2. Accounting for Partnerships
Chapter 19
Accounting for Partnerships
Section 1: Forming a
Partnership
Section Objectives
Chapter 18 concluded the discussion of the basic rules of accounting for plant assets and long term assets and the depreciation and amortization of assets. Chapter 19 focuses on accounting for the partnership form of business organization. This section explains the major advantages and disadvantages of a partnership form of organization and explains the important provisions which should be included in a partnership agreement. The journal entry required to form a partnership is also explained.
Explain the major advantages and disadvantages of a partnership.
State the important provisions that should be included in every partnership agreement.
Account for the formation of a partnership.
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© 2009 The McGraw-Hill Companies, Inc. All rights reserved.

3. Advantages of a Partnership
Objective 1
Explain the major advantages and disadvantages of a partnership
Advantages of a Partnership
It pools the skills, abilities, and financial resources of two or more individuals.
It is easy and inexpensive to form.
A partnership does not pay income tax.
A partnership is an association of two or more persons who carry on, as co-owners, a business for profit. In a business partnership, partners can create debts and they are liable for those debts. In a business partnership, each partner may have different duties to make the business function well. There are advantages and disadvantages of the partnership form of business.
The advantages of the partnership form of business:
Permits a pooling of skills, abilities, and financial resources.
Easy to form
No federal income tax is levied on the net income of a partnership.
Each partner is taxed individually on his or her share of the partnership’s income.

4. Disadvantages of a Partnership
Each partner has unlimited liability.
The partnership is a mutual agency.
The business lacks continuity. It has a limited life.
Ownership rights are not freely transferable.
The disadvantages of the partnership form of business:
Unlimited liability for debts.
Mutual agency: each partner may act as an agent
Limited life: if one partner dies or is incapacitated, the existing partnership is dissolved.
Partnership interest is not freely transferable.

5. What is a partnership agreement?
Explain the important provisions which should be included in a partnership agreement
Objective 2
QUESTION:
What is a partnership agreement?
A partnership agreement is a legal contract forming a partnership and specifying certain details of the operation.
ANSWER:
There are several important provisions which should be included in the partnership agreement when a partnership is formed.
Like a prenuptial agreement, a partnership agreement is a legal contract forming a partnership and specifying certain details of the operation.
A partnership agreement is legally known as the articles of partnership.

6. Every partnership agreement should contain:
Names of the partners.
Name, location, and nature of the business.
Starting date of the agreement.
Life of the partnership.
Rights and duties of each partner.
Review this list of items which should be included in the partnership agreement.

7. Every partnership agreement should contain:
Amount of capital to be contributed by each partner
Drawings (withdrawals) by the partners.
Fiscal year and accounting method.
Method of allocating income or loss to the partners.
Procedures to be followed if the partnership is dissolved or the business is liquidated.
Additional items which should be included are shown. Remember that like a sole proprietorship a partnership will dissolve upon a partner’s death, incapacity, or withdrawal.

8. Account for the formation of a partnership.
Objective 3
Account for the formation of a partnership.
Memorandum entry to record formation of partnership.
Investment of assets and liabilities by partners.
Setting up partners’ capital accounts.
Setting up partners’ drawing accounts.
Subsequent investments and permanent withdrawals.
Partnerships and sole proprietorships use the same types of journals and ledgers as well as asset, liability, revenue, and expense accounts.
Instead of having just one capital account as in a sole proprietorship, a partnership will have a capital account and a withdrawal account for each partner.
The first entry in the general journal of a new partnership is a memorandum entry (informational entry).
The elements included in the memorandum entry to record the formation of a partnership:
Name of the business
Names of the partners
Other pertinent information provided by the partnership agreement.
The next journal entry records the partners contribution of assets and liabilities into the partnership in exchange for a share in the partnership. The initial values of the assets contributed by the partners should reflect fair market value at the time of contribution. (This may require professional appraisal.)

9. Memorandum Entry to Record Formation of Partnership
20--
Jan On this date a partnership was
formed between Ellen Barret and Jerry Reed to carry on a
retail clothing business under the name of Old Army,
according to the terms of the
partnership agreement
effective this date.
Let’s look at the example of Ellen Barret, a sole proprietor of Old Army. She is forming a partnership with Jerry Reed.
This is the first entry in the journal of the new partnership. It is the memorandum entry recording the formation of the partnership.

10. Investments of Assets and Liabilities by a Sole Proprietor
20--
Jan. 1 Accounts Receivable ,500.00
Merchandise Inventory ,200.00
Store Equipment ,000.00
Allow. for Doubtful Accts ,200.00
Notes Payable—Bank ,100.00
Accounts Payable , Interest Payable
Ellen Barret, Capital ,200.00
Investment of Ellen Barret
In the next journal entry, Ellen Barret transfers her assets from her sole proprietorship into the partnership in exchange for a $53,200 partnership interest.
Assets that are transferred to a partnership should be appraised and recorded at the agreed-upon fair market value at the time of transfer.

11. Investment of Cash by Partner
New Partner Given Credit for Amount Invested
Jan. 1
Cash ,000.00
Jerry Reed, Capital ,000.00
Investment of cash by Reed
Jerry Reed, her new partner, invests cash into the partnership in exchange for a $28,000 partnership interest. In this partnership, two capital accounts exist—one for each partner.

12. Drawing Accounts
Any withdrawal by a partner, whether it is cash or some other asset, is a return of equity to that partner.
The partner’s drawing account balance reduces that partner’s equity.
The partnership will create a separate drawing account for each partner. Just like in a sole proprietorship, any withdrawal by a partner, whether it is cash or some other asset, is a return of equity to that partner and will reduce that partner’s equity in the business.

13. Accounting for Partnerships
Chapter 19
Accounting for Partnerships
Section 2: Allocating
Income or Loss
Section Objectives
Partnerships do not pay income tax. Instead income is allocated amongst the partners and the partners report the income on their personal income tax returns. This section describes how to allocate income.
Compute and record the division of net income or net loss between partners in accordance with the partnership agreement.
5. Prepare a statement of partners’ equities.
McGraw-Hill/Irwin
© 2009 The McGraw-Hill Companies, Inc. All rights reserved.

14. Allocating Partnership Income or Loss
Compute and record the division of net income or net loss between partners in accordance with the partnership agreement
Objective 4
Allocating Partnership Income or Loss
Step 1. Close revenue to Income Summary.
Step 2. Close expenses to Income Summary.
Step 3. Close Income Summary to the partners’ capital accounts.
Step 4. Close each partner’s drawing account to the partner’s capital account.
Partners can agree to any kind of distribution of income they desire. In the absence of an agreement to the contrary, partners share profits and losses equally.
The primary difference in accounting for a partnership is in the closing process. Each partner has an equity account to which the balance in Income Summary must be closed. In step 3 of the closing process, the business determines the distributive share of net income or net loss which each partner will receive.
In step 3 the business determines the distributive share for each partner.

15. Allocation of Partnership Income or Loss
Based on the partnership agreement.
Allocated equally to each partner if the partnership agreement is “silent.”
Income distribution does not mean cash distribution.
The Distributive share is the amount of net income or net loss allocated to each partner.
The allocation of partnership income or loss may be based on the partnership agreement or it may be allocated equally to each partner if the partnership agreement does not specify how the allocation should take place. Partnership income and loss can be allocated based on:
an agreed upon ratio specified in the partnership agreement, or
the capital account balances of the partners

16. Agreed Upon Ratio
Example: Barret and Reed agreed that net income should be split in a 3:2 ratio to Barret and Reed, respectively.
Step 1: Add the figures given in the ratio.
Barret
+ Reed
= Total
Step 2: Express each figure as a fraction of the total.
Barret’s share /5
Reed’s share /5
Step 3: Convert each fraction into a percentage.
Barret’s share /5 = 60%
Reed’s share /5 = 40%
The partnership agreement may establish a ratio by which the net income or net loss is divided.
The ratio must be converted to a decimal or a fraction to compute the allocation. For example--the conversion of the 3/2 ratio (Barret/Reed) into a decimal (60/40) or a fraction (3/5 and 2/5).

17. Agreed Upon Ratio Net Income X partner’s share percentage:
Barret’s share ($100,000 x 60% = $60,000)
Reed’s share ($100,000 x 40% = $40,000)
20--
Dec Income Summary ,000.00
Ellen Barret, Capital ,000.00
Jerry Reed, Capital ,000.00
Here is the journal entry distributing the partnership’s income from the Income Summary account into the partner’s capital accounts based on a 60/40 ratio.

18. Capital Account Balances
Step 1: Add the capital account balances.
Barret $53,200
Reed ,000
Total = $81,200
Step 2: Express each balance as a fraction and convert it to a percentage.
Barret $53,200/$81,200 = %
Reed $28,000/$81,200 = %
In this example, the allocation of net income was based on the capital account balances of the partners. We convert the partner’s share to a decimal. Barret would be entitled to % of net income and Reed will get %. Using this method of allocation, the ratio will vary from one period to the next, depending upon capital account balances.

19. Capital Account Balances
Net Income X partner’s share percentage:
Net Income $100,000
Barret $100,000 x % = $65,517
Reed $100,000 x % = $34,483
Barret will get % of the partnership’s $100,000 of net income or $65,517. Reed will get % of $100,000 or $34,883.

20. Salary and Interest Allowances
Allowances for partners’ salaries and interest on their investments can be included in the allocation of net income or loss.
Allowances are debited to the Income Summary account and credited to the partners’ capital accounts.
The remaining net income or loss is then allocated in the proper ratio.
If salary allowances are part of the division of net income then an additional journal entry is required in the closing process to distribute a salary allowance to a partner. (Dr. Income Summary, Cr. partner’s Capital account).
The remaining Income Summary balance is allocated to the partners’ Capital accounts based on the partnership agreement.

21. Salary Allowances
Salary allowances are intended to reward the partners for the time they spend in the business and for the expertise and talents they bring to it.
Salary allowances are withdrawals.
Partners are not employees of the partnership so salary allowances are not treated like the wages of an employee but rather like withdrawals. Salary allowances are intended to reward the partners for the time they spend in the business and for the expertise and talents they bring to it. Salary allowances are part of the division of net income.
Salary allowances do not represent salary expense.

22. Salary Allowances Net Income is $112,800.
Salary allowances for Barret $30,000 and Reed is $22,800.
20--
Dec Income Summary ,800.00
Ellen Barret, Capital ,000.00
Jerry Reed, Capital ,800.00
This is the additional journal entry which is required in the closing process to distribute a $30,000 salary allowance to Ellen Barret and a $22,800 salary allowance to her partner Jerry Reed. The remaining net income ($112,800- $52,800 = $50,000) will be distributed to the partners’ capital account balances based on the 60/40 ratio.

23. Salary Allowances Net Income $112,800 Less: Salary Allowances – 52,800
Balance in Income Summary = $ 60,000
Using the agreed upon ratio, the amount of net income after salary allowances is allocated 60% to Barret and 40% to Reed.
20--
Dec Income Summary ,000.00
Ellen Barret, Capital ,000.00
Jerry Reed, Capital ,000.00
60% of the remaining Income Summary balance of $50,000 ($36,000) is allocated to Ellen Barret’s capital account and 40% ($24,000)is allocated to Jerry Reed’s capital account balance.

24. Net Loss Their capital accounts are debited (decreased).
Assume net loss = $30,000
Record the salary allowances of $30,000 for Barret and $22,800 for Reed.
Record the interest allowances of $4,256 to Barret and $2,240 to Reed.
Income Summary
Net Loss 30,000
Dec. 31
Sal. All ,800
Sometimes a partnership agrees to pay each partner interest on their capital balances as a way to recognize their capital investments in the partnership. Partners may recognize their capital investments by allowing each partner a percentage of interest on their capital balance at the start of the period. Assume that Barret and Reed each have a 8 percent interest allowance.
If the Barret and Reed partnership has a net loss during the period, the allocation would take place as follows:
First any salary allowances are distributed, then
any interest allowance is distributed and then
finally the large debit balance in Income Summary is allocated to the partner’s capital account balances in the 60/40 ratio.
In this situation, to close Income Summary the account would be credited and each of the partners’ capital accounts would be debited (reduced).
Dec. 31
Int. All ,496
Bal $89,296
Distributed between Ross and Wright.
Their capital accounts are debited (decreased).

25. Partnership Financial Statements
Objective 5
Prepare a statement of partners’ equities
Partnership Financial Statements
Income Statement
Same as that for a sole proprietorship.
One exception—on the bottom of the statement, the division of net income is shown between the partners.
Balance Sheet
Same as that for a sole proprietorship.
One exception—there exists a separate capital account for each of the partners in Partner’s Equity section.
Time to prepare the financial statements of the partnership. The Statement of Partner’s Equities contains the details of the partners’ capital accounts.
For the most part, financial statements for a partnership are identical to those of a sole proprietorship with exception of the allocation of net income. The balance sheet usually lists only the partner’s capital balances at the end of the accounting period.

26. Statement of Partners’ Equities
OLD ARMY
Statement of Partners’ Equities
Year Ended December 31, 2010
Barret Reed Total
Capital Capital Capital
Capital Balances, Jan. 1,
Investment During Year , , ,200.00
Net Income (Loss) for Year , (2,908.00) 3,400.00
Totals , , ,600.00
Less Withdrawals During Year , , ,800.00
Capital Balances, Dec. 31, , , ,800.00
The Statement of Partners’ Equities is similar to the Statement of Owner’s Equity in a sole proprietorship. It contains:
Beginning capital
Additional investments
Share of net income or net loss
Withdrawals
Ending capital
Here is Old Army’s Statement of Partner’s Equities for the year ending December 31, Since this is the first year of the partnership, beginning capital balances are $0. The statement shows the investments of each partner, their share of the partnership’s income and the withdrawals (salaries) each partner made during the period.
Each partner’s salary is treated as a withdrawal on the statement.

27. Accounting for Partnerships
Chapter 19
Accounting for Partnerships
Section 3: Partnership
Changes
Section Objectives
In this last section of the chapter, we will discuss adding a new partner as well as what happens when a partner leaves.
Account for the revaluation of assets and liabilities prior to the dissolution of a partnership.
Account for the sale of a partnership interest.
Account for the investment of a new partner in an existing partnership.
Account for the withdrawal of a partner from a partnership.
McGraw-Hill
© 2009 The McGraw-Hill Companies, Inc. All rights reserved.

28. Account for the revaluation of assets and liabilities prior to the dissolution of a partnership
Objective 6
Dissolution
Step 1
Accounting records are closed.
Net income or net loss on the date of dissolution is recorded and transferred to the partners’ capital accounts.
Step 2
Assets and liabilities are revalued at fair market value.
When there is a change in partners (death, withdrawal, admission of new) the old partnership is dissolved and a new partnership is formed. A dissolution is the legal termination of a partnership. A liquidation is the termination of a business by distributing all assets and discontinuing the business. When a partnership is dissolved then all of the assets and liabilities are revalued.
There are certain steps to follow when a partnership is dissolved:
Step 1
Accounting records are closed.
Net income or net loss on the date of dissolution is recorded and transferred to the partners’ capital accounts.
Step 2
Assets and liabilities are revalued at fair market value.

29. Asset Revaluation
When transferred from one partnership to another, assets are revalued to their fair market value.
The new value will not necessarily agree with the book value carried by the old firm.
The revaluation of assets affects the balance sheet only.
Assets are written up or down based upon the revaluation of the assets. Then, any differences between the book value and the appraised value are allocated to the old partner’s Capital accounts. The allocation is made in accordance with the formula for sharing net income or loss. The “revaluation” takes place prior to the partner change.

30. An adjusting entry is prepared for the revalued items.
GENERAL JOURNAL PAGE
DATE DESCRIPTION POST DEBIT CREDIT
REF.
20--
April Merchandise Inventory ,000.00
Allow. for Doubtful Accounts ,300.00
Tom Lee, Capital ,680.00
Joan Wilner, Capital 2,680.00
Nau Flores, Capital ,340.00
To record revaluation of
assets and allocation of
gain to partners.
An adjusting entry is prepared for the revalued items. In this journal entry, Merchandise Inventory is increased by $9,000 and Allowance for Doubtful Accounts is increased by $2,300. The gain (from the re-evaluation) is allocated to each of the existing partners’ capital accounts.
An adjusting entry is prepared for the revalued items.

31. Admission of a New Partner
Objective 7
Account for the sale of a partnership interest
Admission of a New Partner
There are two ways a new partner may be admitted to the partnership:
By purchasing all or part of the interest of an existing partner and paying that partner directly.
By investing cash or other assets directly in the existing partnership.
When a new partner is admitted to a partnership, business law dictates that the original partnership “ends” and the new partnership “begins” with the new partner. (The business continues and does not in fact end. However, the business needs to record its net income for the period just prior to the admission of a new partner.) There are two ways a new partner may be admitted to the partnership:
By purchasing all or part of the interest of an existing partner and paying that partner directly.
By investing cash or other assets directly in the existing partnership.

32. Objective 8
Account for the investment of a new partner in an existing partnership.
A new partner may purchase an interest in a partnership by contributing assets (money or other property) to the partnership directly.
The new partner may receive credit for the amount invested or for a higher or lower amount.
Let’s see how we would account for a new partner joining the partnership.

33. New Partner Given Credit for Amount Invested
20--
April 1
Cash ,500.00
Beth Rivera, Capital ,500.00
To record investment of Rivera for one-fourth interest in partnership.
The first step in calculating the amount to credit to a new partner is to compute the total amount of capital after the new partner’s contribution. Total partnership capital after the investment of $51,500 of the new partner = $206, Beth Rivera, the new partner wanted to buy ¼ interest in the partnership. ¼ of $206,000 = $51,500. She is given credit for exactly the amount she invested.
New partner, Rivera, pays $51,500 for ¼ interest in partnership.

34. New Partner Given Credit for More Than Amount Invested
New partner paid $45,500 for one-fourth interest in partnership. (¼ of partnership capital = $50,000)
20--
April Tom Lee, Capital ,800.00
Joan Wilner, Capital ,800.00
Nau Flores, Capital
Beth Rivera, Capital ,500.00
To record bonus allowed
new partner
Let’s see what happens when the new partner gives less than the percentage of partnership she is receiving.
Again, the first step in calculating the amount to credit to a new partner is to compute the total amount of capital after the new partner’s contribution.
Total partnership capital after her investment of $45,500 is $200,000. ¼ of the partnership would be = $50,000 of the new existing total capital.
Since Beth Rivera only gave $45,000 to purchase the $50,000 interest, she gets a bonus of $4,500. This bonus is removed from the capital accounts of the other partners. (This journal entry shows the bonus being distributed to her capital account)
Giving a new partner credit for more than the amount invested is commonly referred to as “giving a bonus” to the new partner.
After the cash investment is recorded, a bonus is given to the new partner by crediting the new partner’s capital account. This credit is offset by debits to the original partners’ capital accounts.

35. New Partner Given Credit for Less Than Amount Invested
20--
April Beth Rivera , Capital ,500.00
Tom Lee, Capital ,200.00
Joan Wilner, Capital ,200.00
Nau Flores, Capital ,100.00
To record bonus to original
partners.
If a new partner is given credit for less than the amount invested, a bonus is allowed to the existing partners and is credited to their capital accounts in the former profit and loss ratio.
In this journal entry, the new partner gave $5,500 more than the amount of the interest she acquired in the partnership so a bonus is given to the original partners.
If a new partner is given credit for less than the amount invested, a bonus is allowed to the existing partners and is credited to their capital accounts in the former profit and loss ratio.

36. Account for the withdrawal of a partner from a partnership
Objective 9
Account for the withdrawal of a partner from a partnership
When a partner withdraws, the payment given to the withdrawing partner may be more or less than the withdrawing partner’s capital balance.
The difference in the cash payment and the withdrawing partner’s capital account is debited or credited to the remaining partners according to their profit-and-loss ratio.
Upon the withdrawal of a partner, the books of the partnership must be closed and the assets and liabilities revalued.
A partner who leaves the partnership will want to reap the benefit of past efforts in the partnership In general, the departing partner will either take cash to close his or her equity account or will sell outright the partnership interest to a third party. (Most partnership agreements however, restrict the sale of a partnership interest.) The difference in the cash payment and the withdrawing partner’s capital account is debited or credited to the remaining partners according to their profit-and-loss ratio.

37. (Paid the balance of her capital account.)
Withdrawal of Partner
(Paid the balance of her capital account.)
New Partner Given Credit for Amount Invested
20--
Mar. 31
Nau Flores, Capital ,340.00
Cash ,340.00
To record cash payment made to Flores on withdrawal from partnership.
This is the journal entry to pay the withdrawing partner, Nau Flores, the balance of her capital account after the revaluation process.
The revalued assets result in the following capital account balances:
Lee $40,980
Wilner ,180
Flores ,340
Total $154,500

38. Withdrawing Partner’s Capital Account
If the amount paid is higher than the withdrawing partner’s capital account balance, the excess is debited to the capital accounts of the remaining partners according to their income and loss ratio.
If the amount paid is less than the withdrawing partner’s capital account balance, the difference is credited to the remaining partners’ capital accounts based on their income and loss ratio.
There are other procedures for determining how the withdrawing partner’s capital account will be affected. Take a moment to review the procedures that will be demonstrated in the next slide.

39. (Paid more than the balance of her capital account.)
Withdrawal of Partner
(Paid more than the balance of her capital account.)
New Partner Given Credit for Amount Invested
20--
Mar. 31
Nau Flores, Capital ,340.00
Tom Lee, Capital ,500.00
Joan Wilner, Capital ,500.00
Cash ,340
The revalued assets result in the following capital account balances:
Lee $40,980
Wilner ,180
Flores ,340
Total $154,500
This is the journal entry to pay the withdrawing partner, Nau Flores, the balance of her capital account after the revaluation process. Because she is paid $9,000 more than her capital balance, the difference (or bonus) is debited to the remaining partners’ capital accounts.
Flores receives a bonus of $61, ,340 = $9,000
The bonus comes out of the remaining partner’s capital accounts.

40. College Accounting, 12th Edition
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College Accounting, 12th Edition
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