MGT101 - Financial Accounting - I - Lecture Handout 35

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MARK UP ON CAPITAL AND DRAWINGS

The partnership agreement may include one or both of the following clauses:

  • Partners are charged interest on drawings (this may be on the total amount of the current account balance or on the amount exceeding a specific limit, depending upon the terms of agreement).
  • Partners are given interest on their capital (again this can be on the total amount of the capital or the amount exceeding a specific figure).

Reasons for Interest On Capital

The profit/loss sharing ratio may not be equal despite of the fact that partners have contributed equal amount of capital, depending upon the partnership agreement. Take the following example:
Two partners start a business and contribute equal capital and decide to share equal profits. But they also realize that in future the business may need further capital and at that time both partners may not be able to contribute equally. So, instead of revising the contract every time, they include a clause in the agreement, whereby, the partners are allowed an interest on the capital contributed. This interest can be on the whole amount of both partners or only of one partner on the amount contributed in excess of the other partner. This way a partner, who provides capital in excess of his profit sharing ratio, can be compensated. One may say that the same results can be achieved by saying that profit and loss sharing will be proportionate to the amount of capital invested. But, as we have said that in partnership everything depends on the Partnership Agreement.

Reasons for Interest On Drawings

Drawings are opposite to capital invested i.e. these are the funds drawn by partners from the business. Therefore, in order to keep the distribution of profit fair, a clause may be inserted in the agreement, where an interest is charged on the drawings of the partners. Again, this can be on the total amount or on an amount exceeding a specific limit. Both of the above things depend upon the agreement between partners.

Accounting Treatment

One may think that as Interest on Capital is paid to the partners, so it should be treated as business expense and Interest on Drawings is charged from the partners, therefore, it should be treated as income. But this is not the case.
Just like partners salaries, both these items will be included in the Profit and Loss Appropriation Account. Partners’ salaries, interests etc. are never treated as expense or income of the business. They are a part of DISTRIBUTION OF PROFIT.

Exceptions

Rent paid to partner for use of his premises, purchase of stocks, assets or other items for use in business, Markup on loan from partner are the exceptions. All these expenses are charged to profit & loss account of the partnership firm.

Accounting Entries

Interest on Capital

Debit: Profit and Loss Appropriation Account
Credit: Partner A’s Current Account
Credit: Partner B’s Current Account
Credit: Partner C’s Current Account

Interest on Drawings

Debit: Partner A’s Current Account
Debit: Partner B’s Current Account
Debit: Partner C’s Current Account
Credit: Profit and Loss Appropriation Account

Example # 1

Mr. Abid is a partner in a partnership firm. His capital on July 1, 2001 was Rs. 200,000. He invested further capital of Rs. 100,000 on March 1, 2002.

You are required to calculate his mark up. Mark up rate is 5%. The financial year is from July to June.

Solution

Rs. 200,000 was invested in the beginning of the year and extra capital was invested on 1st March. So, from March onward, the capital is Rs. 300,000 (200,000 + 100,000). We will calculate mark up on Rs. 200,000 for 12 months, i.e., from July to June. Mark up on 100,000 will be for 4 months, i.e., from March to June.

Mark up is calculated as follows:

200,000 x 5% = 10,000

= 10,000.00
100,000 x 5% = 15,000 x 4/12
= 1666.67
Total Mark Up
= 11,666.67

Example # 2

Mr. Naeem is a partner in a partnership firm. He drew following amount during the financial year:

September 1

3,000
November 1
5,000
January 1
4,000
March 1
5,000
June 1
2,000

You are required to calculate Mark up on his drawings, if the rate of mark up is 5%. The financial year is from July to June,

Solution

3,000 x 5% = 150 x 10/12 = 125.00
5,000 x 5% = 250 x 8/12 = 166.67
4,000 x 5% = 200 x 6/12 = 100.00
5,000 x 5% = 250 x 4/12 = 83.33
2,000 x 5% = 100 x 1/12 = 8.33
Total Mark Up 483.33

Example # 3

Atif, Babar and Dawar are three partners sharing profits equally.
You are required to prepare profit and loss appropriation account and extract from balance sheet, showing partners capital and current accounts from the following information:

  • Net profit for the year Rs. 558,000
  • Opening balance of Capital accounts Atif Rs. 500,000, Babar Rs. 600,000, Dawar Rs. 400,000
  • Opening balance of Current Account Atif Rs. 55,800, Babar Rs. 63,820, Dawar Rs. 20,555.
  • Salaries to be paid to Babar Rs. 10,000, Dawar Rs. 12,000.
  • Drawings during the year Atif Rs. 180,000, Babar Rs. 220,000 Dawar Rs. 151,000
  • Mark up on Capital @ 5% and Mark up on drawings are: Atif Rs. 9,000, Babar Rs. 11,000 and Dawar Rs. 7,550.

Solution

Profit & Loss Appropriation Account

Atif, Babar, Dawar & Co
Profit Distribution Account
Particulars Note Amount
Rs.
Amount
Rs
.
Net Profit
Less: Partner’s Salary – Babar
Dawar
Less: Interest on capital – Atif (5% of 500,000)
Babar (5% of 600,000)
Dawar(5% of 400,000)
Add: Interest on Drawings – Atif
Babar
Dawar
  10,000
12,000
25,000
30,000
20,000
9,000
11,000
7,550

558,000

(22,000)

(75,000)


27,550

Distributable Profit
Less: Partner’s Share in Profit
Atif (1/3of 488,550)
Amir (1/3 of 488,550)
Babar (1/3 of 488,550)
  162,850
162,850
162,850

488,550

 

(488,550)

      0

 

Babar’s Current Account Account Code --------
Particulars Amount
Dr. (Rs.)
Particulars Amount
Cr. (Rs.)
Drawings
Interest on Drawings
Balance c/d
220,000
11,000
35,670
Opening Balance
Salary
Interest on Capital
Profit for the year
63,820
10,000
30,000
162,850
Total 266,670 Total 266,670

 

Atif’s Current Account Account Code --------
Particulars Amount
Dr. (Rs.)
Particulars Amount
Cr. (Rs.)
Drawings
Interest on Drawings
Balance c/d
180,000
9,000
54,650
Opening Balance
Interest on Capital
Profit for the year
55,800
25,000
162,850
Total 243,650 Total 243,650

 

Dawar’s Current Account Account Code --------
Particulars Amount
Dr. (Rs.)
Particulars Amount
Cr. (Rs.)
Drawings
Interest on Drawings
Balance c/d
151,000
7,550
56,855
Opening Balance
Salary
Interest on Capital
Profit for the year
20,555
12,000
20,000
162,850
Total 215,405 Total 215,405

Admission of A Partner

When a new partner join the business, old agreement of partnership is modified or a new agreement is prepared. This new agreement contains new ratios in which partners share profit and loss in new set up. At the admission of a new partner, all the assets and liabilities of the old business are revalued in order to know the exact worth of the business. Goodwill of the business is also revalued. The value (in monetary terms) of the reputation of the business is called GOODWILL. It is an intangible asset.

Dissolution of A Firm

When a partnership is dissolved, all the liabilities of the firm are paid, out of the assets of the firm, available at the time of dissolution. The remaining amount after paying all the liabilities, if available, will be distributed among the partners in their profit loss sharing ratios. If assets of the firm are not sufficient to pay all the liabilities of the firm, the partners will contribute the balance amount in their profit/loss sharing ratios to meet the liabilities of the firm.

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