When Appropriations Exceed the Profit: Sandhu & Grewal
M/s Sandhu & Grewal is a partnership firm of Harjit Sandhu and Navdeep Grewal, sharing profits and losses in the ratio 3 : 2. Their fixed capitals on 1 April 2023 were ₹6,00,000 and ₹4,00,000 respectively. The partnership deed provides for interest on capital @ 8% per annum, interest on drawings @ 6% per annum, and a quarterly salary of ₹10,000 to Harjit. Profit for the year ended 31 March 2024, before making any of these adjustments and before recording an unrecorded loan, was ₹1,12,000. Harjit withdrew ₹40,000 on 1 July 2023 and Navdeep withdrew ₹60,000 on 1 October 2023. On 1 August 2023 Navdeep advanced ₹1,00,000 to the firm as a loan, and interest @ 6% per annum on it has not yet been recorded in the books. The deed is silent on what to do if appropriations exceed the available profit. Navdeep argues that interest on capital and salary must be paid in full regardless of the level of profit.
1. Prepare the Profit and Loss Appropriation Account for the year ended 31 March 2024 and show how the amount is actually distributed between the two partners.
Read the worked answer
Step 1 – Interest on Navdeep's loan is a charge against profit, not an appropriation. It must be allowed even if the firm makes a loss.
Interest on loan = 1,00,000 × 6% × 8/12 = ₹4,000
Profit available for appropriation = 1,12,000 − 4,000 = ₹1,08,000
Step 2 – Appropriations
Interest on capital: Harjit 6,00,000 × 8% = ₹48,000; Navdeep 4,00,000 × 8% = ₹32,000.
Interest on drawings: Harjit 40,000 × 6% × 9/12 = ₹1,800; Navdeep 60,000 × 6% × 6/12 = ₹1,800.
Salary to Harjit = 10,000 × 4 = ₹40,000.
Profit and Loss Appropriation Account
| Dr | ₹ | Cr | ₹ |
|---|---|---|---|
| To Interest on Capital: Harjit 48,000; Navdeep 32,000 | 80,000 | By Profit (1,12,000 − 4,000 loan interest) | 1,08,000 |
| To Salary to Harjit | 40,000 | By Interest on Drawings (1,800 + 1,800) | 3,600 |
| By Loss transferred – Harjit (8,400 × 3/5) 5,040; Navdeep (8,400 × 2/5) 3,360 | 8,400 | ||
| Total | 1,20,000 | Total | 1,20,000 |
Step 3 – Net effect on each partner
Harjit: 48,000 + 40,000 − 5,040 = ₹82,960
Navdeep: 32,000 − 3,360 = ₹28,640
Check: 82,960 + 28,640 = ₹1,11,600 (₹1,08,000 profit + ₹3,600 drawings interest). The firm has not paid out more than it earned.
2. Navdeep insists that the firm must pay interest on capital and salary in full even though profit is insufficient. Evaluate this claim, explaining the order of treatment and the correct accounting for the shortfall.
Read the worked answer
Navdeep's claim confuses two different categories of payment.
Charge against profit – interest on a partner's loan. Because Navdeep advanced money as a lender and not as capital, interest on the loan is a business expense. It is debited to the Profit and Loss Account before any appropriation and must be paid even if the year ends in a loss. Here ₹4,000 is deducted first.
Appropriations of profit – interest on capital and salary. These arise out of the partnership deed and can be allowed only out of profit. They are not debts of the firm. Therefore, as the account shows, the available ₹1,11,600 is short of the ₹1,20,000 claimed.
Treatment of the shortfall. When the deed is silent, the excess of appropriations over available profit is not carried forward as an asset and is not payable in cash. It is a loss for the year and is debited to the partners' capital accounts in the profit-sharing ratio – 3 : 2 here, giving Harjit ₹5,040 and Navdeep ₹3,360. Effectively each partner's interest on capital and salary is scaled down proportionately, and no partner is preferred over the other.
Key point for the exam. Had the deed guaranteed a minimum amount to a partner, the shortfall would instead be borne by the other partners in their profit-sharing ratio. But with a silent deed, the ordinary ratio applies. Interest on drawings is always a credit (income) to the firm and is added before the shortfall is computed, which is why ₹3,600 appears on the credit side.
3. If the deed instead guaranteed Harjit a minimum profit of ₹1,00,000 per year, show how the final distribution changes and who bears the guarantee.
Read the worked answer
Step 1 – Harjit's entitlement without the guarantee
Harjit: interest on capital ₹48,000 + salary ₹40,000 − share of loss ₹5,040 = ₹82,960
Step 2 – Deficiency against the guarantee
Guaranteed amount = ₹1,00,000
Deficiency = 1,00,000 − 82,960 = ₹17,040
Step 3 – Who bears it
A guarantee given to a partner is borne by the guaranteeing partner(s). Where the deed simply guarantees the amount to Harjit and does not name who will bear it, the deficiency is borne by the remaining partners in their profit-sharing ratio. Navdeep is the only other partner, so he bears the whole ₹17,040.
Step 4 – Revised distribution
| Partner | Before guarantee | Share of deficiency | Final |
|---|---|---|---|
| Harjit | 82,960 | + 17,040 | 1,00,000 |
| Navdeep | 28,640 | − 17,040 | 11,600 |
| Total | 1,11,600 | - | 1,11,600 |
Reasoning to show in the answer. A guarantee is an internal arrangement between partners; it does not increase the firm's profit. The total credited to the two capital accounts must remain ₹1,11,600. The deficiency is simply transferred from the guaranteeing partner's share to the guaranteed partner's share, so the Profit and Loss Appropriation Account total is unchanged. Note that the guarantee is applied to the net amount (including interest on capital and salary), not to the profit share alone, unless the deed says otherwise.