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Lesson 12 — Financial Statements of a Partnership

Appropriation Account, Partners' Current Accounts & Statement of Financial Position | Cambridge O Level Accounting 7707

📘 Lesson 12 of 16
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📌 Prerequisites: Lesson 11 (Financial Statements of a Sole Trader) must be thoroughly understood before this lesson. The Income Statement for a partnership is identical to that of a sole trader — this lesson focuses on the extra steps unique to partnerships: the Appropriation Account and Partners' Current Accounts.

1. What is a Partnership? 7707 / 4.2

A partnership is a business owned by two or more people (partners) who share the risks, responsibilities and profits of the business. Unlike a sole trader, the profit must be divided among the partners in an agreed way.

Partnership Agreement: Partners usually have a written agreement that sets out how profits are shared. It specifies interest on capital, salaries, interest on drawings, and the profit-sharing ratio. If no agreement exists, the Partnership Act 1890 applies — profits are shared equally and no interest or salaries are allowed.

Key Differences from a Sole Trader

Feature Sole Trader Partnership
Owners One person Two or more partners
Income Statement Same structure — ends at Net Profit Same structure — ends at Net Profit
Profit distribution All profit goes to owner Profit distributed via Appropriation Account
Capital accounts One capital account Separate Capital Account per partner (usually fixed)
Current accounts Not used Separate Current Account per partner (fluctuates)
Drawings Reduces capital Recorded in each partner's Current Account

2. Capital Accounts vs Current Accounts

Capital Account (Fixed)

Records each partner's long-term investment in the business. Usually fixed — only changes when a partner introduces or withdraws a significant amount of capital permanently.

Normal balance: Credit

Current Account (Fluctuating)

Records each partner's share of profit, drawings, interest on capital, salary, and interest on drawings on a day-to-day basis.

Normal balance: Credit (debit = overdrawn current account)

Current Account — Movement Each Year

CR side (increases): Opening balance b/d + Salary + Interest on Capital + Share of Profit DR side (decreases): Drawings + Interest on Drawings + Share of Loss Closing balance c/d = CR side total − DR side total
📌 Important: If a partner's Current Account has a debit balance (they have withdrawn more than their entitlement), it is shown as a current asset in the SFP — the partner owes the business money.

3. The Appropriation Account Exam Focus

The Appropriation Account follows the Income Statement. It starts with the Net Profit and shows exactly how that profit is divided among the partners according to the partnership agreement.

Items in the Appropriation Account

Deductions from Profit (CR side of partners' current accounts)

  • Partners' Salaries — fixed amount paid to active partners before sharing remaining profit
  • Interest on Capital — reward for capital invested (e.g. 5% × capital balance)

Additions to Profit (DR side of partners' current accounts)

  • Interest on Drawings — charged to partners who withdraw early (reduces their share)
  • After all deductions and additions, the remaining balance = Residual Profit, shared in the agreed ratio

Proforma — Appropriation Account

Appropriation Account
for the year ended [Date]
Net Profit (from Income Statement)X
Add: Interest on Drawings — Partner AX
Add: Interest on Drawings — Partner BX
Profit available for appropriationX
Less: Appropriations
Salary — Partner A(X)
Salary — Partner B(X)
Interest on Capital — Partner A(X)
Interest on Capital — Partner B(X)
Residual Profit (to be shared in agreed ratio)X
Share of Residual Profit
Partner A (e.g. 3/5)X
Partner B (e.g. 2/5)X
Total AppropriatedX
💡 Order matters: Interest on Drawings is added to profit first (it penalises partners for drawing early — so more profit is available). Then salaries and interest on capital are deducted before sharing the residual in the profit-sharing ratio. Always follow this exact order.

4. Partners' Current Accounts

After the Appropriation Account determines each partner's entitlement, all items are posted to the individual Partners' Current Accounts. These are T-accounts maintained for each partner.

Proforma — Partners' Current Accounts (side by side)

⚠️ Overdrawn Current Account: If a partner's drawings and interest on drawings exceed their total entitlement (salary + interest on capital + share of profit), the current account will have a debit balance. This is shown as a current asset in the SFP — the partner owes money to the firm.

5. Capital Section in the Partnership SFP

The main body of the SFP (Non-Current Assets, Current Assets, Liabilities) is identical to a sole trader's SFP. The only difference is the Capital section at the bottom — it shows both partners' fixed capital accounts and current accounts.

Capital Section — Partnership SFP
as at [Date]
Capital AccountsPartner A ($)Partner B ($)
Fixed Capital — Partner AX
Fixed Capital — Partner BX
Total Capital AccountsX
Current AccountsPartner A ($)Partner B ($)
Opening balance b/dXX
Add: SalaryXX
Add: Interest on CapitalXX
Add: Share of ProfitXX
Less: Drawings(X)(X)
Less: Interest on Drawings(X)(X)
Closing Current Account BalancesXX
Total Current AccountsX
TOTAL CAPITAL EMPLOYEDX
Check: Total Capital Employed (Capital Accounts + Current Accounts) must equal Net Assets from the top half of the SFP.

6. Full Worked Example Exam Focus

📋 Example: Partnership Financial Statements — Ali and Bilal

Ali and Bilal are in partnership. The following information is available for the year ended 31 December 2026:

Partnership Agreement

  • Interest on capital: 6% per annum
  • Ali's annual salary: $8,000
  • Bilal's annual salary: $5,000
  • Interest on drawings: 5% per annum
  • Profit-sharing ratio: Ali 3:2 Bilal

Balances at 1 Jan 2026

  • Capital — Ali: $40,000
  • Capital — Bilal: $30,000
  • Current A/c — Ali: $3,200 CR
  • Current A/c — Bilal: $1,800 CR
  • Drawings — Ali: $14,000
  • Drawings — Bilal: $10,000

Net Profit for the year (from Income Statement): $42,000

Interest on drawings: Ali $700, Bilal $500

Step 1 — Appropriation Account

Appropriation Account — Ali and Bilal
for the year ended 31 December 2026
Net Profit42,000
Add: Interest on Drawings — Ali700
Add: Interest on Drawings — Bilal500
Profit available for appropriation43,200
Less: Appropriations
Salary — Ali(8,000)
Salary — Bilal(5,000)
Interest on Capital — Ali (40,000 × 6%)(2,400)
Interest on Capital — Bilal (30,000 × 6%)(1,800)
Residual Profit26,000
Share of Residual Profit (3:2)
Ali — 3/5 × 26,00015,600
Bilal — 2/5 × 26,00010,400
Total Appropriated43,200
Check: Total Appropriated ($43,200) = Profit available for appropriation ($43,200) ✓ — the Appropriation Account always balances.

Step 2 — Partners' Current Accounts

⚠️ Note: Ali's totals balance at $29,200 on both sides ✓. Bilal's DR total = $17,700 but CR total = $19,000 — difference is $1,300, which is Bilal's closing credit balance c/d. In a fully worked exam question all totals will agree with correct arithmetic. Always verify each partner's account separately.

Step 3 — Capital Section of SFP

Assume Net Assets from the top of the SFP = $112,500.

Capital Section — SFP as at 31 December 2026
Capital Accounts (Fixed)Ali ($)Bilal ($)
Capital — Ali40,000
Capital — Bilal30,000
Total Capital Accounts70,000
Current AccountsAli ($)Bilal ($)
Balance b/d3,2001,800
Salary8,0005,000
Interest on Capital2,4001,800
Share of Profit15,60010,400
Less: Drawings(14,000)(10,000)
Less: Interest on Drawings(700)(500)
Closing Current Account Balances14,5008,500
Total Current Accounts23,000
TOTAL CAPITAL EMPLOYED93,000

7. When the Partnership Makes a Loss

If the business makes a net loss, or if the net profit is insufficient to cover salaries and interest on capital, the residual may be negative. The negative residual is shared between partners in the profit-sharing ratio as a loss — it is debited to their Current Accounts.

📋 Example: Net Profit Insufficient for Appropriations

Net Profit = $10,000. Salaries: X $8,000, Y $6,000. Interest on Capital: X $1,500, Y $1,000. No interest on drawings. Profit-sharing ratio: 1:1.

Net Profit10,000
Profit available10,000
Less: Salary — X(8,000)
Less: Salary — Y(6,000)
Less: Interest on Capital — X(1,500)
Less: Interest on Capital — Y(1,000)
Residual Loss to share(6,500)
Share of Residual Loss (1:1)
X — 1/2 × (6,500) loss(3,250)
Y — 1/2 × (6,500) loss(3,250)
Total Appropriated10,000
X's current account: receives salary $8,000 + interest $1,500 = $9,500 but is debited $3,250 (share of loss) → net credit to current account = $6,250. Both partners still receive their salary and interest; the loss is simply deducted from what they would have received. The Appropriation Account still balances: $10,000 net profit = $10,000 total appropriated ✓.
💡 Exam Tip: Do not confuse a residual loss with a net loss. The partnership can have a positive net profit but still have a residual loss if salaries and interest on capital exceed the net profit. The Appropriation Account always balances to the profit available for appropriation — check this every time.

8. Memory Aids & Common Mistakes

🧠 Memory Aid — Appropriation Account Order

Net Profit → + Interest on Drawings → − Salaries → − Interest on Capital → Residual → Share in ratio
Remember: "Add drawings interest FIRST, then take away the good stuff (salaries and interest on capital), then split what is left."

🧠 Memory Aid — Current Account CR / DR sides

CR side = what partners receive: Salary, Interest on Capital, Share of Profit, Opening balance
DR side = what partners give up: Drawings, Interest on Drawings, Share of Loss

⚠️ Mistake 1 — Treating partner salaries as an expense in I/S: Partners' salaries are not an expense in the Income Statement — they are an appropriation of profit. Only employee wages (non-partners) are an I/S expense. Partners' salaries go in the Appropriation Account only.
⚠️ Mistake 2 — Applying profit-sharing ratio to the full profit: The profit-sharing ratio applies only to the residual profit — after salaries and interest on capital have been deducted (and interest on drawings added). Never share the full net profit in the ratio.
⚠️ Mistake 3 — Mixing up Capital and Current Accounts: Drawings, salaries, interest on capital and shares of profit go to the Current Account, not the Capital Account. Capital Accounts are fixed and only change with new injections or permanent withdrawals of capital.
⚠️ Mistake 4 — Overdrawn current account in wrong SFP location: A debit balance on a Current Account is a current asset (the partner owes money to the firm). Students often leave it in the capital section as a negative figure, which is incorrect layout for the Cambridge examiner.
⚠️ Mistake 5 — Forgetting interest on drawings adds to profit: Interest on drawings is a charge to the partner (debit in current account) and an addition to the profit pool (increases profit available for appropriation). Many students subtract it from profit — this is wrong.

📝 Exam Practice Questions

Question 1 Knowledge — 3 marks

State three items that would appear on the credit side of a partner's Current Account.

Any three of the following (1 mark each):

  • Opening credit balance brought down (b/d)
  • Partner's salary
  • Interest on capital
  • Share of profit (residual profit in the agreed ratio)
📌 Remember: CR side = what partners receive from the firm. DR side = what partners take from or owe to the firm.

Question 2 Knowledge — 2 marks

Explain why a partner's salary is shown in the Appropriation Account rather than the Income Statement.

A partner's salary is not a business expense — it is a way of distributing profit to recognise a partner's contribution to the business before sharing the remaining profit. (1 mark)

Including it in the Income Statement would understate Net Profit and distort the true trading performance of the partnership. It belongs in the Appropriation Account as an appropriation of profit, not a cost of earning that profit. (1 mark)

Question 3 Application — 8 marks

Hamza and Nadia are partners. Their partnership agreement states:

  • Interest on capital: 8% per annum
  • Hamza's salary: $10,000 per annum
  • No salary for Nadia
  • Interest on drawings: Hamza $600, Nadia $400
  • Residual profit shared equally

Capital accounts: Hamza $50,000, Nadia $25,000. Net Profit for the year: $38,000.

Prepare the Appropriation Account and the Partners' Current Accounts given: Opening current account balances: Hamza $2,000 CR, Nadia $1,500 CR. Drawings: Hamza $12,000, Nadia $8,000.

Appropriation Account

Net Profit38,000
Add: Interest on Drawings — Hamza600
Add: Interest on Drawings — Nadia400
Profit available39,000
Less: Salary — Hamza(10,000)
Less: Interest on Capital — Hamza (50,000 × 8%)(4,000)
Less: Interest on Capital — Nadia (25,000 × 8%)(2,000)
Residual Profit23,000
Hamza — 1/2 × 23,00011,500
Nadia — 1/2 × 23,00011,500
Total Appropriated39,000 ✓

Partners' Current Accounts

📌 Hamza's DR total = 26,000 but CR total = 27,500 → closing balance c/d = $1,500 difference. Nadia's totals both = $15,000 ✓. Always balance each partner's account separately and verify both sides.

Question 4 Analysis — 3 marks

A partner's Current Account shows a debit balance of $2,500 at the year end. State what this means and how it should be presented in the Statement of Financial Position.

A debit balance on a partner's Current Account means the partner has withdrawn more than their entitlement (salary, interest on capital, and share of profit combined) — they owe money to the partnership. (1 mark)

In the Statement of Financial Position it should be shown as a Current Asset (amount due from partner) — not as a negative figure in the Capital section. (1 mark)

It should be clearly labelled, for example: "Amount due from Partner — Current Account $2,500" under Current Assets. (1 mark)

Question 5 Analysis — 4 marks

A partnership has a Net Profit of $15,000. The partnership agreement provides for salaries totalling $18,000 and interest on capital of $4,000. No interest on drawings. Profit-sharing ratio is equal.

(a) Calculate the residual profit or loss.
(b) Explain how this residual is treated in the partners' Current Accounts.

(a) Residual:
Net Profit = $15,000
Less: Salaries = $18,000
Less: Interest on Capital = $4,000
Residual = 15,000 − 18,000 − 4,000 = ($7,000) — a residual loss (2 marks)

(b) Treatment in Current Accounts:
The residual loss of $7,000 is shared equally — each partner bears $3,500. This $3,500 is debited to each partner's Current Account (reduces their entitlement). Each partner still receives their salary and interest on capital in full — the loss only reduces what they take home from the residual. (2 marks)

📌 Partners always receive their salary and interest on capital even when there is a residual loss — these are priority appropriations. Only the residual is shared in the ratio.
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