partnership,accounts,profit,sharing,ratio,admission,retirement,death,dissolution,reconstitution,parternership,act

Profit Sharing Ratio, Interest on Capital, Drawings. Commission before/after Charging

partnership,accounts,profit,sharing,ratio,admission,retirement,death,dissolution,reconstitution,parternership,act
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Profit Sharing Ratio  
 
By profit sharing ratio in a partnership firm, we mean the ratio in which the profits and losses of the firm are to be distributed amongst the partners.

The basis for arriving at the ratio is the agreement between the partners. If there is a partnership deed, the ratio should be ascertained from the provisions in the partnership deed. In the absence of a partnership deed and where there is no indication as to the agreement between the partners in this aspect, it should be considered as equal share for all partners.

The ratio may be a specified as absolute values or it may be taken as the ratio fo their Capital account balances or it may be based on anything else as agreed upon by the partners. Deriving this ratio (if it is not given) would be one important requirement in problem solving.

• Different Ratios for Profit Sharing and Loss Sharing

If the partners so agree, the Profit Sharing Ratio and the Loss Sharing Ratio may be different. There may be a partner who has a share in profits only but not in losses.

• Share in Losses only !!

There cannot be a partner who has a share in losses only but not in profits. This is for the reason that there would be no partnership if there is no share in profits.

"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.

Expressing the Profit Sharing Ratio  
 

The profit sharing ratio may be expressed in a number of different forms. Whatever may be the form in which the ratio is expressed it can always be converted to a form suitable to you.

• Simple Ratio [Natural Numbers represent shares]

May, Day and Way are partners sharing profits in the in the ratio 1 : 3 : 4.

Rewriting the ratio as below would aid in your calculations
May : Day : Way = 1 : 3 : 4
=
1
8
:
3
8
:
4
8
[1 + 3 + 4 = 8]

This can be simplified further and written as
1
8
:
3
8
:
1
2
However, expressing the shares as ratios with a common denominator would be helpful.

• Simple Ratio [Fractions represent shares]

Where the shares are represented by fractional numbers, one should always ensure that the sum of the fractional parts adds up to 1.

» Like Fractions represent shares

Fractions with the same denominator are like fractions.
Ramu, Damu and Mamu share profits in the ratio
2
9
:
3
9
:
4
9

• Check

2
9
+
3
9
+
4
9
=
2 + 3 + 4
9
=
9
9
= 1
Sum of Like Fractions =
Sum of Numerators
Common Denominator

Just check up whether the numerators are adding (2 + 3 + 4) up to the common denominator (9) or not.

• Note

To be cautious make it a habit to write down the ratio in fractional form if the shares are given as natural numbers and vice versa so that you can check this aspect as well as have a form useful for calculations.

» Unlike Fractions represent shares

Fractions without a common denominator are unlike fractions
Goon, Doon and Moon share profits in the ratio
1
2
,
1
3
, and
1
4
Sum of Unlike Fractions =
Sum of (Product of the fraction and the LCM of the denominators)
LCM of the Denominators


Thus,
1
2
+
1
3
+
1
4


=
(
1
2
× 12) + (
1
3
× 12) + (
1
4
× 12)
12


[LCM of denominators i.e. 2, 3, 4 is 12]
=
6 + 4 + 3
12
=
13
12
1

• What to do in such cases

If you find that the fractions representing shares of partners are not adding up to 1, you have to derive the actual ratio using the given fractions.
Goon : Doon : Moon =
1
2
:
1
3
:
1
4
=
1
2
× 12 :
1
3
× 12 :
1
4
× 12
[Multiplying all the terms of the ratio with the same number
(the LCM of denominators 2, 3, 4 i.e. 12) will not change the ratio.]
= 6 : 4 : 3
=
6
13
:
4
13
:
3
13
[6 + 4 + 3 = 13]
This represents the ratio of profit sharing between partners and is in a form suitable for calculations.

Try this

A father left his property to be shared by his three sons as follows : 1/2 to the youngest, 1/3 to the middle and 1/6th to the eldest son. They were struck up with the problem of sharing the 17 horses in their stable. They approached their fathers best friend and asked him to help them out. He thought about it and asked them to take one of his horses, include it in the horses to be shared and then share the horses (along with the one he gave). The sons did so and finally were left with 1 horse which they returned to its rightful owner. How did this happen?

This is a small problem that lets you understand the above concept.

partnership,accounts,profit,sharing,ratio,admission,retirement,death,dissolution,reconstitution,parternership,act

Interest on Capital  
 
Interest on Capital is to be paid
  • Only when agreed upon

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

    Interest is to be paid only out of profits. Where there is a loss, no interest should be paid on capital, even if the partnership agreement provides for the same.
  • @ 6% if rate is not mentioned

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

• On What Balance is Interest Paid

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

The balance in Capital account unless where it is fixed, keeps fluctuating on account of a number of reasons, thus making it difficult to assess the amount of capital employed in the business. There would be a change on account of appropriations made at the end of the accounting period like salary to partners, commission to partners, etc. Even during the course of the accounting period, the balances may change on account of additional capital introduced, capital withdrawn, etc.,

In the absence of appropriate information, it is a convention that interest is paid on the opening balances in Capital Accounts.

In problem solving we will come across these situations.

  • Opening Balance known

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

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

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

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

Interest on Drawings  
 
Interest on Drawings is to be charged
  • Only when agreed upon

    Interest on Drawings is to be charged to partners only if it is specifically agreed upon. If there is no mention in the partnership agreement regarding this, no interest need be charged.
  • @ 6% if rate is not mentioned

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

• Calculating Interest on Drawings

Interest is charged on drawings for the reason that the amount has been withdrawn by the partners without allowing it for being used for the purpose of the business.

In the absence of appropriate information, it is a convention that the interest on drawings is calculated on the "Drawings a/c" balance at the end.

In problem solving we will come across these variations.

  • Closing Balance known

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

    Drawings made during the period and the dates on which the drawings have been made are known. Since the period for which the withdrawn amounts are used is known, interest is calculated based on the amount drawn and the period of use.
  • Drawings made at regular intervals

    Where the Drawings are made at regular intervals, all the drawings are converted to an equivalent of drawings for a specified period and interest is calculated thereon.

Salary to Partners  
 
Salary is to be paid to partners only if it is specifically agreed upon.

If there is no mention in the partnership agreement then no salary need be paid.

partnership,accounts,profit,sharing,ratio,admission,retirement,death,dissolution,reconstitution,parternership,act

Commission to Partners  
 
Commission is to be paid to partners only if it is specifically agreed upon.

If there is no mention in the partnership agreement then no commission need be paid.

• Methods of Expressing Commission

Commissions may be calculated on a number of bases, as a % of Sales, as a % of Gross Profit, as a % of Net Profit, as a % of Purchases, etc., depending on the reason for which the commission is being paid and the agreement between the partners.

There are two basic methods of expressing commission as a % of something else. Let us consider Commission being calculated as a % of Net Profit as an example.

» Before Charging Such Commission

This is the normal calculation. Where there is no specific mention of the method, this is what we assume.
Eg: "8% of Net Profits (Rs. 1,25,000)".
⇒ "8% of Net Profits (Rs. 1,25,000) before charging such commission".

Commission = Rs. 1,25,000 × 8%
= Rs. 10,000

» After Charging Such Commission

Under this method, the commission is expressed as a certain % of something after charging such commission.

Eg: "8% of Net Profits (Rs. 1,25,000) after charging such commission".

8% after charging such commission
The commission should work out to 8% of the amount remaining after charging the commission to the net profit i.e. reducing the commission from the net profit.

» Finding Net Profit after Charging Commission (without knowing the commission)

Let the commission be Rs. x (Using Net Profit = Rs. 1,25,000)
Net Profit after charging commission = Net Profit − Commission
= Rs. 1,25,000 − Rs. x
= Rs. (1,25,000 − x)

Therefore, Commission = 8% of Net Profits after charging such commission
⇒ Commission = Net Profit after Charging Commission × 8%
⇒ Rs. x =
Rs. (1,25,000 − x) ×
8
100
⇒ Rs. x =
Rs. (1,25,000 − x) ×
2
25
⇒ 25x = (1,25,000 − x) × 2
⇒ 25x = (1,25,000 × 2) − (2x)
⇒ 25x + 2x = 2,50,000
⇒ 27x = 2,50,000
⇒ x =
2,50,000
27
⇒ x = 9,259.26

• Verify

Net Profit after charging such commission = Rs. 1,25,000 − Rs. 9,259,26
= Rs. 1,15,740,74
Commission = Net Profit after charging such commission × 8%
= 1,15,740.74 × 8%
= Rs. 9,259.26

» Formula for Calculating Commission after Charging Such Commission

From the above calculations, we can derive a formula that would be easier to remember and use

Commission = Net Profit after Charging Commission × 8%
⇒ Rs. x =
Rs. (1,25,000 − x) ×
8
100
⇒ 100x = (1,25,000 − x) × 8
⇒ 100x = (1,25,000 × 8) − (8x)
⇒ 100x + 8x = (1,25,000 × 8)
⇒ 108x = (1,25,000 × 8)
⇒ x =
1,25,000 × 8
108
⇒ x =
1,25,000 ×
8
100 + 8
⇒ Commission =
Net Profit before Charging such Commission ×
Commission %
100 + Commission %
x% of Net Profit
Before charging such commission = Net Profits before charging commission × x%

After charging such commission =
Net Profit before charging such commission ×
x
100 + x

Example

25% of net profits

  Before charging such commission = Net Profits before charging such commission × 25%
  • After charging such commission =
Net Profit before charging such commission ×
25
100 + 25

Author Credit : The Edifier ... Continued Page 6

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