Lesson 12

Accounting for Partnerships

In Chapter 12, there is a shift from the Proprietorship form of organization, to that of the Partnership. The major issues surrounding partnership accounting pertain to the Owners Equity section (called "Partner Equity") of the general ledger, in which each partner has a separate Capital account and Drawing account. Those issues include determination of the capital balances of the partners upon investment, division of profits and losses, changes in partner membership, and liquidation of the partnership.

Learning Objectives

Here is a general list of topics for Chapter 12:

1.     Characteristics of Partnerships, Advantages and Disadvantages

2.     Division of Partnership Income and Losses

3.     Partnership Financial Statements

4.     Admission of a New Partner

5.     Withdrawal of a Partner

6.     Liquidation of a Partnership

Characteristics of a Partnership

There is a lot of detail regarding the characteristics of a partnership. Here are some major points:

1.     A partnership is considered a legal entity and an accounting entity, but is not considered a federally taxable entity. Income taxes are paid by each individual partner upon their share of income from the partnership. The partnership itself files an information return only.

2.     Although no written partnership agreement is required in order to form a partnership, such an agreement is critical. A person getting into a partnership should insist that a partnership agreement be created, with help from a qualified lawyer.

3.     Partners have mutual agency. Any partner can legally obligate the entire partnership, if the obligation appears reasonable.

4.     A partnership has limited life. It will be dissolved at the point where a partner withdraws, or when a new partner is admitted to the partnership. Often, dissolution of the partnership simply means that the business will continue with different ownership. At the point where the business is terminated altogether, the partnership is liquidated. Liquidation involves paying off all debts, and, if cash remains, distributing it to any remaining owners.

5.     As is the case with a proprietorship, each partner has unlimited liability. If the partnership fails, the personal assets of the partners may be seized in order to meet partnership debts. Unlimited liability is the most dramatic disadvantage of the partnership form of business, and a company should carefully consider whether a corporation would be a more advantageous method of organization.

6.     Partners jointly own partnership assets. Furthermore, if there is no written agreement to the contrary, all income and losses of the partnership are divided equally, even if one partner contributed the bulk of the assets to the partnership at its inception.

A partnership allows individuals to combine talents and resources in business, and does not require the legal process involved in forming a corporation. In contrast to these advantages, unlimited liability, mutual agency, and unlimited liability are potential disadvantages to the partnership form of organization.

Partnership Formation

A partnership is formed when the partners pool their assets. All assets contributed are listed in the assets category at their fair market value (FMV). Each partner contributing assets gets credit in their capital account for the total fair market value contributed. Thus, the partners will need to agree as to FMV's because their ownership percentage is at stake. Example: Adams and Baker form a partnership. Adams contributes $5,000 in Cash, and Office Equipment with a FMV of $3000. Baker contributes $2000 in Cash, and a Building with FMV of $10,000. Assuming that partners agree to these valuations regarding the FMV's of the noncash assets, the partnership would be formed as follows:

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Notice that as assets are invested, there must be an equal increase in the partners' equity section; as you would expect, Assets = Liabilities + Partners' Equity.

Division of Partnership Income

When a net income or loss is incurred, it is closed to the individual Capital accounts of the partners, just like a proprietorship. The closing process is illustrated on page 602 of the text, and parallels the closing entries for a proprietorship illustrated in Chapter 4. Revenues are closed to an Income Summary account; expenses are also closed to Income Summary; the Income Summary account is closed to the partners' Capital accounts.  And finally, each partner's Drawing account is closed to the appropriate Capital account. Each partner will get taxed upon his or her share net income from the partnership, not the amount drawn during the period.

The manner in which income is split up among the partners can take on many variations. Some examples of how partners may split profits are as follows:

1.     Partners can agree to a fixed ratio, like 50:50 or 60:40;

2.     Partners can be compensated based upon the total capital each has invested in the partnership (called an "interest" allowance);

3.     Partners can be compensated for the amount of labor contributed (a "salary" allowance);

4.     Other possibilities or combinations of the above.

Although item 2 above sounds like interest expense to the partnership, and number 3 sounds like salary expense, neither of these is an expense. Rather, these are ways to determine how much net income to transfer to each owner's Capital account in the closing process.

Partnership net income is shared when the accounts are closed at the end of the accounting period. You will recall that the closing process consists of four steps:

1.     Close Revenues to Income Summary;

2.     Close Expenses to Income Summary;

3.     Close Income Summary to the Capital accounts;

4.     Close Drawings to the Capital accounts.

Example: Sam and Dave form a partnership, with Sam contributing $40,000 and Dave contributing $60,000. The journal entry for this formation is as follows:

Cash

40,000

 

____Sam Capital

 

40,000

____Dave Capital

 

60,000

This transaction demonstrates that assets increase with debits, and partner equity increases with credits.

The new partnership earns $140,000 of revenue and incurs $110,000 of expenses.

Accounts Receivable

140,000

 

____Service Revenue

 

140,000

 

 

 

Expenses

110,000

 

____Accounts Payable

 

110,000

Service Revenue and the Expenses will be closed to Income Summary. The result will be that Income Summary will have a credit of $140,000 for the Revenue and a debit of $110,000 for the Expenses. The entry to share net income occurs with the third closing entry, in which Income Summary is closed to the two capital accounts. Let us assume that the partners agree to share net income equally. The entry to close Income Summary will appear as follows:

Income Summary

30,000

 

____Sam Capital

 

15,000

____Dave Capital

 

15,000

Note that no cash is paid at this point. The partners are not salaried employees. Each partner will be obligated for income taxes from the partnership of $15,000. In order to get cash from the partnership, each partner would have to make a drawing. At this point, Sam would have capital of $55,000 and Dave would have capital of $75,000.

What happens if the partnership makes a net loss? For example, what if the company makes a loss of $40,000? The closing entry would look like this:

Sam Capital

20,000

 

Dave Capital

20,000

 

____Income Summary

 

40,000

In this case, Sam would end up with capital of $20,000 and Dave would end up with $40,000.

Your textbook illustrates a more complicated way to dividing net income. Suppose that John and Mary form a partnership and agree that John should receive a $20,000 salary allowance and that Mary receive a $30,000 salary allowance. Additionally, each partner is to receive 5% of their capital balance, and any remainder is to be split equally. Assume that John started with a $50,000 capital balance and Mary started with $60,000. Assume further that net income was $90,000 for the year. A table would be used to add up the amounts for each partner:

Net Income: $90,000

John

Mary

Salary Allowances

$20,000

$30,000

Interest on Capital: 5%

2,500

1,500

Total awarded so far:$54,000

$22,500

$31,500

 

 

 

Remainder to Distribute:$36,000

 

 

Remainder Divided Equally

$18,000

$18,000

Totals for each partner

$40,500

$49,500

The goal is to split the $90,000 following the partnership agreement. Begin by awarding the salaries and interest. John receives salary of $20,000 and interest of $2,500 for a total of $22,500. Mary receives $30,000 of salary allowance and $1,500 of interest for a total of $31,500. Out of the $90,000, a total of $54,000 has been assigned, leaving a remainder of $36,000. This remainder is divided in half, $18,000 for each partner. John ends up with $40,500 and Mary ends up with $49,500. Note that the sum of these amounts is $90,000.

The journal entry to split the income is as follows:

Income Summary

90,000

 

____John Capital

 

40,500

____Mary Capital

 

49,500

Example with a Negative Remainder

It is possible that there is not enough net income in order to fully compensate the partners. Suppose in the John and Mary case that the net income was $30,000. See if you can follow the logic in the following table.

Net Income:$30,000

John

Mary

Salary Allowances

$20,000

$30,000

Interest on Capital: 5%

2,500

1,500

Total awarded so far: $54,000

$22,500

$31,500

 

 

 

Remainder to Distribute: ($24,000)

 

 

Remainder Divided Equally

($12,000)

($12,000)

Totals for each partner

$10,500

$19,500

 

 

 

In this second case, note that the salary and interest amounts are the same. However, with only $30,000 of net income, the distribution of $54,000 to the partners results in a negative remainder (deficiency) of $24,000. This deficiency is shared equally by the partners, $12,000 each. John receives $22,500 for principal and interest, but this amount is reduced by the $12,000 deficiency. Note that the total distributions of $10,500 and $19,500 add up to the net income of $30,000.

Partners' Capital Statement

Instead of an Owner's Equity Statement, the Partners' Capital Statement is prepared. The general format is the same as shown in Chapter 1 for a proprietorship. Beginning Capital + Investments + Net Income - Drawings = Ending Capital. If you remember how to set up an owner's equity statement for a proprietorship, you already know how to prepare a partners' capital statement.

Admissions/Withdrawals of Partners

When a the partnership membership changes, the old partnership is dissolved, and a new partnership is formed. For this section on admissions and withdrawals, you should focus on the following questions:

1.     Are new assets coming into (or going out of) the partnership? If so, there will have to be some adjustment in the Partners' capital balances so that the Balance Sheet equation will still work;

2.     What is the new capital total in the partnership? It will always be equal to the sums of the new balances in the partners' capital accounts.

Liquidation of a Partnership

The term "liquidation" refers to conversion of all noncash assets to cash, payment of all liabilities of the partnership, and termination of the partnership itself. The steps necessary for a liquidation are as follows:

1.     Complete the accounting cycle, if necessary;

2.     Sell all noncash assets and record a gain or loss on realization;

3.     Allocate such gain or loss to all partners based on their income ratios;

4.     Pay all partnership liabilities in cash;

5.     Distribute remaining cash to partners based on their capital balances.



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