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= Setting aside Money for a specific purpose
• Factors of Production » Returns
In economic terms, the four basic factors of production are Land, Labour, Capital and Organisation. Each of these factors would be compensated by sharing a part of the income earned. What they get is what is called the return for the factor.
|Organisation » Partnership Firm|
Land, Labour and Capital are factors of production which we see or feel. Organisation is an intangible factor that combines these three factors to achieve the intended objective. Organisation can therefore be understood as, the efforts made by those who have contributed capital. These efforts may take many different forms, some tangible and some intangible.
• What Constitutes "Organisation" in a Partnership Firm
In a partnership firm, the efforts made by the partners who are the contributors of capital, represent the "Organisation". All these contributions, apart from the capital they contribute form the factor we call "Organisation".
Partners contribution to the firm takes many different forms which may be tangible or intangible. Some of them are
» Why not Capital
We do not consider the Capital contributed by the partners since "Capital" itself is dealt with as a separate factor.
» Varied Contributions of Partners towards the Organisation
Since no two human beings can be exactly of the same capabilities, the contributions made by the partners for the factor called organisation varies from partner to partner. Each partner contributes according to his/her abilities and possibilities.
|Remunerating the Factors of Production in a Partnership Firm|
Let us limit our idea to remunerating the two factors of production Capital and Organisation only.
• Judicious Distribution of the Firms Profits
A, B and C are partners in a firm. The firm has made a profit of Rs. 3,00,000. What would be the judicious share of profits to be distributed to each partner A, B and C.
» Share Equally
A, B and C sharing Rs. 1,00,000 each.
This sounds prudent if the contributions of A, B and C towards the firm is the same in all respects. Say, A, B and C are of the same intelligence level, they work for the same time for the firm, they have contributed the same amount of Capital for the firm, they are having more or less the same contacts outside through which sales are generated, they have all withdrawn the same amounts of money for their personal uses (drawings) etc. In such a situation it would be appropriate to give each an equal share.
• Equal Share not a Judicious share always
If we consider the following aspects we may have to agree that sharing the profits of the firm equally amongst partners may not be the judicious (best) way.
» Unequal Capital Contributions
The Capital Contributed by A, B and C is Rs. 2,00,000, Rs. 75,000 and Rs. 1,00,000 respectively. Now, since A, B and C have contributed varied amounts of Capital towards the firm, it would not be appropriate to share the profits equally among them.
To Compensate » Pay interest on Capital.
Compensate for the uneven contributions towards capital and then share the profits equally (if contributions of A, B and C towards the firm in all other respects is the same). Greater the Capital contributed, greater the interest earned. This would set right the difference in contributions in the form of capital.
Profit equal to "Interest on Capital" payable to partners is first paid away and then the remaining profit can be shared equally.
» Unequal time Spent
B works full time in the firm and A and C are passive partners. Now, since A, B and C have contributed varied amounts of time and energy towards the firm, it would not be appropriate to share the profits equally among them.
To Compensate » Pay salary to Partner.
Compensate for the uneven contributions of time and energy towards the firm and then share the profits equally (if contributions of A, B and C towards the firm in all other respects is the same). The salary paid to B would be compensation for his greater contribution.
Profit equal to "Salary to Partners" is first paid away and then the remaining profit can be shared equally.
» Public Relations/Contacts
C has greater contacts in the outside world, a lot of customers are C's contacts. Now, the contribution of C towards the sales of the firm through his contacts is greater than that of A and B. Therefore, it would not be appropriate to share the profits equally among them.
To Compensate » Pay Commission to Partner.
Compensate C for the greater contributions he has made towards the firm and then share the profits equally (if contributions of A, B and C towards the firm in all other respects is the same). The commission paid to C for sales made to customers who are his contacts would be compensation for his greater contribution.
Profit equal to "Commission to Partners" is first paid away and then the remaining profit can be shared equally.
The Drawings of A, B and C are respectively, Rs. 20,000, Rs. 2,000 and Rs. 15,000 respectively. Since Drawings is nothing but capital being withdrawn, A and C have withdrawn greater amount of capital whereas B has withdrawn a lesser amount. This would result in A's and C's capital contribution being lesser and B's capital contribution being greater.
Remedy » Charge Interest on Drawings.
Greater the drawings greater the interest payable by the partners. This would compensate the unevenness in drawings made by the partners.
• Remunerating Organisation = Distributing Profits
As can be seen from the above explanation, Salary to Partners, Commission to Partners, etc., are all paid out of profits made. These are different methods of compensation for the contributions made by partners to the firm.
⇒ The payments for all these are nothing but methods of sharing profits
|Profit Distribution » Accounting Treatment|
Consider the following information in relation to M/S ABC and CO., a partnership firm with A, B and C as partners.
Illustration : Problem
Illustration : Solution
Since Interest on Capital, Salary to Partners etc., are methods of distribution of profit, they are to be made after ascertaining profits. Thus the accounting for the distribution of profits is a process that follows the ascertainment of net profits.
Assuming the distribution to have been made through Profit and Loss a/c, the P/L a/c and the Partners Capital accounts would be as below.
» Distribution of Profits among Partners
|Ledger Postings » Unavailability of information|
If you interpret the ledger postings in the above P/L a/c and the Partners Capital a/c's you can find that all the postings in the Partners Capital a/c's read either "To P/L a/c" or "By P/L a/c" and in the "Profit and Loss a/c" read "To _ Capital a/c" or "By _Capital a/c". These postings can be interpreted as
• Information not available
Generally we would be able to identify the reason for a debit or credit by reading the posting itself. However, here it would be difficult to gather the information relating to all credits and debits that way, since all of them look similar. Thus, we would not be able to derive the information as to the reason for which the debits and credits are made.
Though "To A's Cap (int)" seems to be creating the idea that the posting gives the information relating to the purpose for which the amount is being transferred, it is not so. It would not be practically possible to write down such details as (int), (sal), etc., more so in mechanised systems of accounting (using computers). [To understand this limitation read the posting as "To _ Capital a/c" only ignoring the wordings within the brackets].
» Solution !!
To derive the information that we need we create additional account heads which work as controlling accounts.
|Charge Against Profits Vs. Appropriation of Profits|
• Classification of Debits to Profit and Loss account
The various items debited to the Profit and Loss a/c can be classified into two as
» Charge Against Profit
Debits which represent an expenditure or loss.
Salaries, Wages, Rent, Depreciation, Loss on Sale of Assets etc., are all charges against profits.
» Appropriation of Profit
Debits which result in the profit being kept aside.
Creation of reserves is an example of profit appropriation. Reserves are created by transferring credit balance (a certain amount of profit) from the profit and loss account to the reserve account.
• Interest on Capital, Salary, Commission etc., to Partners » Appropriations
Distribution of profit to partners is appropriation of profits. It is to be understood as profit being kept aside to be given to the owners as a return for their contributions.
"Interest on Capital", "Salary to Partners", etc., paid to partners are different methods adopted to compensate their varied contributions and thus ensure equitable distribution of profits. Therefore all these payments made to partners would also be appropriations of profits and not charge against profits.
|Using Profit & Loss Appropriation a/c|
To differentiate between charges and appropriations of profits being made to the profit and loss account, the P/L a/c is divided into two by creating a new account by name "Profit and Loss Appropriation a/c".
The net profit is transferred to "P & L Appropriation a/c" and all the appropriations are made from this account.
The same postings as above made using the "P & L Appropriation a/c" would be
• What difference does using Appropriation a/c make ?
Using P & L Appropriation account would enable handling all the information relating to appropriation of profits through a separate account. But, when we come to reading the postings in the appropriation account as well as the Capital accounts, the only difference we can see is that "P & L a/c" is replaced by "P & L Appropriation a/c".
Even after replacing the P & L a/c with the P & L appropriation a/c, we will not get the information as to the reason for which the debits and credits are being made. The postings can be interpreted as
» Only a Slight variation
A slightly different idea that the transfers are from profit and loss appropriation account and thus relate to profits distributed can be obtained. But for this, there is virtually no difference in the information available.
|Deriving More/Clear Information|
• Create Controlling a/c's
We create ledger accounts to enable us derive greater information. Apart from this these ledger accounts have no other purpose. While transferring an amount from account ONE to account TWO, we transfer it through this controlling/intermediary account. Thus we transfer the amount from account ONE to CONTROLLING account and from that account to TWO. This will result in the name of the CONTROLLING account appearing in postings made in both account ONE and TWO. The name used would be such that it provides the required information as to why the posting is appearing.
Consider the journal entry for recording "Interest on Capital" through the "Profit and Loss Appropriation a/c"
The journal entries for recording these transactions would be
If this is done the postings in the "Profit and Loss Appropriation a/c" would read "To Interest on Capital" and in the Partners Capital Accounts would read "By Interest on Capital". This would give a clear understanding on the entries that are posted.
One should note that the "Interest on Capital a/c" being a controlling account is raised and written off immediately, thus having nil balance. If we assume presence of controlling accounts, we can use meaningful phrases to represent postings in ledger accounts.
|Common Controlling accounts|
Postings in the "Profit and Loss Appropriation a/c" and the "Partners Capital Accounts" using the above controlling accounts would read
In manual accounting, in using meaningful phrases to derive greater information, we do not create the controlling (ledger) accounts as they are raised and immediately written off and their balances would ultimately be nil. We can assume that they have been created and the required entries have been passed through them without even creating them.
However, in case of computerised accounting, if we intend to use such a facility, we need to create all those accounts which we identify as controlling accounts and ensure that the journal entries that are required (if the controlling accounts are used) are also recorded.
|Author Credit : The Edifier||... Continued Page 4|