Final accounts preparation series
In the prequel to this article, we prepared an appropriation account in order to divide up the net profit of a partnership, in accordance with its partnership agreement.
We had already clarified the difference between a partners’ long-term capital, recorded in their capital account, and their short-term capital, recorded in their current account. We stated that the current account records the routine changes in the amount a business owes each partner that come about in the normal course of business. For example, as profit is generated it increases a partner’s short-term capital and as drawings are taken, the short term capital is decreased. However, neither affect the balance of the long-term capital account.
Whilst in theory the value of a partner’s short-term capital fluctuates over the course of a financial year, in reality, the current accounts are only updated at year-end, unless there is a significant change in the business that requires a partner’s overall capital to be calculated.
Appropriating a loss
If you remember, you and I are in partnership, but our third year of trading was slow. We had made a net profit of £30,000 but the terms of our partnership agreement meant that at the end of the allocation stage, the profit had turned into a small loss which was then appropriated between us. It’s important to remember that it was not a loss as such, because the partnership made a net profit.
Appropriating a loss in this situation is just a way of reflecting the fact that we had been allocated more profit than the partnership actually made, so some needed to be taken back in order to balance the appropriation account.
It’s the same concept as accounting for a profit or loss on the disposal of a non-current asset, here there is no true profit or loss and the adjustment redresses either over or under depreciation.
The appropriation account
Let’s remind ourselves of the completed appropriation account:
The account is presented as a statement but it’s part of the double entry bookkeeping system and can be written up as a T account. Our £30,000 profit will have been calculated as a credit balance on the statement of profit or loss (SoPL). Therefore, the first double entry would be debit SoPL and credit the appropriation account.
You can sanity check your entry by thinking of the profit as a liability. It’s the amount the business owes us, it’s owners, and liabilities have credit balances. The rest of the entries can then be made in relation to the profit. Items that reduce it, in our case salaries and sales commission, are in effect debit entries and items that increase it, like the interest on drawings will be credit entries. The profit, or in our case loss, share will balance the account to nil:
Updating the current accounts
Understanding what is going on behind the scenes, is useful as the entries in the appropriation account now need to be entered into our current accounts. The balances at the end of last year showed, that at that time the partnership owed you £13,500 and that I owed the partnership £600*:
There are two ways of thinking about the entries required to ensure you get them on the right side. Firstly, you can use your understanding of debits and credits and simply post the double entries for the entries made in the appropriation T account into the current accounts. All the debits in appropriation account will be credits in the current account and visa versa.
Alternatively, you can think in terms of increasing and decreasing the current account balances. As the current account is a capital account you would expect it to have a credit balance because it is categorised as a liability. However, as we have seen small debit balances are possible when a partner is the equivalent of overdrawn. Therefore, anything that increases the amount the business owes the partner is entered on the credit side, and items that reduce what the partner is owed, are entered on the debit side.
It doesn’t matter which way you prefer, as long as your thought process results in the correct entries:
The appropriation account’s job is now complete. The current account, on the other hand, is not.
Accounting for drawings in the current account
There is still one more item that needs to be accounted for, and that is drawings. Unlike in the financial statements of a sole trader, neither the net profit or loss, or the drawings are shown as individual items in the ‘financed by’ section on the statement of financial position. The net profit or loss, as we have just seen, is posted to the current accounts via the appropriation account. The drawings are simply double entered into the current account as the balances on the drawings accounts are written off at year-end**:
Finally, the accounts can be balanced and this is easiest to do if we balance each of our account in turn:
You have a closing debit balance. This means you took more out of the partnership, within the year, than was covered by your share of our £30,000 profit.
I have a closing credit balance, which is as a result of the terms of the partnership agreement. As I worked full time in the business, I was paid a salary and was able to generate significantly more sales than you. I also took less in the way of drawings.
In these circumstances, the allocated items guaranteed me a bigger proportion of our profits and the 2:1 ratio gave you a larger share of the so-called loss.
We’ve looked at the year-end adjustment required for a partnership that is operating as a going concern with no significant changes in these articles.
Look out for future pieces that will consider what happens when changes occur that have long-term impacts and therefore affect partners’ capital accounts.
* Remember, that this is just in the short term, so as I also have long term capital of £20,000 then overall, the partnership owed me £19,400.
** Note: these figures have been made up for illustrative purposes.
Gill Myers is a self-employed accounts consultant. She has taught AAT qualifications since 2005 and written numerous articles and e-learning resources.