Partnership Organization and Operation

UNIT 5

PARTNERSHIP ORGANIZATION AND OPERATION

5.1 Introduction

Partnership is another form of organization, in addition to sole proprietorship and corporation. Partnerships are common in retail establishments and in small scale manufacturing companies. Similarly, if you enter a profession such as accounting, law, or medicine, you may find it desirable to form a partnership with other professionals in your field. In this chapter, we will discuss the essential features of partnerships, and explain the major issues in accounting for partnerships.

 

5.2 Definition and Characteristics of a Partnership

Definition of a Partnership

Partnership is an association of two or more persons to carry, as co-owners, a business for profit. In a partnership, there are at least two persons. The assets of the partnership are owned jointly by the owners. The owners in a partnership are called partners. The partners share the profit or loss of the partnership depending on their agreement.

Characteristics of a Partnership

Partnerships have several characteristics that have accounting implications. The principal characteristics of the partnership form of business organization are described below:

a. Limited Life

A partnership has limited life. Its continuance as a going concern rests in the partnership contract. A partnership may be ended voluntarily at any time through the acceptance of a new partner into the firm or the withdrawal of the partner. A partnership may be ended in voluntarily by the death or incapacity of a partner. In short, any change in the member of partners, regardless of the cause, affects the dissolution of the partnership. Dissolution thus refers to changes in ownership in the partnership. Dissolution does not necessarily mean that the business ends. If the remaining partners agree, operations can continue without interruption by forming a new partnership.

b. Unlimited Liability

Each partner is personally and individually liable for all partnership liabilities. The claims of the creditors attach first to partnership assets and then to personal assets of any partner, regardless of that partner’s equity in the company.

c. Voluntary Association of Individuals

A partnership is a voluntary association of two or more individuals based on a legally binding contract. The contract may be written, oral, or implied. A partnership may be divided into two; namely, general partnership and limited partnership. General partnership is a partnership in which each partner is individually liable to creditors for the debts incurred by the partnership.  In a general partnership, individual partner should contribute from his/her personal assets if the partnership becomes insolvent (unable to pay its debt). On the other hand, limited partnership is a partnership in which the liability of some partners is limited to the amount of capital investment. The remaining partners are general partners (partners who have unlimited liability). However, a limited partnership must have at least one general partner who has unlimited liability.

d. Mutual Agency

Mutual agency means that each partner acts on behalf of the partnership when engaging in partnership business. The act of any partner is binding on all other partners, even when partners act beyond the scope of their authority, as long as the act appears to be appropriate for the partnership. Because of mutual agency, an individual should be extremely cautious in selecting partners.

e. Nontaxable Entity

The income of a partnership is not taxed as a separate entity. However, a partnership is required to file an information tax return showing partnership net income and each partner’s share of net income. Each partners’ share is taxable at personal tax rates, regardless of the amount of net income withdrawn from the business during the year.

f. Co-ownership of Property

Partnership assets are co-owned by the partners. Once assets have been invested in the partnership, they are owned jointly by all the partners. Moreover, if the partnership is terminated, the assets do not legally revert to the original contributor. Each partner has a claim on total assets equal to the balance in his/her respective capital account. This claim does not attach to specific assets that an individual partner may have contributed to the firm.

 

5.3 Advantages and Disadvantages of a Partnership

The advantages of a partnership include:

  • A partnership is relatively easy and inexpensive to establish. It is relatively free from government regulations and restrictions. (case of formation).
  • A partnership enables to bring more capital, more skills, and more experience as compared to sole proprietorship.
  • The combined income taxes paid by the individual partners may be lower than the income taxes that would be paid by a corporation.
  • Decisions can be made quickly on substantial matters affecting the firm, whereas in a corporation, formal meetings with the board of directors are often needed. (i.e. ease of decision making)

Even though partnership has many advantages, it is not without limitations. Thus, the main disadvantages (limitations) of a partnership include:

  • Partnership has limited life.
  • Partnership has unlimited liabilities.
  • One partner can bind a partnership to contracts (i.e. mutual agency).
  • Raising large amount of capital is more difficult for a partnership than for a corporation.

Deciding Between  Limited Liability Partnership (LLP) and corporation

  1. Income status of the enterprise and of its owners. An LLP pays no income tax but is required to file an annual information return showing its revenue and expenses, the amount of its net income and division of the net income among the partners. A corporation is a separate legal entity subject to a corporate income the amount of net income distributed to shareholders in the form of dividend is taxable income to shareholder.

  2. Opportunity for obtaining large amount of capital.  Corporations have better opportunity than partnership in terms of raising larger amount of capital.

 

5.4 The partnership Agreement

A partnership is created by a contract expressing the voluntary agreement of two or more individuals. Partnership may be formed in written, oral, or implied. If the partnership is formed in writing, the contract is called partnership agreement, or articles of co-partnership. The articles of co-partnership include such basic information as:

  • The principal and location of the firm.
  • The purpose of the business.
  • Date of establishment.
  • Names and capital contributions of partners.
  • Rights and duties of partners.
  • Basis for sharing net income or net loss.
  • Provision for the withdrawal of assets.
  • Procedures for submitting disputes to arbitration.
  • Procedures for the withdrawal or addition of a partner.
  • Rights and duties of surviving partners in the event of a partner’s death.

 

5.5 Partnership Formation

Most of the day-to-day accounting for a partnership is the same as the accounting for any other form of business organization. For example, the chart of accounts, with the exception of drawing and capital accounts for each partner, does not differ from the chart of accounts of a similar business conducted by a single owner. Transactions that are peculiar (unique) to partnership organizations are:

  1. Formation of a partnership
  2. Income distribution
  3. Dissolution
  4. Liquidation

This topic deals with how to record the initial investments of each partner in the accounting records of the partnership. The investment of each partner is separately recorded in a partnership. Those assets, which are contributed by the partner, are debited to the proper asset accounts. These assets should be recorded at their fair market value at the date of their transfer to the partnership. All partners must agree to the values assigned to assets. Similarly, if liabilities are assumed by the partnership, the appropriate liability accounts are credited. Then, the difference between the assets and liabilities (net amount) should be credited to partner’s capital account.

To illustrate, assume that Lemma and Kassa established a partnership, called LK partnership on October 10,2003. Lemma contributed cash of Br. 50,000, and Kassa contributed equipment, which was purchased 4 years ago for Br. 70,000. The partners agreed that the market value of this equipment is Br. 40,000. The entry to record the investment of each partner is shown below:

To record Lemma’s investment:

    Cash………………… 50,000

           Lemma, capital.………..  50,000

To record Kassa’s investment

     Equipment………..  40,000

            Kassa, capital…...…. 40,000

Note that the original cost of the equipment (Br. 70,000) is no more relevant for the partnership because the equipment should be recorded at its current market value.

After each partner’s investment is recorded properly, the capital of the partnership can be determined. For the example under question, total capital of the partnership is computed as follows:

      Lemma, capital……….   50,000

      Kassa, capital…………  40,000

           Total capital…….….   90,000

A balance sheet can also be prepared for the partnership after recording the partner’s investments. Notes the following balance sheet for the partnership being described:

 

At this time, LK partnership has no liability. No partner’s liability was transferred to the partnership.

After the partnership has been formed, the accounting for its transactions is similar to accounting for transactions of any other type of business organization. The steps described in the accounting cycle are equally applicable to a partnership. i.e.

  • Journalize transactions
  • Posting to accounts in the ledger
  • Trail balance Preparation
  • Worksheet Preparation
  •  Preparation of financial statements
  • Journalizing and posting adjusting entries
  • Journalizing and posting closing entries
  • Post-closing trial balance preparation.
Ledger Accounts for Partners

In accounting for partnership, there are three types of accounts for partners. There are

  1. Capital Accounts
  2. Drawing or Personal Accounts
  3. Accounts for loans to and from partners

To explain Accounts for loans to and from partners, a partner may receive cash from the partnership with the intention of repaying it. Such transaction is recorded in partnership accounts as follows:

Loans Receivable from partners          ***

                      Cash                                  ***

On the other hand, a partner may make a cash payment to the partnership that is considered a loan rather than an increase in the partner’s capital account balance. Such transaction is recorded as follows:

Cash                                       ***

       Loans payable to partners              ***

Loans Receivable from Partners is an asset while Loans Payable to Partners is a liability.

 

5.6 Division of Net Income or Net Loss

The partnership agreement should specify the basis for sharing net income or net loss. If the partnership agreement failed to specify the basis of sharing net income or net loss, partnership net income or net loss is shared equally. In other words, if the partnership agreement is silent as to the manner in which net income or net loss is shared, the amount of net income or net loss is shared equally. The same basis of division is usually applied to both net income and net loss.

The following are typical schemes (plans) that may be used to share net income or net loss.

1. A Fixed Ratio, Expressed as a Proportion (6:4, a percentage 60% and 40%) or a fraction (2/3 and 1/3).

Example

Suppose that TR partnership has net income of Br. 30,000 for 2002. The partners Tesfa, and Rahel, agreed to share net income using a proportion of 6:4.

Required

a. Compute the share of net income for each partner.

b. Prepare the entry to record the share of net income.

Solution

a. Share of Net Income

            Tesfa = 30,00 X 6/10 = Br. 18,000

            Rahel = 30,000 X 4/10 = Br. 12,000

b. After the net income is shared between the partners, the share of each partner should be recorded in the capital account of each partner. This is done to increase the balance of the partner’s capital account. This entry is in essence, a closing entry and it is made as follows:

    Income summary…………….30,000

           Tesfa, capital……………………18,000

           Rahel, capital……………………12,000

The capital account of each partner is credited for the share of net income. If the amount is net loss, the partner’s capital account is debited for the share. Income summary account is debited because share of partnership net income is closed after revenues and expenses are closed.

That is, the following closing entries are made before net income or net loss is closed. These are:-

  1. Debit each revenue account for its balance and credit income summary for total revenues.

       ii. Debit income summary for total expenses and credit each expense account for its balance.

After entry No.( I) and entry No.( ii) are posted, income summary account may have debit or credit balance.

It will have credit balance if total revenues are greater than total expenses. Income summary account will have debit balance if total expenses are greater than total revenues. A debit balance in income summary account represents net loss.

Therefore, closing the share of net income/net loss by the partners is done after revenues and expenses are closed to income summary account.

2. A Ratio Based on Capital Balances at the Beginning of the Period.

Partners may agree to share income or loss on the ratio of their beginning capital balance.

To illustrate, suppose that R and S have beginning capital balances of Br. 45,000 and Br. 55,000 respectively. The net income of the partnership is Br. 20,000 for year 2002. Partners agreed to share income on the basis of capital balances at the beginning of 2002.

Based on the above data, the share of net income for each partner can be computed.

 a.  Partners share income as follows:

           R = (45,000 X 20,000)/100,000 = Br. 9,000
           S =  (55,000 X 20,000)/100,000 = Br. 11,000

The denominator 45,000/100,000 is obtained by adding beginning capital balances of all partners. In the example above, the denominator (Br. 100,000) is the sum of R capital and S capital. The numerator represents the beginning capital balance of the partner for whom we are computing the share of net income.

The entry to record the share of net income is shown below:

Income summary……….20,000

        S. Capital……..……...9,000

        R. Capital……….....…11,000

3. Salaries to Partners and the Remainder on Some Basis

As a means of recognizing differences in ability and amount of time devoted to the business, articles of partnership often provide for the division of a portion of net income to the partners in the form of salary allowance. The articles may also provide for withdrawals of cash by the partners in lieu (instead of) salary payments. Therefore, a clear distinction must be made between the division of net income (which is credited to the capital account) and payments to the partners (which are debited to the drawing accounts)

Example

Assume that the articles of partnership of Hanna and Sosina provide for monthly salary allowances of Br. 500 and Br. 600 respectively. The net income for the year is Br. 60,000. The remaining net income is divided equally.

Required

  1. Compute the share of net income for each partner.
  2. Prepare the entry to close  the share of net income.

 

4. Interest on Partner’s Capital and the Remainder on Some Basis.

This scheme is used by the partners when one partner contributed large portion of capital than the other. In order to recognize differences in capital investments, interest may be allowed on capital as a means of dividing net income or net loss.

To illustrate, assume that Haile and Getachew have beginning capital balances of Br. 40,000 and Br. 70,000 respectively. The partnership agreement states that the partners are allowed interest at 10% on beginning capital balances. The remaining net income is to be shared equally. Assume further that the company generated net income of Br. 18,000 in the year.

 

5. Salaries to Partners, Interest on Partners’ Capital, and the Remainder on Some Basis.

Partners may agree that the most equitable plan of income sharing is to allow salaries based on the services rendered and also to allow interest on the capital investments. The remainder is then shared in an arbitrary ratio.

 

6. Equally

If each of the partner is to contribute equal services and amounts of capital, an equal sharing in partnership net income would be equitable. That is, partners may agree to share income or loss equally.

Example

Suppose that Sara and Tsige have capital balance of Br. 50,000 each in  the partnership of SATE partnership. Sara and Tsige have the same qualifications and contribute equal service to the company. The net income for the year is B r. 3,000. Compute the division of  net income if they agreed to share income equally.

Solution

Division of net income:

Sara = 3000/2= 1,500

Tsige = 3000/2 = 1,500

6. Income Sharing based on bonus to managing partner

A specified percentage of income may be provided to the managing partner in the form of bonus. The partnership contract should state clearly whether the percentage is applied to net income before deducting bonus, or net income after bonus.

 

Withdrawals in A Partnership

Withdrawal refers to the taking out of cash or other assets by the partner from the partnership. In a partnership, withdrawal may be made in lieu (instead) of salary allowances, and/or for personal purposes. Regardless of the purpose for which the asset is withdrawn, the partner’s drawing account is debited and the asset withdrawn is credited.

Example

Assume that DB partnership is owned and operated by Demeke and Bekele. During the month, Bekele withdrew cash of Br. 3,000 from the partnership. Prepare the entry to record the withdrawal.

Solution

The withdrawal is debited to Bekele’s drawing account, and credited to cash, i.e.

 Bekele, Drawing……..3,000

             Cash………....…3,000

Bekele, drawing account is a temporary capital account. As a result, it is closed to Bekele, capital at the end of the period. The closing entry is presented below:

Bekele, Capital…………3,000

     Bekele, Drawing………….3,000

Withdrawal decreases the balance of capital. Thus, Bekele’s capital is decreased by Br. 3,000 during the month.

 

5.7 Financial Statements for a Partnership

The financial statements of a partnership are similar to those of a sole proprietorship. There are three financial statements for a partnership. These are income statement, capital statement (or statement of owner’s equity) and balance sheet.

The income statement of partnership similar with that of sole proprietorship except that the income statement of the partnership discloses the details of the division of net income. The following is the partial income statement of H and G partnership in which Haile and Getachew have capital balances of Br. 40,000 and Br. 70,000 respectively. The net income of the partnership for the year ended December 31, 2002 was Br. 18,000. The partnership agreement provided interest allowance of 10% on beginning capital balances and the remaining income to be shared equally.

Therefore, the bottom part of income statement for a partnership includes the manner in which income or loss was divided.

The capital statement of the partnership is different from sole proprietorship in the sense that there are more than two owners in a partnership. Capital statement shows or explains the changes in each partner’s capital account and in total partnership capital during the year. Changes in capital results from three causes; namely, additional investments, drawing, and net income/net loss.

To exemplify, assume the data given for H and G partnership and consider the following additional information:

 

Haile

Getachew

Additional Investment

Br. 15,000

Br. 16,000

Drawings

8,000

7,500

The capital statement of H and G partnership is shown below:

                                               

The sources of information for the preparation of capital statement are income statement, partner’s capital account, and drawing accounts.

The balance sheet for a partnership is the same as that of a sole proprietorship except in the owner’s equity section. In a partnership, the capital balances of each partner are shown in the balance sheet. The owner’s equity section for H and G partnership is shown in the following partial balance sheet.

 

 

5.8 Partnership Dissolution

Partnership type of organization is characterized by limited life. Any change in the members (ownership) results in the dissolution of the partnership. Factors that result in partnership dissolution are admission of new partner, withdrawal of the existing partner, death, or bankruptcy. The winding up of the affairs of the business does not necessarily follow dissolution of a partnership. When a partnership is dissolved, a new partnership may be formed and the new article of partnership should be prepared.

 The following section describes accounting for the dissolution of a partnership.

5.8.1 Admission of a New Partner

An additional person may be admitted to a partnership enterprise only with the consent of all the current partners. The admission of a new partner results in the legal dissolution of the existing partnership, and the beginning of a new partnership. However, from an economic standpoint, the admission of a new partner (or partners) may be of minor significance in the continuity of the business.

A new partner may be admitted to a partnership in one of the following two ways. These are:-

  1. Purchasing the interest of one or more existing partners.
  2. Investing assets in the partnership.

5.8.1.1 Admission of a Partner by Purchasing the Existing Partner’s Interest

The capital interest of the incoming partner is obtained from one or more of the current partners. The admission of a partner by purchase of an interest in the firm is a personal transaction between one or more of the existing partners and the new partner. Each party is acting as an individual separate from the partnership entity. The price paid is negotiated and determined by the individuals involved. In a purchase of an interest, the partnership is not a participant in the transaction. No cash is distributed from the partnership. The amount of the purchase price passes directly from the new partners to partners who are giving up part or all of their ownership claims. Upon purchase of an interest, the new partner acquired each selling partner’s capital interest, and income-sharing ratio is decided then.

Note that the selling partner does not have to obtain the approval of the other partners to sell his or her interest. However, some partnership acts may state that the purchaser does not become a partner until he/she is accepted into the firm by the continuing partners.

Accounting for the purchase of an interest is straightforward. The only entry needed in the records of the partnership is the transfer of the proper amounts of owner’s equity from the capital account of the selling partner to the capital account of the incoming (new) partner. That is, the capital account is debited for the ownership sold, and the capital account of the incoming partner is credited for the ownership obtained.

Note that the amount of cash paid to the selling partner may be greater, less than or equal to the ownership obtained. Regardless of the amount of payment, the capital accounts of the partners are recorded at the ownership received.

When a new partner is admitted to a partnership by purchasing ownership interest, the total assets and total capital of the partnership are not changed.

Example

Assume that Kassa and Tollera agreed to sell one third of their interest to Assefa. At the time of admission of Assefa, each partner has a Br. 48,000 capital balance. Assume that Assefa paid Br. 18,000 each to the selling partners for 1/3 interest acquired.

Required

  1. Prepare the entry to record the admission of Assefa.
  2. Compute the total capital of the partnership after admission.

Solution

a.Kassa, Captial (48,000 – 16,000) ………….16,000

  Tollera, Capital (48,000 X1/3)…………………16,000

             Assefa, capital (48,000 X 1/3 X 2)……………32,000

b. Total Capital

Assefa, Capital………………………….32,000

Kassa, Capital (48,000 – 16,000)…….32,000

Tolera, cpatial (48,000 – 16,000)………32,000

Total capital………………………………96,000

Note that the total capital of the partnership before the admission (48,000 + 48,000 = Br. 96,000) is the same as after the admission of Assefa (Br. 96,000). Assefa’s ownership interest is one-third of the selling partner capital balance (Br. 16,000) regardless of the amount of cash he paid. In the foregoing example, Assefa paid Br. 18,000 to get ownership interest of Br. 16,000. The entry is the same whether the amount Assefa paid to the selling partner is equal to, greater than, or less than Br. 16,000. This implies that the amount paid by the buyer has no effect on the entry when the new partner is admitted to a partnership by purchasing the ownership interest from one or more of the existing partners.

5.8.1.2 Admission by Investment of Assets in a Partnership

Instead of buying an interest from the current partners, the incoming partner may contribute (or invest) assets to the partnership. The admission of a new partner by an investment of assets is a transaction between the new partner and the partnership. In this case, the transaction increases both the assets and capital of the partnership. The investment by the new partner may be cash, equipment, furniture, automobile, or other asset. The market value of the asset contributed to the partnership is debited to the appropriate asset account and credited to capital account of the new partner.

Example

Assume that Demere and Adugna are partners with capital balances of Br. 40,000 and Br. 55,000 respectively. On December 1, 2003, they agreed to admit Bulcha for cash investment of Br. 30,000, for which he is to receive ownership equity of Br. 30,000.

Required

  1. Compute total capital of the partnership before Bulcha’s admission.
  2. Prepare the entry to record Bulcha’s admission.
  3. Determine total capital of the partnership after admission.

Solution

1. Total capital before Bulcha’s admission:

         Demere, capital…………………Br. 40,000

         Adugna, capital…………………     55,000

                        Total capital…………Br. 95,000

2. Entry to record Bulcha’s admission is:

     Cash…………………….30,000

            Bulcha, capital…………. 30,000

3. Total partnership capital after Bulcha’s admission:

       Demere, capital……………Br. 40,000

       Adugna, capital………………..55,000

       Bulcha, capital…………………30,000

               Total capital…………Br. 125,000

Note that Bulcha’s cash investment of Br. 30,000 increases the total capital of the partnership by Br. 30,000 (i.e. 125,000 – 95,000 = 30,000). Total assets of the partnership are also increased by Br. 30,000. Due to this transaction, the capital balances of the existing partners are not affected.

At the time of admitting new partner by investing assets, the partnership assets should be stated in terms of their current market values. If the partnership assets are not fairly stated at their current market value, the capital accounts of the old partners should be adjusted accordingly. The net increases or decreases in assets of old partnership due to revaluation should be allocated to old partners capital accounts according to their income-sharing ratio. It is only then that the investment of new partner should be recorded.

In the case of admission by the investment, further complications occur when the new partner’s investment differs from the capital equity acquired. When those amounts are not the same, the difference is considered the bonus either to (1) the existing (old) partners or (2) the new partner.

Bonus to Old Partners

The existing partners may be unwilling to admit a new partner without receiving a bonus for both personal and business reasons. In an established firm, existing partners may insist on a bonus as compensation for the personal scarifies they have made for the company over the years. Two accounting related factors underline the business reason. These are:

  1. Total capital of the partnership equals the book value of the recorded assets of the partnership. At the time the new partner is admitted, the fair market values of assets such as land and building may be higher than their book values.
  2. When the partnership has been profitable, goodwill exist.

In such cases, the new partner is usually willing to pay the bonus to become a partner. A bonus to old partners results when the new partner’s capital credit (acquired ownership interest) on the date of admittance is less than her/his investment in the firm. The bonus results in an increase in the capital balances of the old partners. The bonus is allocated to them on the basis of income sharing ratio before the admission of the new partner.

The procedures for determining the ownership of the new partner and the bonus to the old partners are described below:

Step 1: Determine the total capital of the new partnership by adding the new partner’s investment to the total capital of the old partnership.

Step 2: Determine the new partner’s ownership interest by multiplying the total capital of the new partnership by the new partner’s ownership interest percentage.

Step 3: Determine the amount of bonus

            New partner’s investment………………………xxx

            Less: new partner’s ownership interest………...xxx

            Amount of Bonus…………………………………xxx

Step 4: Allocate the bonus to the old partners on the basis of their income-sharing ratio.

Bonus to new partner

If a partnership admits a new partner who is expected to improve the fortunes of the firm, old partners may agree to give a bonus to new partner. In other words, the new partner possesses resources or special attributes that are desired by the partnership. A bonus to a new partner results when the new partner’s ownership equity is greater than his/her investment of assets in the firm. For example, when bank interest rates are high, the new partner may be able to supply cash that is urgently needed for expansion or to meet maturing debt. Alternatively, the new partner may be a recognized expert or authority in a relevant field. For example, an engineering firm may be willing to give known engineers a bonus to join the firm.

Similarly, the partner of a sporting goods store may offer a bonus to a spots celebrity in order to add the athlet’s name to the partnership name.

5.8.2 Withdrawal of a partner

A partner may withdraw from a partnership voluntarily by selling his/her equity in the firm, or involuntarily by reaching mandatory retirement age or dying. Like the admission of a partner, the withdrawal of a partner legally dissolves the partnership. The legal effects may be recognized in accounting for a withdrawal by dissolving the firm. However, it is customary to record only the economic effects.  The partnership agreement should specify the terms of the withdrawal.

The withdrawal of a partner may be accomplished in two ways. These are:-

  1. Selling to one or more of the remaining partners.
  2. Payment from partnership assets.

Each of these ways of withdrawal will be explained in the following section.

5.8.2.1 Withdrawing by selling to one or more of the remaining partners

In this type of withdrawal, the withdrawing partner sells his/her ownership equity to one or more of the existing partners. Payment is made to the withdrawing partner from the personal assets of the buying partners, and not from partnership assets. The withdrawal of a partner when payment is made from partner’s personal assets is the direct opposite of admitting a new partner who purchases a partner’s interest. This transaction is a personal transaction between the partners. Partnership assets are not involved in the withdrawal of the partner. As a result, the total assets and total capital of the partnership are not changed. A change occurs only in individual partner’s capital account. The required accounting entry debits the equity of the withdrawing partners, and the capital account(s) of the buying partner(s). The amount received by the withdrawing partner does not affect the entry. Whether the amount of cash received by the withdrawing partner is equal to, less than, or greater than his/her ownership equity, the entry is the same. The entry required to record the withdrawal is made after all assets are revalued to reflect their current market value. 

Example

Assume that Tsige, Kebede, and Tulu have capital balances of Br. 50,000, Br. 60,000, and Br. 45,000 respectively. Assume further that Kebede decides to withdraw from the partnership, and Tsige and Tulu agree to buy Kebede’s ownership equity. Each of them agreed to pay Kebede Br. 35,000 in exchange for one-half of Kebede’s ownership interest of Br. 60,000.

Required

  1. Compute the total capital before Kebede’s withdrawal
  2. Prepare the entry to record Kebede’s withdrawal
  3. Determine the capital balance of each partner and total capital after Kebede’s withdrawal. 

Solution

a. Total capital before withdrawal:

Tsige, capital……………Br. 50,000

Kebede, capital…………....60,000

Tulu, capital…………………45,000

      Total capital………………………Br. 155,000

b. The entry to record the withdrawal:

Kebede, capital………….60,000

        Tsige, capital………..…30,000

       Tulu, capital………...….30,000

c. Capital balance of each partner and total capital after withdrawal:

Tsige, capital (50,000 + 30,000) ………Br. 80,000

Tulu, capital (45,000 + 30,000)…………....75,000

Total capital…………………………….Br. 155,000

Note that the total capital of the partnership remains the same at Br. 155,000. Note also that the Br. 70,000 paid to Kebede is not recorded. Similarly, Tsige capital is credited only for Br. 30,000, not the Br. 35,000 she paid. Tsige and Tulu will sign new articles of partnership.

5.8.2.2 Payment from Partnership assets to the Withdrawing partner

Using partnership assets to pay for a withdrawing partner’s equity is the reverse of admitting a new partner through investment of assets in the partnership. Payment from partnership assets is a transaction that involves the partnership. Thus, both total assets and total capital of the partnership are decreased. The withdrawing partner will be settled with the amount equal to his/her capital balance. This capital balance is determined by revaluing the current market value of the assets. This is the case when the fair market values of the assets at the time of the partner’s withdrawal are different from the recorded value of these assets.  Any difference between the current market value and book value of the assets should be divided between (among) the partners’ capital accounts and adjusting entry is made accordingly.

Example

Assume that Tigist, Tesfa, and Meseret have capital balances of Br. 20,000 Br. 18,000, and Br. 26,000 respectively at the time Tigist decided to withdraw. At the same time, merchandise inventory with a book value of Br. 5,000 has market value of Br. 7,000. The partnership has paid Tigist’s interests after adjusting for the difference in merchandise inventory value. The partners share income on 5:3:2 basis.

Required

  1. Prepare adjusting entry to revalue merchandise inventory.
  2. Compute each partner’s capital balance.
  3. Prepare the entry to record the withdrawal of Tigist.

Solution

1. Merchandise inventory……………2,000

       Tigist, capital (2000 X 5/10)…………....1,000

       Tesfa, capital (2000 X 3/10)……………..600

       Meseret, capital (2000 X 2/10)………....400

2. Partners’ capital balances:

       Tigist, capital (20,000 + 1,000)…………21,000

      Tesfa, capital (18,000 +    600)…………18,600

       Meseret, capital (18,000 +  400)………18,400

              Total capital………………………...58000

3. The entry to record Tigist’s withdrawal:

       Tigist, capital………21,000

              Cash………………21,000

After Tigist’s withdrawal, total capital of the partnership is equal to Br. 45,000 (i.e. 18,600 + 26,400 = 45,000)

 

5.8.3 Death of a Partner

The death of a partner dissolves a partnership. When a partner dies it is necessary to determine the partner’s at the date of death. This is done by:

  1. Determining the net income or net loss for the fractional part of a year.
  2. Closing the accounts.
  3. Preparing financial statements.

Then the balance in the capital account of the deceased partner is transferred to a liability account with the deceased’s estate. The surviving partners may continue the business or the affairs may be wound up. The ownership equity is paid to the deceased person’s heir (s).

Example

Assume that XYZ partnership has three partners; namely X,Y & Z. Their capital balances on January 1, 2003, the beginning of the fiscal period, are X Br. 12,000, Y Br. 15,000 and 2 Br. 19,000. Partner Y has died on August 30, 2003. Net income for the period between January 1 and August 30,2003 is Br. 8,000. The partners agreed to share income on 4:4:2. Y’s legal heir is W.

Required

  1. Compute the share of net income on August 30.
  2. Prepare the entry to record the division of net income.
  3. Determine each partner’s capital balance.
  4. If W decides to take the ownership equity of Y from the partnership, prepare the entry to record the payment to W.
  5. If W decides to join the partnership in place of Y, prepare the entry to record the admission of W.

Solution

1. Division of Net Income:

X = 8,000 X 4/10 = 3,200

Y = 8,000 X 4/10 = 3,200

Z = 8,000 X 2/10 = 1,600

2. Entry to record the division of net income:

Income summary………8,000

       X, capital…………………3,200

       Y, capital………………...3,200

        Z, capital………………..1,600

3. Partner’s capital balances:

         X, capital = 12,000 + 3,200 = 15,200

         Y, capital = 15,000 + 3,200 = 18,200

         Z, capital = 19,000 + 1,600 = 20,600

4.  Y, capital …………18,200

             Cash………..……18,200

5. Y, capital……………18,200

           W, Capital……………18,200

 

5.9 summary

A partnership form of organization is owned and operated by two or more persons for the purpose of profit. It is characterized by limited life, unlimited liabilities, mutual agency, non taxability and so on.

Partnership agreement may be in writing, orally, or impliedly. It is generally believed that partnership agreement should be in writing to avoid minimize potential conflict between the partners.

There are four unique (peculiar) transactions for partnership, namely, partnership formation, division of net income, or net loss, partnership dissolution, and partnership liquidation, the first three are dealt with in this chapter, and partnership liquidation will be addressed in unit six.

The possible means of sharing net income or net loss of the partnership are equally, based on some fixed rations, based the services of the partners, based the partners’ capital investments of the partnership liquidation may result due to admission of new partner, withdrawal of partner, death of partner etc.

A new partner may be admitted to a partnership either by purchasing ownership interest from one or more of the existing partners, or by investing assets into the partnership. On the other hand, withdrawal of a partner may take either by selling the ownership interest to one or more of the remaining partners, or by obtaining payment from the partnership.

 

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