FAC1502 · Financial Accounting · Study Unit 13
The Partnership
Formation, Capital, Profit Distribution & Dissolution
Contents
01
What is a Partnership?
A partnership is an association of two or more persons who carry on a business together with the shared goal of making a profit. Unlike a company, a partnership is not a separate legal entity — the partners themselves are the business in the eyes of the law, and they bear unlimited personal liability for the firm’s debts.
Legal Definition
In South African law, a partnership is defined by the Partnerships Act and common law. Key characteristics: (1) two or more persons, (2) carrying on a business, (3) in common, (4) for the joint benefit of all partners, and (5) each partner contributes something of value.
For FAC1502 purposes, we deal almost exclusively with general partnerships where partners share profits/losses and bear unlimited liability. The accounting principles below apply to this form.
02
The Partnership Agreement
While a partnership agreement can be oral, it is strongly recommended that it be reduced to writing. The agreement governs the financial relationship between partners and determines how profit is divided, how capital contributions are handled, and what happens upon dissolution.
If no agreement exists (or the agreement is silent on a matter), South African partnership law implies certain default rules, mirroring the Partnerships Act provisions.
Typical Clauses in a Partnership Agreement
Capital contributions — the amount each partner brings in, and whether it is fixed or variable.
Profit & loss sharing ratio — how net profit (or loss) is divided after appropriations.
Partner salaries — fixed amounts payable to partners for services rendered, treated as an appropriation of profit.
Interest on capital — a percentage return on capital balances, also an appropriation before the residual split.
Interest on drawings — a charge against partners who withdraw funds during the year, increasing the net profit available for distribution.
Goodwill provisions — how goodwill is valued and shared on admission or dissolution.
If the agreement is silent on profit sharing, profits and losses are divided equally among all partners — regardless of capital contributions or workload. This is a frequently tested default rule.
03
Capital & Current Accounts
Each partner’s equity is tracked through two separate accounts. Keeping them separate provides clarity: the capital account reflects the long-term investment while the current account captures ongoing transactions with the business.
The total equity of a partner = Capital Account balance + Current Account balance.
A debit balance on the current account means the partner has taken out more than was allocated — they owe the partnership. A credit balance means the partnership owes the partner.
04
Profit & Loss Distribution — The Process
Distributing profit in a partnership follows a structured step-by-step appropriation process. Think of it as working through a waterfall — each step reduces the pool before the remainder is split in the agreed ratio.
The Appropriation Waterfall
Step 1 — Start with Net Profit (per the income statement).
Step 2 — Add back Interest on Drawings (these are debited to partners, increasing distributable profit).
Step 3 — Deduct Partner Salaries (fixed amounts per agreement).
Step 4 — Deduct Interest on Capital (applied to opening or average capital balances as specified).
Step 5 — Deduct any Bonus entitlements.
Step 6 — The residual amount is split in the agreed profit-sharing ratio.
If the residual amount is negative after salaries and interest allocations, the loss is still shared in the profit-sharing ratio (as a debit to each partner’s current account). Partners can still receive their salary and interest allocations even if the residual is a loss — unless the agreement says otherwise.
05
Salaries, Interest on Capital & Interest on Drawings
Partner Salaries are not expenses on the income statement — they are appropriations of profit. They appear in the Profit & Loss Appropriation Account, not as an operating cost.
Interest on Capital
Compensates partners for different levels of capital invested. Calculated as:
Interest = Capital Balance × Rate × Time
The base is usually the opening capital balance for the year, unless mid-year capital changes occurred, in which case a time-weighted average is used.
Interest on Drawings
Discourages partners from withdrawing funds early in the year. It is a charge to partners (debited to their current accounts) and increases the profit available for distribution. Calculated on each drawing from the date of withdrawal to year-end:
Interest = Drawing × Rate × (Months remaining / 12)
If the agreement specifies a simplified method (e.g., assume drawings are evenly spread), an average period of 6 months is often used.
Partner salaries and interest on capital are credits in the partner’s current account. Interest on drawings is a debit. Drawings themselves are also debited to the current account when they are made.
Worked Example — Interest on Drawings
Partner B drew the following amounts during the year ended 28 Feb 2025. The agreement stipulates 12% p.a. interest on drawings.
| Date | Drawing | Amount (R) | Months to Y/E | Interest (R) |
|---|---|---|---|---|
| 1 Mar 2024 | Monthly allowance | 5 000 | 12 | 600 |
| 1 Jun 2024 | Cash withdrawal | 20 000 | 9 | 1 800 |
| 1 Sep 2024 | Cash withdrawal | 15 000 | 6 | 900 |
| 1 Dec 2024 | Cash withdrawal | 10 000 | 3 | 300 |
| TOTAL INTEREST ON DRAWINGS | 3 600 | |||
Each monthly drawing of R5 000 runs the full 12 months only if drawn on 1 March. In practice, if drawings are made monthly on the 1st, they are treated individually, or simplified using the 6-month average rule if the agreement allows it.
06
The Profit & Loss Appropriation Account
The Appropriation Account is a nominal account that distributes the net profit (transferred from the P&L Account) to the individual partners. It sits between the income statement and the partners’ current accounts.
The Appropriation Account is unique to partnerships (and companies). Sole traders have no need for it — profit simply transfers to the owner’s capital account.
Comprehensive Example
Partnership of Absa and Biko. Year ended 28 Feb 2025. Net profit per income statement: R240 000. Agreement: Absa salary R48 000; Biko salary R36 000. Interest on capital at 10% p.a. Capital balances: Absa R200 000, Biko R150 000. Interest on drawings: Absa R3 600; Biko R2 400. Residual profit ratio: 3:2 (Absa:Biko).
| Description | Absa (R) | Biko (R) | Total (R) |
|---|---|---|---|
| CREDITS — Sources of distributable profit | |||
| Net profit (from P&L) | — | — | 240 000 |
| Interest on drawings | 3 600 | 2 400 | 6 000 |
| Distributable profit | — | — | 246 000 |
| DEBITS — Appropriations | |||
| Partner salaries | 48 000 | 36 000 | (84 000) |
| Interest on capital | 20 000 | 15 000 | (35 000) |
| Residual profit (3:2) | — | — | 127 000 |
| Absa (3/5 × 127 000) | 76 200 | — | — |
| Biko (2/5 × 127 000) | — | 50 800 | — |
| NET ALLOCATION TO CURRENT ACCOUNTS | |||
| Total credited to current account | 144 200 | 101 800 | 246 000 |
Note: Interest on capital = Absa R200 000 × 10% = R20 000; Biko R150 000 × 10% = R15 000. The interest on drawings (R6 000) added to net profit is exactly offset by the debits to each partner’s current account, so the Appropriation Account always balances.
Journal Entries — Closing the Appropriation Account
| Date | Account | Debit (R) | Credit (R) |
|---|---|---|---|
| 28 Feb 2025 | Profit & Loss Account | 240 000 | — |
| Profit & Loss Appropriation Account | — | 240 000 | |
| Transfer net profit to Appropriation Account | |||
| 28 Feb 2025 | Current Account — Absa | 3 600 | — |
| Current Account — Biko | 2 400 | — | |
| Profit & Loss Appropriation Account | — | 6 000 | |
| Interest on drawings charged to partners | |||
| 28 Feb 2025 | Profit & Loss Appropriation Account | 246 000 | — |
| Current Account — Absa | — | 144 200 | |
| Current Account — Biko | — | 101 800 | |
| Allocate salary, interest on capital & residual profit to partners | |||
07
Admission of a New Partner
When a new partner joins a partnership, the existing partners must agree to the terms of admission. The key accounting challenge is the treatment of goodwill — the premium the new partner pays over and above the net asset value of the business.
Goodwill on Admission
Goodwill arises because the existing partners have built up customer relationships, reputation, and earning power. The new partner must compensate them for their share of this intangible value.
Two methods are typically used: (a) Raise and Write-Off the goodwill, or (b) Premium method where the new partner pays extra into the existing partners’ accounts directly.
Method A — Raise and Write-Off Goodwill
- 01 Raise goodwill in the books: Dr Goodwill / Cr Capital accounts of OLD partners (in old profit-sharing ratio). This recognises the existing partners’ contribution.
- 02 New partner joins and contributes capital (which may implicitly include a goodwill premium).
- 03 Write off goodwill immediately: Dr Capital accounts of ALL partners (new ratio) / Cr Goodwill. This recognises that goodwill is not carried on the books going forward.
The net effect of raising and writing off goodwill is a transfer of value from the new partner to the old ones — without actually recording a goodwill asset permanently. This is the most commonly tested method in FAC1502.
Revaluation of Assets on Admission
Before admitting a new partner, assets should be revalued to fair value so that the new partner does not benefit from — or be prejudiced by — unrealised gains or losses accrued before their arrival.
08
Dissolution & Realisation
A partnership dissolves when it ceases to exist — through agreement, death of a partner, insolvency, or court order. On dissolution, all assets are realised (sold), liabilities settled, and any remaining cash distributed to partners.
The Realisation Account
The Realisation Account is a temporary account opened specifically for the dissolution process. All assets are transferred into it at book value, and the proceeds from their sale are credited. The balance represents the profit or loss on realisation, which is shared among partners in their profit-sharing ratio.
Step-by-Step Dissolution Process
- 01 Transfer all assets to the Realisation Account at book value: Dr Realisation / Cr each Asset Account.
- 02 Record proceeds from asset sales: Dr Bank / Cr Realisation (for amounts received).
- 03 Settle liabilities: Dr Creditors/Loans / Cr Bank.
- 04 Close the Realisation Account: balance = profit or loss on realisation. Share among partners in P:L ratio via their current/capital accounts.
- 05 Close partners’ loan accounts (if any) and current accounts — transfer balances into capital accounts.
- 06 Pay partners final capital balances from the Bank account: Dr Capital Accounts / Cr Bank.
If a partner’s capital account shows a debit balance after absorbing the realisation loss, that partner owes the partnership money. They must pay cash to make good the deficiency before the remaining partners can be paid. If they cannot pay, the deficiency is borne by the solvent partners in their profit-sharing ratio (Garner v Murray rule applies in some jurisdictions — check the question facts).
Dissolution — Worked Skeleton Journal
| Account | Debit | Credit | Narration |
|---|---|---|---|
| Realisation Account | BV of assets | — | Transfer assets |
| Asset Accounts (each) | — | BV of assets | |
| Bank | Proceeds | — | Sale of assets |
| Realisation Account | — | Proceeds | |
| Liabilities (Creditors etc.) | Carrying amount | — | Settle liabilities |
| Bank | — | Amount paid | |
| Realisation Account | Profit (if any) | — | Share realisation profit |
| Capital / Current — each partner | — | Each share | |
| Capital Accounts (each) | Final balance | — | Pay out partners |
| Bank | — | Final balance |
09
Practice Exercises
Partners Nkosi and Peters share profits in the ratio 3:1. The following information is available for the year ended 31 August 2025:
- Net profit per income statement: R180 000
- Capital balances (1 Sep 2024): Nkosi R120 000; Peters R80 000
- Partner salaries: Nkosi R30 000; Peters R24 000
- Interest on capital: 8% p.a.
- Drawings during the year: Nkosi R40 000; Peters R20 000
- Interest on drawings: 10% p.a. — assume drawings were made evenly throughout the year (use 6-month average)
Prepare the Profit & Loss Appropriation Account for the year ended 31 August 2025, showing the allocation to each partner’s current account.
Step 1: Calculate interest on drawings
Nkosi: R40 000 × 10% × 6/12 = R2 000 | Peters: R20 000 × 10% × 6/12 = R1 000
Step 2: Calculate interest on capital
Nkosi: R120 000 × 8% = R9 600 | Peters: R80 000 × 8% = R6 400
Step 3: Distributable profit = R180 000 + R3 000 (interest on drawings) = R183 000
Step 4: Residual = R183 000 − R54 000 (salaries) − R16 000 (interest on capital) = R113 000
Nkosi 3/4: R84 750 | Peters 1/4: R28 250
| Description | Nkosi (R) | Peters (R) | Total (R) |
|---|---|---|---|
| Net profit | — | — | 180 000 |
| Interest on drawings | 2 000 | 1 000 | 3 000 |
| Distributable profit | — | — | 183 000 |
| Salaries | (30 000) | (24 000) | (54 000) |
| Interest on capital | (9 600) | (6 400) | (16 000) |
| Residual (3:1) | — | — | 113 000 |
| Share of residual | 84 750 | 28 250 | — |
| Total to current account | 124 350 | 58 650 | 183 000 |
Partners Stein and Oba share profits 2:3. Net profit for the year: R45 000. No interest provisions exist. Stein’s salary is R40 000 and Oba’s salary is R35 000. There is no interest on capital or drawings.
Prepare the appropriation account and show the allocation. What is the residual result, and how is it treated?
Residual = R45 000 − R75 000 (salaries) = (R30 000) — a deficit.
This R30 000 loss is shared 2:3. Stein bears R12 000; Oba bears R18 000.
| Description | Stein (R) | Oba (R) | Total (R) |
|---|---|---|---|
| Net profit | — | — | 45 000 |
| Salaries | (40 000) | (35 000) | (75 000) |
| Residual deficit (2:3) | — | — | (30 000) |
| Share of deficit | (12 000) | (18 000) | — |
| Net to current account | 28 000 | 17 000 | 45 000 |
Both partners still receive net positive allocations despite the residual deficit, because their salaries exceed their share of the loss. Their current accounts are credited with R28 000 and R17 000 respectively.
The partnership of Dlamini and Jacobs (ratio 1:1) dissolves on 30 June 2025. Balance sheet extracts on that date:
- Inventory: R60 000 (sold for R45 000)
- Equipment: R80 000 (sold for R95 000)
- Debtors: R30 000 (collected in full)
- Bank: R5 000
- Creditors: R40 000 (paid in full)
- Capital: Dlamini R100 000; Jacobs R130 000
Prepare the Realisation Account and show the final cash distributed to each partner.
Total assets transferred to Realisation = R60 000 + R80 000 + R30 000 = R170 000
Total proceeds = R45 000 + R95 000 + R30 000 = R170 000 (note: debtors collected at face value)
Loss on Inventory = R15 000; Gain on Equipment = R15 000; Net = nil.
Realisation profit/loss = R0
| Dr | R | Cr | R |
|---|---|---|---|
| Inventory | 60 000 | Bank (inventory) | 45 000 |
| Equipment | 80 000 | Bank (equipment) | 95 000 |
| Debtors | 30 000 | Bank (debtors) | 30 000 |
| 170 000 | 170 000 |
Bank Account movements:
Total available = R135 000. Capital totals = R100 000 + R130 000 = R230 000. But cash available is only R135 000. The shortfall = R95 000. Shared equally: each bears R47 500.
Revised capital balances after sharing shortfall:
Dlamini: R100 000 − R47 500 = R52 500 (paid out)
Jacobs: R130 000 − R47 500 = R82 500 (paid out)
Total: R135 000 ✓
The shortfall arises because total asset book values (R170 000 + R5 000 = R175 000) minus liabilities (R40 000) = R135 000 in net assets, which is less than R230 000 capital. This difference (R95 000) represents accumulated losses or drawings already absorbed in prior periods — it is not a realisation loss here since proceeds matched book values perfectly. The partners simply have more capital recorded than there is cash to pay.
Study Unit 13 — Key Takeaways
1. Partnerships are not separate legal entities — partners bear unlimited personal liability.
2. Capital accounts are fixed; current accounts absorb ongoing transactions (salary, interest, drawings, profit share).
3. The appropriation waterfall: net profit → add interest on drawings → deduct salaries → deduct interest on capital → deduct bonuses → split residual in P:L ratio.
4. A residual loss is still shared in the P:L ratio, even if partners receive salary and interest allocations that exceed the net profit.
5. On admission, goodwill is raised in the old ratio and written off in the new ratio, transferring value to existing partners without permanently recognising goodwill.
6. Dissolution: transfer all assets to Realisation Account, record proceeds, settle liabilities, share realisation profit/loss, pay partners their final capital balances.