What is a Profit and Loss Appropriation Account?
In this post, we will talk about appropriation accounts in accounting for partnerships. The appropriation account is another account that is prepared by a partnership firm.
In contrast to a sole proprietorship, the earnings of a partnership are split proportionally among the partners. The profit must be split among the partners in accordance with the profit-sharing ratio stipulated in the partnership agreement, after making any required modifications, such as interest on capitals, interest on draws, wages or/and commissions to partners, etc.
A Profit and Loss Appropriation Account is created for this reason, in which the nett profit is moved from the Profit and Loss Account and any required adjustments are done before the profit is distributed among the partners.
Items that are adjusted in profit and loss appropriation account
Interest on Capital
Where the profit-sharing ratio differs from the ratio of capital supplied by the partners, interest on capital may be allowed to partners and levied against the firm’s earnings in order to ensure equitable profit distribution.
Interest on capital, being an allocation of earnings, should be deducted solely from available profits. In the event of a loss, no capital appreciation is offered. Interest is mostly computed on capitals at the beginning of the year. When new capital is introduced throughout the course of the year, interest is also allowed on this amount for the time it has been in operation.
Interest on Drawings
Interest may be levied on partner withdrawals to ensure more equal profit distribution. Interest on withdrawals should be imposed on varying amounts and for varying periods.
Salary or Commission Payable to Partners
In a business with both active and sleeping participants, the active partners may be compensated for their effort. The payment of salary is viewed as a distribution of a portion of the company’s profit. Thus, the amount of profit is lowered prior to its distribution according to the predetermined profit sharing ratio.
Past Adjustments of Profit
Occasionally, amounts already distributed among the partners as profits or losses for a given year must be readjusted after the close of accounts for the year, either due to the discovery of some mistakes after the close of the books or the retroactive revision of a certain condition of the partnership contract. In this scenario, revenue accounts that have already been closed are not reopened.
A comparison is made between the amounts previously debited or credited to various partners and the amounts that should have been debited or credited, and an entry for the difference is made to amend the various accounts.
Guarantee of Profit to a Partner
Sometimes, in order to involve a person to become a partner, other partners will guarantee that his share of earnings would not fall below a specified threshold. Typically, when such a guarantee is provided, it is also stipulated that if his share of profit exceeds the minimal limit in a given year, he will be required to reimburse the excess amount that was previously awarded to him in excess of his normal part of profits.
When such an agreement exists, profits should first be split as if no assurance was provided. Then, the amount by which the actual share falls short of the guaranteed share should be awarded to the partner who received the guarantee and deducted from the other partners’ mutual profit sharing ratio. In order to recover the excess in the following years, a reverse entry will be made.
One partner may provide a guarantee to a new partner that if the new partner’s share of earnings falls below a specified threshold, the guarantor will make up the difference. In such a circumstance, the capital account of the partner in whose favour the guarantee is issued will be credited, while the capital account of the guarantor partner will be debited for the excess of the guaranteed amount over the real share of the partner in whose favour the guarantee was issued.
There may also be an agreement that if the new partner’s profits exceed a given threshold, a certain partner will be responsible for the excess. It is a promise to the other partners that the new partner’s share will not exceed a specified amount.