MGT101 Financial Accounting GDB Solution, Spring 2014

Topic to be tested:

• Markup on Capital and Drawing

Learning Objectives:

•  To develop an understanding regarding rights and obligation of Directors and Partners

CONSTRUCT:

Mr. A, Mr. B and Mr. C joined hands for mutual business as partnership firm. They are agreed on equal share in capital and profit & loss. However, after one year Mr. B provided extra Rs. 100,000 for contingency expense on 12% interest rate (Annual) until the repayment. It was not possible to return the loan amount to the Partner Mr. B due to the increasing requirement of capital for flourishing business. Mr. C withdraws Rs. 50,000 on 10% interest rate (Annual) from business resources for the treatment of his wife.
After few years, all partners agreed to convert partnership firm into public limited company, no change in business line, to meet the capital requirements and all partners with other four members became directors of newly incorporated ABC Corporation. Before signing the directorship document, each director legally bound to subscribe and paid for its shareholding. Mr. B has also been investedone million more in the newly incorporated Company. Company rules allow giving the interest free loan to the directors for not more than one year.

DISCUSSION QUESTIONS:
You are required to comment with logical reasoning,

1.      Is Mr. B still having the right to receive interest on its extra-invested amount? If, yes why, not why? Give logical reasoning.

2.      Is Mr. C still liable to pay interest on withdrew amount? If, yes why, not why?

Is Mr. B still having the right to receive interest on its extra-invested amount? If, yes why, not why? Give logical reasoning.

 Ans. (01)

Mr. B invested extra Rs. 100,000 as a capital to meet the expenses of partnership firm.

It was not possible for partnership form to return the loan amount to the Partner Mr. B due to the increasing in the requirement of capital for flourishing business.

Mr. B has also been invested one million more in the newly incorporated Company.

Before signing the directorship document, each director legally bound to subscribe and paid for its shareholding.

No interest should be on its extra-invested amount in case of public limited.

Please, assume and shares the logic behind this issue.

Is Mr. C still liable to pay interest on withdrew amount? If, yes why, not why?

 Ans. (02) 

Mr. C withdraws Rs. 50,000 on 10% interest rate (Annual) from business resources for the treatment of his wife.

Company rules allow giving the interest free loan to the directors for not more than one year after incorporated the public limited company.

If Mr. C reimbursement the (loan or Drawings) Amount of Rs. 50000 before the complication of one year, in this situation he is not liable to pay interest on withdrew amount and vice versa. .

Please, assume and shares the logic behind this issue

·         INTEREST ON CAPITAL AND DRAWINGS

The partnership agreement may include one or both of the following clauses:

Partners are charged interest on drawings (this may be on the total amount of the current account balance or on the amount exceeding a specific limit, depending upon the terms of agreement).

Partners are given interest on their capital (again this can be on the total amount of the capital or the amount exceeding a specific figure).

·         REASONS FOR INTEREST ON CAPITAL

The profit/loss sharing ratio may not be equal despite the fact that partners have contributed equal capital, depending upon the partnership agreement.

Take the following example:

Two partners start a business and contribute equal capital and decide to share equal profits.

But they also realize that in future the business may need further capital and at that time both partners may not be able to contribute equally.

So instead of revising the contract every time they include a clause in the agreement, whereby, the partners are allowed an interest on the capital contributed.

This interest can be on the whole amount of both partners or only of one partner on the amount contributed in excess of the other partner.

This way a partner, who provides capital in excess of his profit sharing ratio, can be compensated.

One may say that the same results can be achieved by saying that profit and loss sharing will be proportionate to the amount of capital invested.

But, as we have said that in partnership everything depends on the Partnership Agreement.

·         REASONS FOR INTEREST ON DRAWINGS

Drawings are opposite to capital invested i.e. these are the funds drawn by partner from the business.

Therefore, in order to keep the distribution of profit fair, a clause may be inserted in the agreement, where an interest is charged on the drawings of the partners.

Again, this can be on the total amount or on an amount exceeding a specific limit.

Both of the above things depend upon the agreement between partners.

·        Partnership to Public limited company

When an established partnership business is incorporated, that is turned into a limited company (nearly always a company limited by shares), the proper procedure is for the new limited company to be registered, a date chosen for the transfer of the business, and then for the partners to enter into a contract with the new company for all (or some) of the assets of the business to be transferred to the company in return for shares in it. The partners will then have limited liability in respect of all transactions that take place after the date of the transfer, but will remain personally liable for any debts incurred as partners before such date.

E.g. If the existing business has assets worth Rs100,000 and has two equal partners, the assets will be listed in a schedule to the contract and, typically, transferred to the company in return for100,000 Rs10 for each share, 5,000 Shares are issued to each of the partners.

From an accounting point of view the most convenient date for the transfer will usually be at the end of the financial year of the existing business so that accounts can be drawn up for whole years and the partnership accountant should be consulted on this matter.