Not-for-Profit Organisations & Partnership Accounts
Weightage: Chapters 9 and 10 of ICAI's Paper 1 syllabus, together roughly 22 marks — the largest block in the paper. Partnership alone usually carries a full-length question, and goodwill on reconstitution is the single most examined idea within it.
These two topics are joined here because they are variations on the same theme. In both, the ordinary sole-proprietor framework is retained and one element is changed. For a not-for-profit organisation, the profit motive disappears and with it the Trading and Profit and Loss Account. For a partnership, the profit remains but must be divided among several owners, and every event that changes who those owners are requires the accounts to be adjusted.
Not-for-Profit Organisations
What changes when there is no profit motive
A club, a hospital, a school or a charitable trust exists to render service rather than to earn profit. It has no proprietor, no capital in the ordinary sense, and no trading activity, so several familiar statements have no meaning: there is no Trading Account because nothing is bought for resale, and there is no Profit and Loss Account because profit is not what is being measured.
What such an organisation does need is an account of what it received and spent, a statement of whether its regular income covered its regular expenditure, and a statement of its position. These are provided by three statements.
The three statements
Receipts and Payments Account. A summarised cash book for the period. It is a real account, prepared on the cash basis, and it records every receipt and every payment during the period regardless of two things: the period to which the item relates, and whether the item is capital or revenue in nature. It opens with the cash and bank balance and closes with it.
So a subscription for last year received this year appears in full; a subscription for this year not yet received does not appear at all; the purchase of furniture appears in full; and a payment covering three years appears in full.
Income and Expenditure Account. The equivalent of a Profit and Loss Account. It is a nominal account prepared on the accrual basis, and it records only revenue items and only those relating to the current period. Its balance is a surplus, described as excess of income over expenditure, or a deficit.
Balance Sheet. As for any entity, but the ownership side is a Capital Fund — sometimes called a General Fund or Accumulated Fund — rather than capital. It accumulates surpluses, together with capitalised items such as legacies and life membership fees.
The distinction between the first two statements is the most examined idea in the topic, and it is best held as two independent tests applied to every item:
- Is it revenue or capital? Only revenue items enter the Income and Expenditure Account.
- Does it relate to this period? Only current-period amounts enter, and amounts for other periods are excluded regardless of when the cash moved.
The recurring items
Subscriptions are the principal income and the most examined single item. The Receipts and Payments Account shows cash received; the Income and Expenditure Account must show the amount relating to the current year. The conversion is:
Subscription for the year = cash received − amounts received for previous years − amounts received in advance for next year + amounts outstanding at the year end − amounts outstanding at the beginning that were received this year.
The reliable way to handle it is to construct a Subscriptions Account as a working note rather than to manipulate the formula, because the account forces every opening and closing balance to be placed and cannot be half-applied.
Donations. A general donation, given without restriction, is income and is credited to the Income and Expenditure Account. A specific donation, given for a stated purpose such as building a pavilion, is not income at all — it is a fund held for that purpose, credited to a separate fund account on the liabilities side and used only for that purpose.
Legacies are amounts received under a will. Being non-recurring and in the nature of a capital receipt, they are normally capitalised and added to the Capital Fund, unless the amount is small or the question directs otherwise.
Entrance or admission fees are treated as income where they recur regularly and form part of the ordinary income of the organisation; they are capitalised where the question indicates they are non-recurring. Follow the instruction given — ICAI questions usually specify the policy.
Life membership fees are capitalised and added to the Capital Fund. The reasoning is that a life member has paid once for a benefit extending over an indefinite future period, so treating the whole receipt as income of the year of receipt would overstate that year and understate every subsequent year.
Sale of old newspapers or scrap is income. Sale of an old asset is not: the book value is removed from the asset and only the profit or loss on sale is taken to the Income and Expenditure Account.
Honorarium is a payment to a person for services rendered voluntarily, and is an expense.
Consumption of consumables such as stationery, sports material or medicines must be computed rather than taken from cash paid:
Consumption = opening stock + purchases during the year − closing stock
where purchases themselves may need deriving from payments adjusted for opening and closing creditors. This two-stage computation is a standard examination step and should be shown as a working note.
Partnership Accounts
The Act and the deed
Partnership is defined by section 4 of the Indian Partnership Act, 1932 as 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.
The partners' mutual rights are governed by their agreement, the partnership deed. Where the deed is silent — or where there is no deed — the Act supplies default provisions, and these are examined constantly:
- Profits and losses are shared equally, regardless of capital contributed.
- No interest on capital is allowed.
- No salary or commission is payable to any partner.
- Interest on a partner's loan to the firm is allowed at 6% per annum, and this is a charge against profit rather than an appropriation, so it is payable even if the firm makes a loss.
The last distinction carries marks. Interest on capital is an appropriation of profit and is allowed only if the deed provides for it. Interest on a loan is a cost of borrowing, is payable at 6% by statute in the absence of agreement, and is debited to the Profit and Loss Account rather than the Appropriation Account.
Capital accounts: fixed and fluctuating
Under the fluctuating capital method, one account per partner carries everything — capital introduced, drawings, interest, salary and share of profit — so the balance changes every year.
Under the fixed capital method, two accounts are maintained per partner. The Capital Account carries only capital introduced or permanently withdrawn and therefore stays fixed. A Current Account carries everything else. Where fixed capitals are maintained, the Capital Account can never show anything but the agreed capital, and a debit balance on a Current Account is shown on the assets side of the balance sheet.
Profit and Loss Appropriation Account
This account sits below the Profit and Loss Account and distributes the net profit. It is credited with net profit and with interest on drawings, and debited with interest on capital, partners' salaries and commissions, transfers to reserve, and finally the share of profit distributed to each partner.
The distinction between a charge against profit and an appropriation of profit is fundamental. A charge — rent paid to a partner for premises, interest on a partner's loan, a manager's salary — is deducted in arriving at net profit and is payable whether or not there is a profit. An appropriation — interest on capital, partners' salary, share of profit — is a distribution of profit already earned and is made only out of available profit.
Interest on drawings compensates the firm for money withdrawn early. Where dates are given, interest runs from each drawing to the year end. Where equal amounts are drawn at regular intervals, the average period shortcut applies: for equal monthly drawings, interest is computed on the total for 6.5 months if drawn at the beginning of each month, 5.5 months if at the end, and 6 months if in the middle.
Guarantee of minimum profit. Where a partner is guaranteed a minimum share, profits are first distributed in the agreed ratio; if the guaranteed partner's share falls short, the deficiency is borne by the guaranteeing partner or partners in their agreed ratio.
Goodwill
Goodwill is the value of a business's ability to earn more than a normal return — the reputation, customer connection, location and management quality that make its profits exceed what its net assets alone would command. It matters in partnership because every change in the profit-sharing arrangement transfers a share of that earning power from one partner to another, and the transfer must be paid for.
Three valuation methods are examined.
Average profit method. Goodwill equals the average profit of a stated number of past years multiplied by an agreed number of years' purchase. Adjustments are made first for abnormal items — an abnormal loss is added back and an abnormal gain deducted — so that the average reflects sustainable earnings.
Super profit method. Super profit is the excess of actual profit over normal profit, where normal profit is the capital employed multiplied by the normal rate of return. Goodwill is super profit multiplied by the agreed number of years' purchase. This method is superior in principle because it measures only the excess earning power, which is what goodwill actually is.
Capitalisation method. The firm's average or super profit is capitalised at the normal rate of return to give the capitalised value of the business, and goodwill is the excess of that value over the actual capital employed. Equivalently, under capitalisation of super profit, goodwill is super profit divided by the normal rate of return, expressed as a proportion.
Admission of a partner
Six adjustments arise, and working through them in a fixed order prevents most errors.
New profit-sharing ratio. Determined by the terms of admission. Read carefully whether the incoming partner's share is taken from the old partners equally, in their old ratio, or in a specified ratio.
Sacrificing ratio. The ratio in which the old partners give up share:
Sacrificing ratio = old share − new share
This is the ratio in which goodwill brought by the new partner is credited to the old partners, because it measures who gave up what.
Goodwill. Where the incoming partner brings in cash for goodwill, it is credited to the old partners in the sacrificing ratio. Where goodwill already appears in the books, it is written off among the old partners in their old ratio before anything else, because existing goodwill belongs to the old partners in their old proportions.
Revaluation of assets and liabilities. A Revaluation Account is prepared. Increases in assets and decreases in liabilities are credited; decreases in assets and increases in liabilities are debited. The resulting profit or loss belongs to the old partners in their old ratio, because the changes accrued before admission.
Reserves and accumulated profits or losses existing at admission are similarly distributed to the old partners in their old ratio.
Adjustment of capitals. Capitals may be brought into the new profit-sharing ratio, either by the partners bringing in or withdrawing cash, or by transfer through current accounts.
Retirement and death
The mirror image of admission, with one important difference in the ratio used.
Gaining ratio is the ratio in which continuing partners acquire the outgoing partner's share:
Gaining ratio = new share − old share
Goodwill is debited to the continuing partners in their gaining ratio and credited to the outgoing partner for their share, because the continuing partners have acquired earning power that belonged to the retiring partner. This is the exact converse of admission, where the sacrificing ratio governs.
Revaluation profit or loss and accumulated reserves are distributed among all partners including the outgoing one in the old ratio, since these accrued while that partner was still a member.
The amount due to a retiring partner is settled in cash, or transferred to a loan account carrying interest, or paid in instalments as agreed. In the absence of agreement, section 37 of the Act entitles the outgoing partner to interest at 6% per annum on the amount left in the firm, or the share of profits attributable to the use of that amount, at their option.
On death, the same adjustments apply, with the additional question of the deceased partner's share of profit from the last balance sheet date to the date of death. This is computed either on a time basis, using the previous year's profit apportioned for the elapsed period, or on a turnover basis, using the ratio of turnover in the elapsed period to turnover of the full previous year. The amount due is paid to the legal representatives.
Dissolution
Dissolution ends the firm. The books are closed through a Realisation Account, which is where the topic differs most from what students expect.
The Realisation Account is debited with all assets transferred at their book values — except cash, bank, and any fictitious assets or debit balances of profit and loss — and credited with all external liabilities transferred at book value. It is then credited with the amounts actually realised on the sale of assets and debited with the amounts actually paid to discharge liabilities, along with realisation expenses. The balance is the profit or loss on realisation, transferred to the partners' capital accounts in their profit-sharing ratio.
Note carefully what does not go to the Realisation Account: cash and bank balances, which are used to make payments; partners' loan accounts, which are settled separately after external liabilities; and accumulated losses, which are transferred directly to capital accounts.
The order of payment is fixed: first the external liabilities, then partners' loans, then the partners' capitals.
Insolvency of a partner. Where a partner's capital account shows a debit balance that they cannot pay, the deficiency must be borne by the solvent partners. The rule in Garner v Murray provides that, in the absence of agreement to the contrary, the deficiency is borne by the solvent partners in the ratio of their capitals standing just before dissolution, and not in their profit-sharing ratio. The reasoning is that the loss arises from the partner's personal insolvency rather than from the business, so it falls in proportion to what each solvent partner had at stake. Note that the rule applies only in the absence of an agreement, and that its application in India has always been subject to the terms of the partnership deed.
How these two chapters are examined
Not-for-profit organisations appear as a Receipts and Payments Account plus additional information, from which an Income and Expenditure Account and a Balance Sheet must be prepared. The marks concentrate in the conversion: subscriptions, consumables consumed, and the treatment of donations, legacies and life membership fees. Show a Subscriptions Account and a consumables computation as working notes.
Partnership appears as either a full-length reconstitution question — admission or retirement with revaluation, goodwill, reserves and capital adjustment — or a dissolution with a Realisation Account, sometimes with an insolvent partner. In both cases the marks are in the working notes: the new ratio, the sacrificing or gaining ratio, and the goodwill computation. Derive and label each explicitly before touching any account, because every subsequent figure depends on them and an error in the ratio propagates through the entire answer.
