UNIT 8: ACCOUNTING FOR PARTNERSHIPS
8.1 INTRODUCTION
In your previous course you have studied the three most dominant forms of business organization: sole proprietorship, partnership, and corporation. For accounting purposes, each form should be viewed as an economic unit separate from its owners, though legally only the corporation is considered separate from its owners. In the previous section you have also studied the basic accounting principles and practices used in accounting for a sole proprietorship form of business organization. The accounting for corporate form of businesses will be explained in the next unit. Therefore, the main focus of this chapter is to acquaint the learns with the basics of accounting for partnerships. As will be explained later in this section, the same accounting principles that are used in accounting for a sole proprietorship are applied in partnership form of businesses. However, there are accounting practices that are unique to partnerships. These unique accounting features relate to the partners’ capital and drawing accounts, division of income (or loss), and changes in ownership of the partnership.
8.2 PARTNERSHIPS AND THEIR CHARACTERSTICS
A partnership is an association of two or more persons to carry-on as co-owners of a business for profit. This association is based on a partnership agreement or contract known as the articles of a partnership.
The partnership agreement should specify the name location, and purpose of the business; the capital contributions and duties of each partner; the methods of income and loss division; the rights of each partner upon liquidation (winding up) of a partnership, etc.
The partnership agreement should be in writing to avoid any misunderstandings about the formation, operation, and liquidation of a partnership.
Characteristics of a partnership
For purposes of accounting, partnerships are treated as separate economic entities. The next paragraphs describe some of the important features of a partnership.
A) Voluntary Association
A partnership is a voluntary association of individuals rather than a legal entity in itself. Therefore, a partner is responsible under the law for his or her partner’s business actions with in the scope of the partnership. A partner also has unlimited liability for the debts of the partnership. Because of these potential liabilities, an individual must be allowed to choose the people who join the partnership.
B) Limited Life
Because a partnership is formed by the consent of two or more partners, it has a limited life. This means that, anything that ends the contract dissolves the partnership.
A partnership can be dissolved when (1) a new partner is admitted; (2) a partner withdraws, retires, dies or becomes bankrupt. At this point, the remaining partners should sign a new contractual agreement to continue the affairs of the business. In place of the old partnership a new partnership is formed. Thus, a partnership is said to have a limited life.
C) Unlimited Liability
Each partner is liable for all the debts of the partnership. When and if the partnership fails to pay its debts, creditors can seize (take) each partner’s personal assets to satisfy their claims. Therefore, partnerships creditors claims are not limited to the assets of the business, but is extends to the personal property of the partners. Each partner, then, could be required by law to pay all the obligations (debts) of the partnership.
Suppose, for example, the liabilities of ABC company (a partnership business) as of a certain date is birr 600,000, however, the total properties (assets) of ABC company could only be sold for birr 450,000. Thus, to settle creditors claims fully, the house or personal assets of the partners may have to be sold.
D) Mutual Agency
Each partner is an agent of the partnership within the scope of the business. This means that partner’s act to any contract is binding on the remaining partners as long as it is with in the apparent scope of the business’ operations.
For example, a partner in a public accounting firm can bind the partnership through the delivery of accounting services. redundent. But this partner cannot bind the partnership to a contract for delivering (or providing) cars because it is out of the scope of the business.
E) Co ownership of partnership property
Once invested, the properties contributed by the partners become the property of the partnership and is owned jointly by all the partners. Upon liquidation of the partnership and distribution of assets, the partner’s claim on the assets is measured by the amount of the balance in his/her capital account.
8.3 Advantages and Disadvantages of Partnership
Advantages:
A partnership form of business ownership has the following advantages:
- Easy and inexpensive to form than a corporation. A partnership is easy to form. It only requires the consent of two or more parties. Two or more competent persons simply agree to be partners in some common business purpose.
- Advantageous to raise a large amount of capital and managerial skill (talent) than a sole proprietorship. Because a partnership is formed by two or more persons, it is possible to raise a large amount of capital and managerial skill than a single owner.
- Not subject to separate taxation as a case in a corporation because each partner reports his/her own share of partnership income and is individually taxed, and
- Not required to observe on many restrictive laws unlike a corporation.
Disadvantages
Partnership has the following disadvantages:
- Partners assume unlimited liability. The liability of the partners is not limited to what they have in the partnership, but it goes to the extent of their personal properties (assets).
- Disadvantageous if each partner does not exercise his/her good judgment because one partner’s act can bind a partnership into a contract.
- Limited life. Partnerships are subject to possible termination due to many uncontrollable circumstances such as the death of a partner.
- The transfer of ownership from one partner to another person is difficult unless the remaining partners approve of this
8.4 RECORDING THE FORMATION OF A PARTNERSHIP
A separate capital account is maintained for each partner in a partnership. Each partner’s capital account is credited for the value of their investment upon formation of the partnership.
Illustration
Dr. Teklay and Dr.Mamo decided to form a partnership business, which would provide medical services. They have been in business separately before they form the partnership. The partnership assumed the liabilities of their separate business. The assets were valued and recorded at their current fair market value.
Shown below are the assets contributed and the liabilities assumed by the partnership at their fair market value.
Dr. Teklay Dr. Mamo
Cash Birr 6.500 Cash Birr 3,300
Accounts Receivable 8,600 Accounts Receivable 4,300
Supplies 21,000 Supplies 12,000
Medical Equipment 3,000 Medical Equipment 150,000
Accounts Payable (2,300) Accounts Payable (3,200)
The journal entry on January 1, 2002 to record the investment of each partner and the formation of the partnership would be:
2002, Jan.1. Cash 6,500
A/R 8,600
Supplies 21,000
Medical Equipment 3,000
A/p 2,300
Teklay Capital 36,800
2002, Jan.1. Cash 3,300
A/R 4,300
Supplies 12,000
Building 150,000
Accounts Payable 3,200
Mamo, Capital 166,400
8.5 DIVISION OF PARTNERSHIP INCOME AND LOSSES
A partnership’s income and losses can be distributed according to whatever method the partners specifies in the partnership agreement. The agreement should be specific and clear, to avoid later disputes.
If a partnership agreement does not mention the distribution of income and losses, the law requires that they be shared equally by all partners. Also, if a partnership agreement specifies only the distribution of income, but is silent as to losses, the law requires that losses be distributed in the same ratio as income.
The Income of a partnership normally has three components:
- return to the partners for the use of their capital – called interest on partners’ capital,
- compensation for direct services the partners have rendered – called partners’ salaries, and
- other income for any special characteristics individual partners may bring to the partnership or risks they may take.
The breakdown of total income into its three components helps clarify how much each partner has contributed to the firm.
Income can be shared among the partners in one of the following ways:
- Net income divided in a stated ratio such as:
- equally
- agreed upon ratio (other than equally)
- ratio based on beginning capital balances
- Net Income divided by allowing interest on the capital investments, salaries, or both with the remaining net income divided in an agreed ratio.
Example
Assume that Dr. Teklay and Dr. Mamo partnership had a net income of Birr 60,000
1. A. Assume that the articles of a partnership provides equal share of Net Income or Loss.
- In this case the capital accounts of each partner will be credited for Birr. 30,000
Income Summary-------------------------------60,000
Dr. Teklay capital-----------------------------------30,000
Dr. Mamo capital------------------------------------30,000
B. Net income is divided in ratio of 3.2 to Dr. teklay and Dr. Mamo respectively.
- Income summary-------------------------------------60,000
Dr. Teklay capital (3/5 X 60,000) --------------------------36,000
Dr. Mamo capital (2/5 X 60,000) ---------------------------24,000
C. Net income is divided in a ratio of partners’ capital account balances at the beginning of the fiscal period.
Income summary ------------------------------- 60,000
Dr. Teklay capital 
-----------------------------10,860
Dr. Mamo capital 
------------------------------ 49,134
- 36800 + 166400 = 203200
2. Net income is divided by allowing 5% interest on their beginning capital balances, a salary of Birr. 5,000 to Dr. Teklay and the remainder is divide equally.
Net Income Division
Income to be
Dr. Teklay Dr.Mamo Total Distributed
Net income Birr, 60,000
Interest (5%) 1,840 8,320 10,160 49,840
Salary 5,000 -- 5,000 44,840
Remainder 22,420 22,420 44,840 -- 0 –
Distribution 29,260 30,740 60,000
Journal entry
Income summary ---------------------------- 60,000
Dr. Teklay capital ---------------------------- 29,260
Dr. Mamo capital ---------------------------- 30,740
8.6 FINANCIAL STATEMENTS FOR A PARTNERSHIP
The income statement of a sole proprietorship and that of a partnership are the same. At the end of the period a statement of partners’ capital is prepared which summarizes the effect of transactions on the capital account balances of each partner. The statement of owners equity for Teklay and Mamo using assumed data and the income division shown above is illustrated below:
Dr. Teklay and Dr Mamo
Statement of partners’ Capital
For the year Ended Dec, 31, 2002
Dr. Teklay Dr. Mamo
Capital Bal. January 1, 2002 Br. 36,800 Br. 166,400
Add: Additional investment 4,200 4,300
Total Br. 41,000 Br. 170,700
Net income distribution 29,260 30,740
70,260 201,440
Deduct: Withdrawals during the year 5,000 5,000
Capital Bal. Dec. 31, 2002 Br. 65260 Br. 196,440
NB- The balance sheet of a partnership is different from that of a sole proprietorship only
in the owner’s equity section. In the partnership business since two or more persons
owns the business, there are two or more capital accounts whereas for a sole
proprietorship there will always be one capital account.
8.7 DISSOLUTION OF A PARTNERSHIP
- Dissolution of a partnership occurs whenever there is change in the original association of partners. When a partnership is dissolved, the partners lose their authority to continue the business as a going concern. This does not mean that the business operation necessarily is ended or interrupted, but it does mean – from a legal and accounting standpoint – that the separate entity stops to exist.
- The remaining partners can act for the partnership in finishing the affairs of the business or in forming a new partnership that will be a new accounting entity.
- A partnership is legally dissolved (terminated) when a new partner is admitted or an existing partner withdraws.
8.7.1. Admission of a New Partner:
The admission of a new partner dissolves the old partnership because a new association has been formed.
Dissolving the old partnership and creating a new one require the consent of all the old partners and the ratification of a new partnership agreement.
When a new partner is admitted, a new partnership agreement should be prepared.
- A new partner can be admitted into a partnership in one of two ways:
- by purchasing ownership right from one or more of the original partners, or
- by investing assets in the partnership.
1. Admission by Purchase of Ownership Right
When an individual is admitted to a firm by purchasing ownership right from an old partner, each partner must agree to the change. A journal entry is needed in the partnership to transfer the ownership right purchased from the capital account of the selling partner to the capital account of the new partner. The partnership’s assets and liabilities remain unchanged.
Suppose, for example, Sister Helen joins the partnership of Dr. Teklay and Dr. Mamo by buying ownership right of Br. 8000 from Dr. Mamo. The entry to record the admission of Sister Helen and the transfer of the ownership right from the capital account of Dr. Mamo to the capital account of Sister Helen in the partnership books shown below
Journal entry
Dr. Mamo---------------------------------- 8,000
Sr. Helen --------------------------------------8,000
The price that sister Helen paid to Dr. Momo can be more or less than Br. 8,000 but that is irrelevant as it wouldn’t be reflected in the record (books) of the partnership.
2. Admission by Investing Assets
Assume that instead of purchasing ownership right from the existing partners, Sister Helen invested cash of Br. 80,000 into the partnership. In this case both partnership assets and total owners’ equity are increase. The journal entry must record such an investment and the increase in partnership assets.
Consider the following scenarios as an example:
- Sister Helen receives a 50% ownership right in the partnership. Assume also that Dr. Teklay and Dr. Mamo’s capital balance were Br. 25,000 and Br. 55,000 respectively. Dr. Teklay and Dr. Mamo share income in a ratio of 2:1 respectively.
Journal Entry
Sister Helen’s capital account would be credited for Br. 80,000 i.e., (55,000 + 25,000 + 80,000) X ½.
Cash------------------------------------------80,000
Sister Helen, Capital------------------------80,000
2- Sister Helen receives a one –fourth ownership right upon admission.
Assume everything else as above. In this case Sister Helen’s capital account would be
credited for birr 40,000 ie, (Birr 25,000 + Birr 80,000) X ¼.
The difference Br. 40,000, (80,000 – 40,000) would be shared between the remaining two partners with the income-sharing ratio.
Journal entry
Cash----------------------------80,000
Helen capital ------------------------40,000
Dr. Teklay capital --------------------- 26,667
Dr. Mamo capital --------------------- 13,333
8.7.2 Retirement or Withdrawal of a Partner
When an existing partner withdraws he/she can sell his/her ownership right or he/she can withdraw assets from the partnership. Both options are considered below:
1. Sale of Ownership Right to the Existing Partner
When ownership right is sold by a withdrawing partner to an existing partner, the entry on the partnership’s books transfers the retiring partner’s capital balance to the buyer’s capital account.
Example:
Dr. Mamo withdraws from the partnership because of a disagreement. He sells his Br. 38,333 ownership right to Dr. Teklay.
Journal entry
Dr. Mamo Capital----------------------------- 38,333
Dr. Teklay Capital ----------------------------- 38,333
The amount paid by Dr. Teklay is not recorded on the partnership books, because the transaction involves no flow of assets to or from the partnership.
2. Withdrawal of Assets From the Partnership
When a partner withdraws he/she may be paid above or below the amount shown in his/her capital balances.
Example
a. Assume Dr. Mamo was paid Br. 50,000 cash when he withdraws from the partnership of T,M&H. The capital balances of each partner were as follows as of that date:
Dr. Teklay capital ---------------------------Br. 100,000
Dr. Mamo capital --------------------------- --- 50,000
Sister Helen capital ----------------------------- 35,000
Total Equities Birr 185,000
Journal entry
Dr,Mamo capital -------------------------------- 50,000
Cash -----------------------------------------------------------50,000
b. Assume Dr. Mamo was paid Br. 56,000 instead of Br. 50,000, the excess amount of Birr 6,000 is charged to the remaining partner’s capital accounts based on the income- sharing ratio. (Assume a 3:2:1 income-sharing ratio between Dr Teklay Dr. Mamo and Sister Helen respectively).
Journal entry
Dr. Mamo capital ------------------------------50,000
Sister Helen capital ---------------------------- 1,500
Dr. Teklay capital ------------------------------ 4,500
Cash ----------------------------------------------------56,000
- The Birr 6,000 excess is shared on the basis of a 3:1 ratio, i.e., Dr. Teklay would be charged for 6,000 X c/4 = birr 4500, and Sister Helan would be charged for
Birr 6000 X ¼= Birr 1500.
8.8 LIQUIDATION OF A PARTNERSHIP
Liquidation of a partnership is the process of ending the business, of selling enough assets to pay the partnership’s liabilities and distributing any remaining assets among the partners.
Liquidation is a special form of dissolution. When a partnership is liquidated, the business will not continue.
- A partnership may be liquidated if:
- the objectives sought in forming the partnership has been achieved.
- the time period for which the partnership was formed expires (ends)
- newly enacted laws have made the partnerships activities illegal,
- the partnership becomes bankrupt.
The partnership agreement should indicate the procedures to be followed incase of liquidation. Usually, the books (records) are adjusted and closed, with the income or loss distributed to the partners and the assets are sold.
The sale of the assets at the time of liquidation of a partnership is known as realization.
As the assets of the business are sold, any gain or loss should be distributed to the partners according to the income and loss sharing ratio.
As cash is realized, it must be applied first to outside creditors. Finally, the remaining cash is distributed to the partners in accordance with the balance of their capital accounts.
Illustration
The partnership of Resom, Sultan, and Tassew is liquidated on September 1,2002. The income and loss sharing ratio of the partners is: Resom 40%, Sultan 35%, and Tassew 25%. After discontinuing the ordinary business operations of their partnership and closing the accounts, the following summary of a trial balance is prepared:
R, S And T
Trial Balance
Septamber 1, 2002
|
|
Debit |
Credit |
|
Cash |
10,000 |
|
|
Other assets |
90.000 |
|
|
Liabilities |
|
10,000 |
|
R. Capital |
|
30,000 |
|
S. Capital |
|
30,000 |
|
T. Capital |
________ |
30,000 |
|
Total |
100,000 |
100,000 |
Based on the information on the trial balance, accounting for liquidation of R,S, and T partnership will be illustrated using different selling prices for the non cash assets.
Case One: Gain On Realization
Assume that Resom, Sultan, and Tassew sell all noncash assets for Birr 95,000, realizing a gain of birr 5000, (Birr 95,000 – Birr 90,000). The gain is divided among Resom, sultan and Tassew in the income and loss sharing ratio of 40% 35%, and 25% respectively. Then, the liabilities are paid, and the remaining cash is distributed to the partners according to the balances in their capital accounts. The entries to record the steps in the liquidation of a business are as follows:
Cash………………………………95,000
Other assets………………………….90,000
Gain on sale of assets……………….. 5,000
Entry to record the sale of non cash assets and the recognition of gain on realization
- Gain on sale of assets…………… 5,000
R Cap. (5,000 X 40%)………………… 2.000
S Cap. (5,000 X 35%)…………………. 1,750
T Cap. (5000 X 25%)…………………...1,250
To distribute gain on realization
- Liabilities……………………….10,000
Cash………………………………..10,000
To record the settlement of partnership liabilities.
After the above entries are posted, the partners’ capital accounts shows:
R’s Beg Bal. 30,000 + 2,000 = Birr 32,000
S’s Beg Bal. 30,000 + 1,750 = Birr 31,750
T’s Beg Bal. 30,000 + 1,250 = Birr 31,250
The cash account now shows a balance of Birr 95,000 (10,000 + 95,000 – 10,000). The entry recorded upon distribution of this cash among the partners would, therefore, be
R, capital……………………… Birr 32,000
S, capital……………………… Birr 31,750
T, capital……………………… Birr 31,250
Cash-------------------------------------95,000
To record the distribution of cash among the partners.
Case two: Loss on Realization: No capital Deficiencies
Assume that Resom, Sultan, and Tassew sell all non cash assets for Birr 70,000, instead of Birr 95,000, incurred a loss of birr 20,000,(Birr 90,000 – Birr 70,000)
Journal entry
-Cash --------------------------------------70,000
Loss on realization-----------------------20,00
Other Assets-------------------------------------90,000
To record the sale of the assets
-R capital---------------------- (40% X 20,000) -----------------8,000
S capital----------------------- (35,000 X 20,000) --------------7,000
T capital ---------------------- (25% X 20,000) --------------- 5,000
Loss on Realization ------------------------------------- 20,000
To distribute the loss on realization
- Liabilities ---------------------------------- 10,000
Cash -----------------------------------10,000
To record the settlement of partnership liabilities
After the above entries have been posted; the accounts show cash 70,000 R, cap. Birr22,000 S,cap. Birr 23,000 and T, cap. Birr 25,000. The entry to record the cash distribution to the partners would, therefore, be as follows:
R cap --------------------------------- 22,000
S cap ----------------------------------23,000
T cap --------------------------------- 25, 000
Cash -------------------------------------- 70,000
Entry to record the distribution of cash to partners.
Case three: Loss on Realization with Deficiency in one Partner Capital
- Assume the non-cash assets of R,S and T partnership are sold for only Birr 10,200, incurring a loss of Birr 79,800,( Birr 90,000 – Birr 10,200). The entries to record the division of loss among the partners and the liquidation to this point are shown below:
Cash -------------------------------- 10,200
Loss on sale of Assets ----------- 79,800
Other Assets-------------------------- 90,000
To record the sale of assets
R capital (79800 X 40%) ----------------------31,920
S capital (79800 X 35%) ---------------------- 27,930
T capital (79800 X 25%) ---------------------- 19,950
Loss on sale of Assets ---------------------------- 79,800
To distribute loss on realization
- Liabilities ----------------------------------- 10,000
Cash ------------------------------------------------10,000
To record settlement of liabilities
At this stage of the liquidation the capital accounts of the partners have the following balances
R capital = 30,000 – 31920 = 1,920
S capital = 30,000 – 27930 = 2,070
T capital = 30,000 – 19950 = 10,050
Only Birr 10,200 cash is available (10,000 + 10200 – 10,000) for distribution to S and T while the combined balances of their capital accounts is Birr 12,120. Therefore, additional Birr 1,920, (12120 – 10200) is needed which is the amount owed by R to the partnership.
Therefore, either R will have to pay this amount first and the cash will be distributed to S and T, or S and T will have to share the Birr 1920 loss in their income and loss-sharing ratio of 35:25.
Let’s assume, the loss was distributed since R couldn’t pay the amount immediately.
Journal Entries
S capital (35/60 X 1920) -------------- 1,120.00
T capital (25/60 X 1920) -------------- --800.00
R capital -------------------------------------1,920
To charge R’s capital deficiency to S and T
S, capital -----------------------------------950.00
T, capital -----------------------------------9,250.00
Cash ----------------------------------------------10,200
To record the final cash distribution to partners.
The various entries in the liquidation of R,S, and T partnership are summarized in the following statement.
R, S, T partnership
Statement of Partnership Liquidation
For period Sept. 1-15,2002
Non cash = Liabilities + Capital
Cash + Asset
R(40%) S(35% T(25%)
Bal.before realization Birr 10,000 90,000 10,000 30,000 30,000 30,000
Sales of Assets &
Division of loss +10,200 -90,000 --- -31,920 -27,930 19,950
Bal.after realization 20,000 -0- 10,000 (1920) 2,070 10,050
Payment of Liab. – 10,000 --- -10.000 --- --- ---
Bal. After payment
Of liab. 10,200 -0- -0- (1920) 2,070 10,050
Division of deficiency --- --- --- 1920 (1120) 800
Bal. After division of
Deficiency – 10,200 -0- -0- -0- 950 9,250
Dist.of cash 10,000 --- --- --- -950 -9250
Balance -0- -0- -0- -0- -0- -0 -
