profit appropriation statement

In my previous articles on the subject of business accounts, I have focused on the accounts of sole traders. However, as you will be aware, these are not the only type of business entity that you may come into contact with in your role as a solicitor. I will now briefly move on to looking at the accounts of partnerships before we conclude with the accounts of companies.

Generally, the accounts of a partnership are very similar to those of a sole trader, having the same year-end adjustments. The main differences between the two is seen in the bottom half of the Balance Sheet (which you will recall denotes the capital held in the business). The reason for this is that in a partnership, the business will be owned by at least two different people. Therefore, to correctly show the capital of a partnership on the Balance Sheet, it is necessary to make an intermediate step in the preparation of the accounts. This is the preparation of a profit appropriation statement.

In short, the profit appropriation statement records the division of the profits of the business for the relevant accounting period between the partners.

Separate accounts for each partner

Within a partnership, each partner will have his or her own accounts, and commonly there are two accounts for each partner:

1. a Capital account, which represents the partner’s original investment in the partnership, together with any subsequent investments. This is long-term capital which cannot be withdrawn in normal circumstances.
2. a Current account, representing the capital that can be withdrawn at the partner’s discretion. This account records the partner’s share of the ongoing business profits. It will also show any drawings that the partner has taken out over the year.

Applying the ALCIE classification, both of these accounts are capital accounts.

Drawings are withdrawals of profits by the partners during the year, to pay themselves, in much the same way as sole traders pay themselves. The drawings are usually based on an estimate of the partner’s share of expected profits for the year. If a partner draws too much then they could be liable to make a balancing payment back to the partnership depending on the terms of the partnership agreement.

Appropriation of profits

Once the Profit and Loss account has been drawn up and the profit for the business as a whole has been calculated, the profit which the partnership has made needs to be divided amongst the partners. This is done as follows: firstly, sums are allocated to individual partners corresponding to any ‘interest’ on their capital or ‘salaries’ due to them under the partnership agreement. Then the residual profit will be distributed to the partners according to an agreed profit share ratio.

Notional interest on capital

The notional interest is a a payment representing interest on the capital in the partner’s long-term capital account. This will be calculated using a rate of interest that is specified in the partnership agreement. It is important to note that although it is labelled ‘interest’, it should not be treated as an expense item in the Profit and Loss Account. It is notional interest, i.e. it is really an appropriation of profit to a particular director under a different name.

Notional salary

One or more of the partners might receive a notional salary, which again will be in the partnership agreement and is also really an appropriation of profits. Generally, for partners, any salary paid to them:

1. must be treated as an appropriation of profit, not an expense in the Profit and Loss Account (which is how the salaries of any employees the partnership has would be represented); and
2. will be treated as drawings.

Residual profits

The residual profits are the profits for the period remaining after each partner has appropriated any amount(s), to which they are entitled as notional interest and/or notional salary. The residual profits are divided amongst the partners according to an agreed ratio, which will again be specified in the partnership agreement.

Profit appropriation statement

A profit appropriation statement is a practical way to work out the distribution of the profits and must be completed before the Balance Sheet can be drawn up. To complete a profit appropriation statement it is necessary to:

1. give each partner his/her appropriation of profit for notional salary and notional interest.
2. calculate how much profit is left over (the residual profit).
3. share this residual profit between the partners according to the profit-sharing ratio.

Example profit appropriation statement

Brown Design is a partnership of architects. The trial balance of the firm at 31 December 2020 included the following items:

 For the year ended 31 December Year 2, the partnership made a profit of £135,000 and the profits are shared as follows:

1. Brown is given a notional salary of £21,000 and Smith is given a notional salary of £26,000.
2. Each partner is paid interest on (long-term) capital of 5% p.a.
3. The partners share the residual profits in the ratio 5:3:2 to Brown: Smith: Jones.

Once this information has been obtained, the Profit Appropriation Statement can be drawn up as follows:

Partner	Notional salary £	Notional interest £	Share of residual profit £	Total share of profit £
Brown	21,000	3,750	38,825	63,575
Smith	26,000	4,100	23,295	53,395
Jones		2,500	15,530	18,030
	47,000	10,350	77,650	135,000

Calculations:
Notional Interest = 5% of £75,000 for Brown, 5% of £82,000 for Smith and 5% of £50,000 for Jones.
Residual profit = £110,000 minus notional salaries (£47,000) and notional interest (£10,350).
Residual profit = £77,650, divided 5/10 to Brown, 3/10 to Smith and 3/10 to Jones.

 

Partnership Balance Sheet

The top half of a partnership Balance Sheet is similar to that of a sole trader, but the bottom half, which shows capital, follows a different format:

1. the Balance Sheet shows the capital position for each partner separately;
2. the Balance Sheet shows each partner’s capital account and current account; and
3. the balance of each partner’s current account is adjusted by adding that partner’s total share of profit (as calculated in the profit appropriation table) and subtracting that partner’s drawings.

The example below shows the bottom half of the balance sheet for Brown Design based on the information given previously.

			£	£	£
Brown:	Capital account			75,000
	Current account	At start of year	25,000
		Share of profit	63,575
		Drawings	(22,000)
		At end of year		66,575
Brown: total capital					141,575
Smith:	Capital account			82,000
	Current account	At start of year	35,000
		Share of profit	53,395
		Drawings	(30,000)
		At end of year		58,395
Smith: total capital					140,395
Jones:	Capital account			50,000
	Current account	At start of year	40,000
		Share of profit	18,030
		Drawings	(35,000)
		At end of year		23,030
Jones: total capital					73,030
Total partnership capital:					355,000

The total partnership capital would equal the Net Assets from the top half of the Balance Sheet.