Partnership: Guaranteed Minimum Profit, Partner's Loan and Interest on Capital
X, Y and Z share profits and losses 4:3:3. Under the deed, interest on capital is allowed at 8% per annum on capitals of ₹5,00,000 (X), ₹3,00,000 (Y) and ₹2,00,000 (Z). Z is guaranteed a minimum annual profit share of ₹1,50,000, any deficiency to be borne by X and Y in the ratio 3:1. The deed says nothing about interest on loans from partners. On 1 October 20X4, Y advanced ₹2,00,000 to the firm by cheque.
Profit for the year ended 31 March 20X5, before interest on Y's loan and interest on capital, was ₹4,60,000. Z drew ₹1,40,000 during the year.
Y now claims interest on his loan at 12% per annum, saying that this is the rate he pays on his own borrowings, and argues further that Z's guarantee should be treated as a charge against profit in the profit and loss account rather than as an adjustment between partners. Z contends that his guaranteed ₹1,50,000 should be measured after including the interest on his capital, since that interest is also an appropriation of profit.
1. Deal with Y's claim for interest and compute the distributable profit and each partner's share, applying the guarantee on the basis that it attaches to the share of divisible profit.
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Interest on Y's loan. Where the deed is silent, Section 13(d) of the Indian Partnership Act, 1932 allows interest on a partner's loan at 6% per annum; a higher rate needs agreement. Y's own borrowing cost is irrelevant. The interest is a charge against profit, not an appropriation. 2,00,000 × 6% × 6/12 = ₹6,000.
| ₹ | |
|---|---|
| Profit before loan interest and capital interest | 4,60,000 |
| Less interest on Y's loan | (6,000) |
| Less interest on capital: X 40,000, Y 24,000, Z 16,000 | (80,000) |
| Divisible profit | 3,74,000 |
| X 4/10 | 1,49,600 |
| Y 3/10 | 1,12,200 |
| Z 3/10 | 1,12,200 |
Guarantee. Z's share of divisible profit is ₹1,12,200 against the guaranteed ₹1,50,000; deficiency ₹37,800, borne by X and Y in 3:1 - X ₹28,350, Y ₹9,450.
Final allocation: X 1,49,600 − 28,350 = ₹1,21,250; Y 1,12,200 − 9,450 = ₹1,02,750; Z ₹1,50,000. Total ₹3,74,000, agreeing with the divisible profit.
2. Z argues that his guarantee should be measured after adding the interest on his capital. Compute the alternative and advise which reading should be adopted and how it should be disclosed.
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Alternative reading. If the guarantee is applied to Z's total appropriation rather than to his share of residual profit: interest on capital ₹16,000 + share ₹1,12,200 = ₹1,28,200, against ₹1,50,000, deficiency ₹21,800, borne X ₹16,350 and Y ₹5,450. Z then receives ₹1,50,000 in total and X and Y receive ₹1,33,250 and ₹1,06,750 respectively; the total distributed is ₹3,90,000, i.e. ₹3,74,000 of divisible profit plus ₹16,000 of interest on capital.
The difference between the two answers is exactly the ₹16,000 interest on Z's capital - nothing else changes.
Which is right? Read the deed. If it promises a minimum share of profit, the guarantee attaches to the residual share, because interest on capital is a prior appropriation and is not 'profit share' (reading one). If it promises that the partner shall receive at least ₹1,50,000, the total credited to him must reach that figure (reading two). Indian practice leans to reading one where the deed speaks of a share of profit, but the wording governs.
Disclosure. State the interpretation adopted in the notes to accounts and apply it consistently year on year. Because the difference of ₹16,000 alters the partners' capital accounts and their taxable shares, the basis should be recorded in the deed by a supplementary agreement at the first opportunity; an oral understanding is exactly the kind of ambiguity that ends in litigation.
3. Y argues that Z's guarantee should be debited to the profit and loss account as a charge so that X and Y's shares are computed on the reduced profit. Advise, and state the correct entries.
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A guarantee is an agreement among partners about how profit is divided; it is not a liability of the firm to an outsider and it is not an expense incurred in earning revenue. It therefore belongs in the profit and loss appropriation account, never in the profit and loss account.
If Y's proposal were accepted, the firm's reported profit would be reduced by ₹37,800 (or ₹21,800), understating the firm's performance, distorting the capital accounts, and understating the income on which partners are taxed. The firm's profit is determined independently of the partners' private arrangement for sharing it - that is the whole point of separating the two accounts.
Correct entries (reading one):
- X's capital/current account Dr ₹28,350; Y's capital/current account Dr ₹9,450; To Z's capital/current account ₹37,800 - being the deficiency borne under the guarantee.
- Interest on capital: Profit and loss appropriation A/c Dr ₹80,000; To X ₹40,000, Y ₹24,000, Z ₹16,000.
- Interest on loan: Profit and loss A/c Dr ₹6,000; To Y's loan A/c ₹6,000 (a charge, correctly debited to profit and loss).
Two further cautions. First, if the firm had made a loss, X and Y would bear Z's deficiency only if the deed guarantees a minimum against losses as well; a profit guarantee does not automatically extend to losses. Second, Z's drawings of ₹1,40,000 against a credit of ₹1,50,000 (plus his capital interest) leave a small credit balance, so any claim that he has over-drawn must be tested after the guarantee entries are passed, not before.