rs. 25,000. Mahesh and Dinesh continue to share profits as before but agree to bear any deficiency on account of guarantee to Rakesh in the ratio of 3:2 respectively. The profits of the firm for the year ending December 31, 2015 amounted to Rs. 1,20,000. Prepare Profit and Loss Appropriation Account.

Books of Mahesh and Dinesh Profit  and Loss

Appropriation Account for the year ending .....

Working Notes:

New profit sharing Ratio will be calculated as follows:

Rakesh to share 1/10 of the profit. The remaining profit 9/10 will be shared by Mahesh and Dinesh in the ratio of 2:1.

Mahesh’s share in profit will be  2/3 × 9/10 = 3/10

Dinesh’s share will be 1/3 × 9/10 = 3/10

The New ratio become3/5 : 3/10 : 1/10 or 6:3:1

Mahesh’s share in profit = 1,20,000 ×  6/10 = Rs. 72,000,

Dinesh’s share in profit = Rs. 36,000,

Rakesh’s share in profit = Rs. 12,000.

 

Deficiency of Rakesh (Rs. 13,000) will be shared by Mahesh and Dinesh in the ratio of 3:2.

Mahesh will bear  3/5 of 13,000, i.e. Rs. 7,800 and Rakesh,  2/5 of Rs. 13,000, i.e. Rs. 5,200.

Thus, the profits of the firm will be shared as follows.

Mahesh will get Rs. 72,000 – Rs. 7,800 = Rs. 64,200.

Dinesh will get Rs. 36,000 – Rs. 5,200 = Rs. 30,800

Rakesh will get Rs. 12,000 + Rs. 7,800 + Rs. 5,200 = Rs. 25,000

 

Past Adjustments

Sometimes a few omissions or errors in the recording of transactions or the preparation of summary statements are found after the final accounts have been prepared and the profits distributed among the partners. The omission may be in respect of interest on capitals, interest on drawings, interest on partnersloan, partner’s salary, partner’s commission or outstanding expenses. There may also be some changes in the provisions of partnership deed or system of accounting having impact with retrospective effect. All these acts of omission and commission need adjustments for correction of their impact. Instead of altering old accounts, necessary adjustments can be made either; (a) through ‘Profit and Loss Adjustment Account’, or (b) directly in the capital accounts of the concerned partners. This is explained with the help of following example.

Rameez and Zaheer are equal partners. Their capitals as on April 01, 2015 were Rs. 50,000 and Rs. 1,00,000 respectively. After the accounts for the financial year ending March 31, 2016 have been prepared, it is discovered that interest at the rate of 6 per cent per annum, as provided in the partnership deed has not been credited to the partnerscapital accounts before distribution of profit. In this case, the interest on capital not credited to the partnerscapital accounts works out to be Rs. 3000 (6/100 × Rs. 50,000) for Rameez and Rs. 6,000 (6/100 × Rs. 1,00,000) for Zaheer. Had the interest on capital been duly provided, the firm’s profit would have reduced by Rs. 9,000. By this omission, the whole amount of profit as per Profit and Loss Account (without adjustment of Rs. 9,000) has been distributed among the partners in their profit sharing ratio, and the amounts of interest on capital have not been credited to their capital accounts. This error can be rectified in any of the following ways;

(a) Through Profit and Loss Adjustment Account

(b) Directly in PartnersCapital Accounts

For direct adjustment in partnerscapital accounts first a statement to ascertain the net effect of omission on partnerscapital accounts will be worked out as follows and then the adjustment entries can be recorded.

Statement Showing  Net Effect  of Omitting Interest  on Capital

The statement shows that Rameez has got excess credit of Rs. 1,500 while Zaheer’s account has been credited less by Rs. 1,500. In order to rectify the error Rameez’s capital account should be debited and that of Zaheer, credited with Rs. 1,500 by passing the following journal entry;

journal entry.

Rameez’s Capital A/c                                            Dr.        1,500

To Zaheer’s Capital A/c                                 1,500 (Adjustment for omission of interest on capital)

Revision 14

Nusrat, Sonu and Himesh are partners sharing profits and losses in the ratio of 5 : 3 : 2. The partnership deed provides for charging interest on drawing’s @ 10% p.a. The drawings of Nusrat, Sonu and Himesh during the year ending March 31, 2015 amounted to Rs. 20,000, Rs. 15,000 and Rs. 10,000 respectively. After the final accounts have been prepared, it was discovered that interest on drawings has not been taken into consideration. Give necessary adjusting journal entry.

Statement showing  Net  Effect  of  Omitting Interest  on  Drawings

 

Journal Entry for adjustment of interest on drawings would be:

Summary

1. Definition of partnership and its essential features: Partnership is defined as “Relation between persons who have agreed to share the profits of a business carried on by all or any one of them acting for all”. The essential features of partnership are : (i) To form a partnership, there must be at least two persons; (ii) It is created by an agreement; (iii) The agreement should be for carrying on some legal business; (iv) sharing of profits and losses; and (v) relationship of mutual agency among the partners.

2Meaning and contents of partnership deed: A document which contains the terms of partnership as agreed among the partners is called ‘Partnership Deed’. It usually contains information about all aspects affecting relationship between partners, including objective of business, contribution of capital by each partner, ratio in which profit and losses will be shared by the partners, entitlement of partners to interest on capital, interest on loan and the rules to be followed in case of admission, retirement, death, dissolution, etc.

3. Provisions of Partnership Act 1932 applicable to accounting: If partnership deed is silent in respect of certain aspects, the relevant provisions of the Indian Partnership Act, 1932 become applicable. According to the Partnership Act, the partners share profits equally, no partner is entitled to remuneration, no interest on capital is allowed and no interest on drawings is charged. However, if any partner has given some loan to the firm, he is entitled to interest on such amount @ 6% per annum.

4. Preparation of capital accounts under fixed and fluctuating capital methods: All transactions relating to partners are recorded in their respective capital accounts in the books of the firm. There can be two methods of maintaining Capital Accounts. These are; (i) fluctuating capital method, (ii) fixed capital method. Under fluctuating capital method, all the transactions relating to a partner are directly recorded in the capital account. Under fixed capital method, however the amount of capital remains fixed, the transactions like interest on capital, drawings, interest on drawings, salary, commission, share of profit or loss are recorded in a separate account called ‘Partner’s Current Account’.

5. Distribution of profit and loss: The distribution of profits among the partners is shown through a Profit and Loss Appropriation Account, which is merely an extension of the Profit and Loss Account. It is usually debited with interest on capital and salary/commission allowed to the partners, and credited with net profit as per Profit and Loss Account and the interest on drawings. The balance being profit or loss is distributed among the partners in the profit sharing ratio and transferred to their respective capital accounts.

6. 6. Treatment of guarantee of minimum profit to a partner: Sometimes, a partner may be guaranteed a minimum amount by way of his share in profits. If, in any year, the share of profits as calculated according to his profit sharing ratio is less than the guaranteed amount, the deficiency is made good by the guaranteeing partnersin the agreed ratio which usually is the profit sharing ratio. If, however, such guarantee has been given by any of them, he or they alone shall bear the amount of deficiency.

7. Treatment of past adjustments: If, after the final accounts have been prepared, some omission or commissions are noticed say in respect of the interest on capital, interest on drawings, partner’s salary, commission, etc. necessary adjustments can be made in the partner’s capital accounts through the Profit and Loss Adjustment Account, to rectify the same.

8 Preparation of final accounts of a partnership firm: There is not much difference in the final accounts of a sole proprietary concern and that of a partnership firm except that in case of a partnership firm an additional account called Profit and Loss Appropriation Account is prepared to show distribution of profit and loss among the partners.

3. Guarantee of profit to a partner, Past adjustments, Final accounts

Guarantee of Profit

  • In some cases, a partner may be admitted in the firm on a guarantee in respect of his minimum profit from the business.
  • Such a guarantee may be given to an existing partner as well.
  • Such a guarantee to the incoming partner is given ;
  • All the old partners in agreed ratio
  • Some of the old partners

When all the partners guarantee that one of the partners shall be given a minimum amount of profit, the following amounts have to be calculated separately

  • Share of profit as per profit sharing ratio
  • Minimum Guaranteed Profit
  • The minimum of the above two is given to that partner & the balance of profit (i.e. total profit – profit given to the guaranteed partner) is shared by the remaining partners in the profit-sharing ratio.
  • If the partner’s actual share of profit turns out to be more than the guaranteed profit then in that case the partner will be given the actual amount instead of the guaranteed amount.
  • When one or more than one partner guarantees a minimum profit, the adjustment is made through the partner’s capital accounts. The following steps are followed;
  • Distribute the profit among the partners in their profit sharing ratio
  • If the share of the guaranteed profit of the partner falls short of the minimum amount then the difference is deducted from the original share of profit of the partners who guarantee & it is added with the original share of profit of the guaranteed partner.
  • When two or more partners give guarantee, the shortfall is shared by them in the agreed ratio or in their profit-sharing ration as the case may be.
  • Accounting Treatment of Guarantee of Profit in case of Loss
  • Sometimes it is possible that the firm has incurred losses but the guaranteed profit is to be paid to the partner who has been guaranteed minimum profit. In such a case, the adjustment has to be made through partner’s capital A/c in the following manner;​​​​​​
  1. Distribute the loss among the partners in their profit sharing ratio
  2. Capital A/c of the guaranteed partner is credited with guaranteed minimum profit plus the amount of loss. This amount is debited to remaining partners in their profit sharing ratio or to the debit of the partner who has guaranteed minimum profit.

Past Adjustments

Sometimes, after the final accounts of a firm have been closed, it is found that certain matters have been left out by mistake. In such cases, instead of altering the final accounts which have already been closed, the firm rectifies the error or omission by passing an adjustment entry in the beginning of the financial year. Such adjustments are called past adjustments as they relate to the past.
Steps to pass adjusting journal entry:

Step 1 Calculate the amount already recorded.
Step 2 Calculate the amount which should have been recorded.
Step 3 Calculate the difference between Step 1 and Step 2.
Step 4 Find out the partner who received excess and the partner who received short.
Step 5 Pass the adjusting journal entry by debiting the partner who received excess and by crediting the partner who received short.

PREPARATION OF FINAL ACCOUNTS OF PARTNERSHIP FIRM

Final accounts of a partnership firm are prepared in the usual way in which they are prepared for a sole proprietorship concern except that the profits in the partnership have to be distributed among the various partners according to the terms of the partnership contract and the amount of profit may be arrived at after making adjustments for interest on capital, interest on drawings, salaries to partners, etc. for this another account “Profit & Loss Appropriation Account” is prepared after preparing Profit & Loss Account.

The final accounts prepared by partnership firms are:

a)     Manufacturing account – if manufacturing activity is carried on

b)    Trading and profit and loss account – to ascertain profitability

c)     Profit and loss appropriation account – to show the disposal of profits and surplus

d)    Balance sheet – to ascertain the financial status.

1. Modes of reconstitution of a partnership firm, Admission of a new partner

(MODES OF RECONSTITUTION)

A partnership firm may go for reconstitution for various reasons such as;

  • Change in the profit-sharing ratio among the Existing Partners.
  • Admission of a Partner.
  • The Retirement of an Existing Partner.
  • Death or Insolvency of a Partner.

ADMISSION OF A PARTNER

  • Admission of a partner is one of the modes of reconstitution of partnership firm because when a new partner is admitted, the existing agreement among the partners comes to an end & a new agreement comes into existence which results in change in profit sharing ratio, goodwill valuation & reassessment of assets & liabilities.
  • The capital contribution of the new partner, his liabilities, and share of profits is decided upon.
  • As per Section 31 of the Indian Partnership Act, the new partner shall not be admitted to the firm without the consent of all existing partners.
  • After admission, the new partner gets the following two rights :
  • Right to share future profits of the firm
  • Right to share in the assets of the firm
  • He/she  also becomes liable for any liability of the business incurred after admission & any loss incurred by the firm
  • The new/incoming partner receives share in future profits that is equal to the sacrifice of profit by an existing partner/partners of the firm & the same new partner has to compensate the partner/partners who are sacrificing their share in profits in his/her favor.
  • Such amount paid by the incoming partner is known as Goodwill or Premium for Goodwill.
  • Besides Goodwill/Premium for Goodwill, the new partner also contributes in Capital to get the rights in the assets of the firm.

Effects of Admission of Partner

  1. Old partnership agreement comes to an end & a new agreement is formed.
  2. New or incoming partner becomes entitled to the future share of profits & losses of the firm.
  3. New or incoming partner contributes an agreed amount of capital in the firm.
  4. New or incoming partner gets a right to the assets of the firm.
  5. Adjustments are made regarding the accumulated profits & losses
  6. Assets are revalued & liabilities are reassessed & the net change is adjusted in existing or old partner’s capital accounts in their old profit sharing ratio.
  7. Goodwill of the firm is valued in order to pay the sacrificing partner for their sacrificed share by the gaining partners through their capital accounts.

What are the adjustments required on the admission of a partner?

  1. Determining new profit sharing ratio
  2. Valuation of adjustment of goodwill
  3. Adjustment of profit/loss arising from revaluation of assets & reassessment of liabilities.
  4. Adjustments of accumulated profits, reserves & losses.
  5. Adjustment of capital (if agreed)

 

1. Modes of reconstitution of a partnership firm, Admission of a new partner

CHAPTER -3

Reconstitution of a Partnership Firm – Admission of a Partner

 

Partnership is an agreement between two or more persons (called partners) for sharing the profits of a business carried on by all or any of them acting for all. Any change in the existing agreement amounts to reconstitution of the partnership firm. This results in an end of the existing agreement and a new agreement comes into being with a changed relationship among the members of the partnership firm and/or their composition. However, the firm continues. The partners often resort to reconstitution of the firm in various ways such as admission of a new partner, change in profit sharing ratio, retirement of a partner, death or insolvence of a partner. In this chapter we shall have a brief idea about all these and in detail about the accounting implications of admission of a new partner or an on change in the profit sharing ratio.

Modes of Reconstitution of a Partnership Firm

Reconstitution of a partnership firm usually takes place in any of the following ways:

Admission of a new partner: A new partner may be admitted when the firm needs additional capital or managerial help. According to the provisions of Partnership Act 1932 unless it is otherwise provided in the partnership deed a new partner can be admitted only when the existing partners unanimously agree for it. For example, Hari and Haqque are partners sharing profits in the ratio of 3:2. On April 1, 2017 they admitted John as a new partner with 1/6 share in profits of the firm. With this change now there are three partners of the firm and it stands reconstituted.

Change in the profit sharing ratio among the existing partners: Sometimes the partners of a firm may decide to change their existing profit sharing ratio. This may happen an account of a change in the existing partnersrole in the firm. For example, Ram, Mohan and Sohan are partners in a firm sharing profits in the ratio of 3:2:1. With effect from April 1,2017 they decided to share profits equally as Sohan brings in additional capital. This results in a change in the existing agreement leading to reconstitution of the firm.

Retirement of an existing partner: It means withdrawal by a partner from the business of the firm which may be due to his bad health, old age or change in business interests. In fact a partner can retire any time if the partnership is at will. For example, Roy, Ravi and Rao are partners in the firm sharing profits in the ratio of 2:2:1. On account of illness, Ravi retired from the firm on March 31, 2017. This results in reconstitution of the firm now having only two partners.

Death of a partner: Partnership may also stand reconstituted on death of a partner, if the remaining partners decide to continue the business of the firm as usual. For example, X,Y and Z are partners in a firm sharing profits in the ratio 3:2:1. X died on March 31, 2017. Y and Z decide to carry on the business sharing future profits equally. The continuity of business by Y and Z sharing future profits equally leads to reconstitution of the firm.

Admission of a New Partner

When firm requires additional capital or managerial help or both for the expansion of its business a new partner may be admitted to supplement its existing resources. According to the Partnership Act 1932, a new partner can be admitted into the firm only with the consent of all the existing partners unless otherwise agreed upon. With the admission of a new partner, the partnership firm is reconstituted and a new agreement is entered into to carry on the business of the firm.

A newly admitted partner acquires two main rights in the firm–

1. Right to share the assets of the partnership firm; and

2. Right to share the profits of the partnership firm.

For the right to acquire share in the assets and profits of the partnership firm, the partner brings an agreed amount of capital either in cash or in kind. Moreover, in the case of an established firm which may be earning more profits than the normal rate of return on its capital the new partner is required to contribute some additional amount known as premium or goodwill. This is done primarily to compensate the sacrificing partners for loss of their share in super profits of the firm.

Following are the other important points which require attention at the time of admission of a new partner:

1. New profit sharing ratio;