Accounting for Partnership — Basic Concepts
When two or more people run a business together, they need clear rules for sharing profits, rewarding hard work, and tracking every rupee each partner owns — this chapter gives you exactly those tools through the Profit and Loss Appropriation Account and partners' capital accounts.
Partnerships are the dominant business structure among India's kirana owners, CA firms, medical clinics, and tech co-founders — mastering their accounting is core to your Plus Two board exam and the direct foundation for CA Foundation and B.Com courses.
Concept
Lots of students think…
"Partner salary is an expense in the Profit and Loss Account, just like wages paid to employees."
Actually…
A partner is an owner, not an employee. Partner salary is an appropriation of profit, recorded only in the Appropriation Account after net profit is computed — it never appears as an operating expense in the P&L Account.
When two people run a business together, there are clear rules for splitting profits and tracking each person's share — this chapter shows you exactly how partnership accounting works, step by step.
What is a Partnership?
A partnership is a business owned by two or more people called partners. They share the capital, the work, the profits, and the losses. Before starting, they write a partnership deed — a simple agreement that spells out who puts in how much money, how profits are split, and whether anyone gets a salary.
Meera and Suresh open a tailoring shop in Kochi. Meera brings ₹6,00,000 and Suresh brings ₹4,00,000. Their deed says they share profits in a 3:2 ratio and Suresh gets ₹15,000 per month because he manages the shop every day.
The Profit and Loss Appropriation Account
After the business works out its net profit, a second account called the Profit and Loss Appropriation Account decides who gets what share of that profit. Think of it this way: the P&L Account measures what the firm earned; the Appropriation Account divides it up fairly among the partners.
Arjun and Divya's jewellery export unit in Thrissur earns a net profit of ₹3,60,000 in Year 1. The Appropriation Account first pays interest on capital and Divya's salary before splitting the remaining profit 2:1 between them.
Interest on Capital
When a partner puts money into the firm, they could have earned interest by keeping it in a bank instead. To compensate for this, the firm pays the partner interest on the amount they invested. This is called interest on capital, and it is paid before profits are shared.
Arjun has ₹8,00,000 in the firm at 6% per annum, so he earns ₹48,000 as interest on capital. Divya has ₹4,00,000, so she earns ₹24,000. These amounts are credited to each partner first, before any remaining profit is split.
Fixed Capital vs Fluctuating Capital
There are two ways to keep track of a partner's money. In the fluctuating capital system, one single account records everything — capital brought in, salary earned, profits, and money withdrawn. In the fixed capital system, the Capital Account stays frozen at the original amount; all the year-end additions and withdrawals go into a separate Current Account. Most exams use the fixed capital system because it keeps the permanent investment and temporary changes clearly apart.
Divya's Capital Account always shows ₹4,00,000 — the amount she invested on day one. Her Current Account for the year shows her salary of ₹1,44,000, interest of ₹24,000, profit share of ₹48,000, minus her drawings of ₹2,00,000, leaving a credit balance of ₹16,000.
Interest on Drawings
When a partner takes money out of the firm during the year, the firm charges them a small interest called interest on drawings. The earlier you withdraw, the more months of interest you pay. This is fair — it stops a partner who withdraws early from having an advantage over one who withdraws late.
Suresh withdraws ₹60,000 on 1 July at an interest rate of 10% per annum. Interest = ₹60,000 × 10% × 6/12 = ₹3,000. This ₹3,000 is charged to Suresh's account and added back to the pool of profit available to all partners.
No Deed? The Partnership Act Steps In
Sometimes partners start a business without a written deed, or the deed does not cover every situation. The Indian Partnership Act, 1932 fills the gaps with default rules: no interest on capital, no partner salary, profits split equally, and any loan given by a partner to the firm earns 6% interest. These rules only apply when the deed is silent on that point.
Rajan and Priya start a stationery shop in Kozhikode without a deed. At year end, Rajan claims a salary because he runs the shop. Under the Act, no salary is allowed — profits must be split equally between them, whether or not the work was equal.
Notes
The full picture
A partnership is a business owned jointly by two or more people called partners. What sets it apart from a sole proprietorship is that ownership, responsibility, and risk are all shared. Before the firm opens its doors, partners draw up a partnership deed — a written contract specifying each partner's capital contribution, the profit-sharing ratio (the fraction in which profits and losses are divided), whether partners earn interest on their capital, and whether any partner receives a salary. Picture Meera and Suresh starting a tailoring unit in Kochi: the deed might say Meera puts in ₹6,00,000, Suresh puts in ₹4,00,000, they share profits 3:2, and Suresh gets ₹15,000 a month because he manages the shop daily. Every clause in the deed directly drives the accounting entries you will prepare.
Once the net profit is calculated in the regular Profit and Loss Account, a second account called the Profit and Loss Appropriation Account takes over. Think of the P&L Account as measuring what the business earned; the Appropriation Account decides who gets how much of that earning. The Appropriation Account starts with the net profit figure on the credit side and then makes deductions in a strict order. First, interest on capital is credited to each partner — this is the return partners receive just for keeping money locked in the firm, compensating for the opportunity cost of not putting it in a bank. Next, any partner salary or commission stipulated in the deed is credited to the relevant partner. Only after these contractual obligations are settled is the remaining balance (which could be a profit or, if appropriations exceed profit, a loss) shared in the agreed profit-sharing ratio.
Partnership accounting offers two systems for maintaining capital accounts. Under the fluctuating capital system, a single Capital Account per partner records everything: opening capital, interest on capital, salary, share of profit, and drawings (withdrawals). The balance fluctuates every year. Under the fixed capital system, the Capital Account is kept constant at the original contribution; all the year-end adjustments — interest, salary, profit share, and drawings — flow through a separate Current Account. Most firms and exam questions use fixed capital because it immediately shows whether a partner's temporary position (Current Account) is positive or negative, while the permanent stake (Capital Account) remains untouched. When you see a partner's Current Account with a debit balance, it means the partner has drawn more than they have earned — the firm is effectively extending them a loan.
Interest on drawings is the mirror image of interest on capital: if a partner withdraws money during the year, the firm charges interest on those drawings, which is debited in the partner's account and credited to the Appropriation Account (increasing the pool available for distribution). The rate and date of withdrawal determine how many months' interest is charged. For example, if Suresh withdraws ₹60,000 on 1 July and the interest rate is 10% per annum, interest for 6 months = ₹60,000 × 10% × 6/12 = ₹3,000. This entry ensures that partners who draw early in the year bear a fair cost, so those who withdraw later are not disadvantaged.
Sometimes a partnership has no deed, or the deed is silent on a particular point. In that case, the Indian Partnership Act, 1932 fills the gaps with default rules: no interest on capital, no partner salary, profits shared equally, and interest on loans given by partners at 6% per annum. Knowing these defaults is important for exam questions that describe a partnership with missing information — you apply Act provisions, not your own assumptions. The moment a deed specifies something, the Act's default on that point no longer applies.
The Revaluation Account becomes relevant when a firm needs to adjust the book values of assets or liabilities — for instance, if a building has appreciated or a debtor has turned bad since the last balance sheet. The gain or loss on revaluation is shared among existing partners in their current profit-sharing ratio before any new partner joins or an old one retires. This protects both incoming and outgoing partners: an incoming partner does not benefit from past appreciation, and a retiring partner is not penalised for a loss that occurred during their tenure. The Revaluation Account is then closed, and any profit or loss transfers to the partners' Capital or Current Accounts.
An Indian example
Arjun and Divya are Plus Two graduates who open a handmade-jewellery export unit in Thrissur. Arjun contributes ₹8,00,000 and Divya contributes ₹4,00,000. Their deed grants 6% annual interest on capital, a monthly salary of ₹12,000 to Divya (who handles orders and GST filings), and profits split 2:1. In Year 1 the firm earns a net profit of ₹3,60,000. The Appropriation Account first credits interest — ₹48,000 to Arjun and ₹24,000 to Divya — then Divya's annual salary of ₹1,44,000. That leaves ₹3,60,000 − ₹48,000 − ₹24,000 − ₹1,44,000 = ₹1,44,000 to split 2:1, giving Arjun ₹96,000 and Divya ₹48,000. Arjun ends the year with a Current Account credit of ₹48,000 + ₹96,000 = ₹1,44,000 (no drawings); Divya's Current Account shows ₹24,000 + ₹1,44,000 + ₹48,000 − ₹2,00,000 drawings = ₹16,000, a credit balance meaning the firm owes Divya ₹16,000. Even though Divya drew ₹2,00,000 during the year, her combined entitlements (interest + salary + profit share = ₹2,16,000) slightly exceed her drawings, so she is still in credit. This single example shows exactly why the Appropriation Account and Current Accounts exist: without them, neither partner would know at a glance whether withdrawals had consumed more or less than the partner's entitlement.
Common misconceptions to watch for
- Partner salary is an expense in the Profit and Loss Account, just like staff wages. This is wrong — a partner is an owner, not an employee. Partner salary is an appropriation of profit, recorded only in the Appropriation Account after net profit is computed; it never appears as an operating expense in the P&L Account.
- If the partnership deed does not mention interest on capital or profit-sharing ratio, partners can decide these informally each year. This is wrong — when the deed is silent, the Indian Partnership Act, 1932 automatically applies its defaults: no interest on capital, no partner salary, and profits divided equally. These are legal defaults, not optional starting points.
- Under fixed capital, the Current Account balance shows what the partner permanently invested. This is also wrong — the Capital Account shows the permanent investment (unchanged throughout normal operations); the Current Account shows only the net of temporary items for the year (interest earned, salary, profit share, minus drawings). A debit balance in the Current Account means the partner has overdrawn, not that their capital has reduced.
Questions
Ravi and Priya form a partnership on 1 January, contributing ₹5,00,000 and ₹3,00,000 respectively. The deed allows 8% annual interest on capital and a salary of ₹20,000 per month for Ravi (manager) only. The net profit for the year is ₹4,80,000 and profits are shared in the ratio 5:3. Ravi withdrew ₹2,00,000 and Priya withdrew ₹80,000 during the year. Using the fixed capital method, prepare the Profit and Loss Appropriation Account and show the closing balances in the partners' Current Accounts.
- 1Step 1: Decide which account handles partner salaries and interest on capital.Consider this: if Ravi's salary were treated as a business expense in the Profit and Loss Account, it would reduce the net profit figure — but Ravi is an owner, not an employee. Does paying an owner from profit change what the business actually earned from its operations? Think about what the P&L Account is meant to show versus what the Appropriation Account is meant to show, and decide where these items belong.
Question 1 of 5 · easy
Why is the Profit and Loss Appropriation Account prepared separately from the main P&L Account?
Quiz
Test yourself — pick an answer, then hit "Check" to see the explanation and your running score.
Question 1 of 5 · easy
Why is the Profit and Loss Appropriation Account prepared separately from the main P&L Account?
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