Partnership Agreement & Partnership Act 1890 (Cambridge International AS Accounting)

Spec point — the contents of a partnership agreement the advantages and disadvantages to partners of maintaining a partnership agreement the provisions of the Partnership Act 1890 in respect of partners’ salaries, division of profit or loss, interest on partners’ loans, interest on capital and interest on drawings

Partnership agreement & Partnership Act 1890

What is a partnership agreement?

• A partnership agreement is a document that sets out the terms of how the partnership should operate
• Its purpose is to help partners avoid disagreements in the future
• If there is no partnership agreement, then the Partnership Act 1890 applies

What is contained in the partnership agreement?

• The agreement contains information about:

  • The amount of capital each partner is to invest

  • Whether the partners are entitled to interest on their capital

    • And if so, the percentage to be paid
    • Interest on capital is given to reward partners for investing their money into the business

  • Whether salaries are paid to each partner

    • And the amount to be paid

  • Whether partners are entitled to drawings

    • And if so, the limit on the amount each partner can withdraw from the business

  • Whether interest is charged on partners' drawings

    • And if so, the percentage to be charged
    • Interest on drawings is charged to discourage partners from withdrawing money from the business

  • Whether the partners are entitled to interest when they loan their own money to the business

    • And if so, the percentage to be paid
    • Interest on loans is given to reward partners for loaning their money to the business

  • The distribution of profits and losses to be shared between partners

What are the provisions of the Partnership Act 1890?

• The main financial provisions are:

  • Profits and losses are shared equally
  • No interest is charged on drawings
  • No interest is allowed on capital
  • Partners are allowed interest of 5% on partners' loans
  • Partners are not entitled to a salary

Why might a partner provide a loan to the business instead of increasing their capital investment?

• A partner might provide a loan to the business because the loan is repayable

• The partner is then guaranteed a return from the repayments each year

  • The partner also receives interest

• The partner might not want to invest more capital in order to avoid:

  • having to alter the partnership agreement
  • having capital tied up in the business

What are the advantages of maintaining a partnership agreement?

• A partnership agreement allows the partners to set their own agreed terms

  • Division of profits and losses

    • If one partner invests significantly more capital than the other(s), then it would be unfair to share the profits and losses equally

  • Partners' salaries

    • Salaries can be given to partners who work more hours or have more responsibilities

  • Interest on capital

    • Interest can be included to reward partners who invest more money into the business

• A partnership agreement protects the business's cash flow

  • Charging interest on drawings can deter a partner from making excessive drawings

• A partnership agreement can help prevent disputes and clarify roles

  • The agreement sets out clear terms

What are the disadvantages of maintaining a partnership agreement?

• Maintaining a partnership agreement incurs legal costs
• It takes time to prepare and maintain a partnership agreement
• The partnership agreement needs to be updated whenever agreed changes are made