Advanced Accounting Accounting for partnership: Formation, Operation, Dissolution, & Liquidation

CHAPTER ONE:- ACCOUNTING FOR PARTNERSHIPS:

FORMATION, OPERATION, CHANGES IN MEMBERSHIP, AND LIQUIDATION

INTRODUCTION

Partnerships are a popular form of business because they are easy to form and because they
allow several individuals to combine their talents and skills in a particular business venture. In

addition, partnerships provide a means of obtaining more equity capital than a single individual can

obtain and allow the sharing of risks for rapidly growing businesses. Partnerships are fairly

common in the service professions, including law, medicine, and accounting. Historically, these

professions have generally not adopted the corporate form of business because of their long-

standing tradition of close professional association with clients and the total commitment of the

professional’s business and personal assets to the propriety of the advice and service given to

clients.

Accounting for partnerships requires recognition of several important factors. From an accounting

viewpoint, the partnership is a separate business entity. From a legal viewpoint, however, a

partnership, like a sole proprietorship, is not separate from the owners. Therefore several

differences exist between tax and financial accounting for specific events, such as the value

assigned to assets contributed in the formation of the partnership. This chapter presents the

generally accepted accounting principles of partnership accounting.

Definition of a partnership

A partnership may be defined as an “association of two or more persons to carry on as co-owners a

business for profit.” This definition encompasses three distinct factors.

1. Association of two or more persons. The “Persons” are usually individuals;
however, they could be organizations
2. Carry on as co-owners. A partnership is an aggregation of partners’ individual
rights. This means that all partners are co-owners of partnership property and are
co-owners of the profits or losses of the partnership.

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3. Business for profit. A partnership may be formed to perform any legal business,
trade, profession, or other service. However, the partnership must attempt to make
a profit; therefore, not-for-profit organizations, such as fraternal groups, may not be

partnerships.

Major Characteristics of Partnerships

The partnership form of business has several unique elements because of its legal and accounting

status. The following section describes the major characteristics which distinguish the

partnership form of organization.

 Ease of formation

A primary advantage of the partnership form of entity is ease of formation. The agreement to

form a partnership may be as informal as a handshake or as formal as a many paged agreement

typically termed the articles of co-partnership. Each partner must agree to the formation

agreement, and partners are strongly advised to have a formal written agreement in order to

avoid potential problems that may arise during the operation of the business.

The articles of co partnership may include the following items:

1. The name of the partnership and the names of the partners.

2. The type of business to be conducted by the partnership

3. The initial capital contribution of each partner and method by which capital contributions

are to be accounted for.

4. A complete specification of the profit or loss distribution,

5. Procedures used for changes in the ownership of a partnership, such as admission of new

partners and the retirement of a partner.

6. Other aspects of operations the partners decide on, such as the withdrawals by partners…

Each partner should sign the partnership agreement to indicate acceptance of the terms. A

carefully prepared partnership agreement can eliminate many of the more common types of

problems and disputes that may arise in the future operations of the partnership.

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Limited Life. A partnership legally terminates as an entity each time there is a change in

Membership. This legal termination is called “dissolution of the partnership.” Most Partnership

includes provisions in their articles of co partnership for changes in membership so that the

business is not interrupted.

Agency Relationship. Each partner is a co-owner of the partnership assets and liabilities.

Creditors view each partner as an agent of the partnership capable of transacting business in the

name of the partnership. Consequently, any partner can bind the partnership when acting within

the scope of the partnership activities. For example, partner A signs a lease in the partnership

name, even though the articles of co partnership specify that only partner B may sign leases. The

partnership is still bound by the lease because the other party to the lease can assume mutual

agency of each partner. Any legal remedy is strictly between partners A and B.

Unlimited Liability. Because partnerships are not incorporated, all partners in a general

partnership have unlimited liability. In the event the partnership fails and its assets are not

sufficient to pay its liabilities, partnership creditors may take recourse by obtaining liens or

attachments against the personal assets of any or all of the partners. Generally, creditors will

take action against the partner with the most liquid assets. This means that any individual partner

may be required to pay the partnership’s creditors from personal assets in an amount exceeding

his or her capital balance in the partnership. This unlimited liability of partners differs from the

corporate form of business, in which an investor’s ultimate loss is limited to the amount invested

in the corporation’s stock.

Non-taxable entity. Because a partnership is not a separate legal entity to the owners, it is not

levied tax on periodic income. Rather, the income tax is levied by the name of each partner on

their share of partnership income

II. ACCOUNTING FOR FORMATION OF A PARTNERSHIP (INITIAL CONTRIBUTIONS)
At the formation of a partnership, it is necessary to record the partners’ contributions (cash, non

cash, and liabilities) in the appropriate ledger accounts at the fair value. Thus, the accounting for

contributions (initial or subsequent) of partners involves:

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1) Proper valuation of partners’ contributions

2) Recording the partners’ contributions in the appropriate ledger accounts

1. VALUATION OF CONTRIBUTIONS

It is necessary to assign a proper value to the non cash assets and liabilities contributed by the

partners and record the partners’ contributions (cash, non cash, and liabilities) in the appropriate

ledger accounts. An item contributed by a partner becomes partnership property co-owned by all

partners. The partnership must clearly distinguish between capital contributions and loans made

to the partnership by individual partners. Loan arrangements should be evidenced by promissory

notes or other legal documents necessary to show that a loan arrangement exists between the

partnership and an individual partner.

The contributed assets should be valued at their Current fair values, which may require appraisals

or other valuation techniques. Liabilities assumed by the partnership should be valued at the

present (current) value of the remaining cash flows.

The individual partners must agree to the percentage of equity that each will have in the
net assets of the partnership. Generally, the capital balance is determined by the
proportionate share of each partner’s capital contribution. However, each partner’s capital
amount recorded does not necessarily have to equal his or her capital contribution. The
partners could decide to divide the total capital in any manner they desire regardless of
the source of the contribution. The key point is that the partners may allocate the capital
contribution in any manner they desire. The accountant must be sure that all partners
agree to the allocation and must then record it accordingly.

2. Recording partners’ contributions

The partnership may maintain several accounts for each partner in its accounting records. These

partners’ accounts are as follows:

i. Capital Accounts. The initial investment of a partner, any subsequent capital contributions,

profit or loss distributions, and any withdrawals of capital by the partner are ultimately

recorded in the partners’ capital accounts. The balance in the capital account represents

the partner’s share of the net assets of the partnership

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ii. Drawing Accounts. Partners generally make withdrawals of assets from the partnership

during the year in anticipation of profits. A separate drawing account often is used to

record the periodic withdrawals and is then closed to the partner’s capital account at

the end of the period. Non cash drawings should be valued at their market values at the

date of the withdrawal.

iii. Loan Accounts. The partnership may look to its present partners for additional financing.

Any loans between a partner and the partnership should always be accompanied by

proper loan documentation such as a promissory note. A loan from a partner is shown as

a payable on the partnership’s books, the same as any other loan. Alternatively, the

partnership may lend money to a partner, in which case it records a loan receivable from

the partner.

Illustration of Accounting for Partnership Formation

Example: - Partners capital equals to contributions

Alt, a sole proprietor, has been developing software for several types of microcomputers. The

business has the following account balance as of January 1, 20X1:

Cash 3,000 Accumulated Depreciation-Equipment 5,000

Inventory 7,000 Liabilities 10,000

Equipment 20,000 Alt, Capital 15,000

Alt needs additional technical assistance to meet the increasing sales and offers Blue an

interest in the business. On January 1,20x1 Alt and Blue agree to form a partnership. Alt’s

business is audited, and its net assets are appraised. The audit and appraisal disclose that

$1,000 of accrued liabilities has not been recorded, inventory has a market value of $9,000,

and the equipment has a fair value of $19,000.

Case 1: - Partners capital equals to contributions

Alt and Blue prepare and sign articles of co partnership that include all significant operating

policies. Blue will contribute $10,000 cash for a one-third capital interest. The AB Partnership

is to acquire all of Alt’s business and assume its debts.

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Required:- Prepare a journal entry to record the initial capital contribution on the

partnership’s books.

Journal Entry: on Jan. 1/20x1

Cash 13,000
Inventory 9,000
Equipment 19,000
Liabilities 11,000
Alt, Capital 20,000
Blue, Capital 10,000

Case 2 : - Partners capital does not equal to contributions

In the above case, although Alt contributed $20,000 of the $30,000 partnership capital, he

could permit Blue 50% percent of the total capital of the firm as his initial capital balance

since Alt believed that Blue has some particularly important business experience and skills

(intangible contributions) needed by the partnership .

Required:- Prepare a journal entry under both Bonus and Goodwill to record the initial

capital contribution on the partnership’s books.

I. Bonus method:
Journal Entry: on Jan. 1/20x1 :
Cash 13,000
Inventory 9,000
Equipment 19,000
Liabilities 11,000
Alt, Capital 15,000
Blue, Capital 15,000

II. Goodwill Method

Journal Entry: on Jan. 1/20x1:
Cash 13,000
Inventory 9,000
Equipment 19,000
Goodwill 10,000

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Liabilities 11,000
Alt, Capital 20,000
Blue, Capital 20000

III. ACCOUNTING FOR OPERATIONS OF A PARTNERSHIP

A partnership provides services or sells products in pursuit of profit. These transactions are

recorded in the appropriate journals and ledger accounts. Many partnerships use accrual

accounting and generally accepted accounting principles to maintain their books because GAAP

result in better measures of income than alternative accounting methods such as the cash basis

or modified cash basis. Partnership financial statements are prepared for the partners and

occasionally for partnership creditors.

Accountants often encourage the use of GAAP for financial statement purpose because the

partners may then compare the partnership’s financial statements with those of other business

entities; and if a creditor requires audited financial statements as a condition for a loan to the

partnership, the partnership’s statements are not restricted from receiving an unqualified

audit opinion.
Methods of Profit or Loss allocations to Partners
Profit or loss is allocated to the partners at the end of each period in accordance with the

partnership agreement. If no partnership agreement exists, profits and losses are to be shared

equally by all partners. Virtually all partnerships have a profit or loss allocation agreement. The

agreement must be followed precisely, and if it is unclear, then the accountant should make

sure that all partners agree to the profit or loss distribution. Many problems and later

arguments can be avoided by carefully specifying the profit or loss distribution in the articles

of co partnership.

A wide range of profit distribution plans is found in the business world. Some partnerships

have straightforward distribution plans, while other has extremely complex ones. It is the

accountant’s responsibility to record the distribution of the profit or loss according to the

partnership agreement regardless of how simple or complex that agreement is. Profit

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distributions are similar to dividends for a corporation: these distributions should not be

included on the income statement. Regardless of how the profit is distributed, Profit

distributions are recorded directly in to the partners’ capital accounts, not as expense items.

Most partnerships use one or more of the following distribution methods:

1. Pre selected ratio.

2. Capital contribution ratio

3. Interest on capital balances.

4. Salaries to partners.

5. Bonuses to partners.

Note:- The accountant must carefully read the articles of co partnership to determine

the precise profit distribution plan for the specific circumstances at the time.
1. Preselected ratio.
Preselected ratios are usually the simplest and most widely used method of income

distributions. It is usually the result of negotiations between the partners. Ratios for profit

distributions may be based on the percentage of total partnership capital, time and effort

invested in the partnership, or other factors. Often, smaller partnerships split profits evenly

among the partners. In addition, some partnerships have different ratios if the firm suffers a

loss versus earns a profit. The partnership form of business allows a wide selection of profit

distribution ratios to meet the individual desires of the partners.

2. Capital contribution ratio
Distributing partnership income based on capital balances recognizes the contribution of the

partners’ capital investments to the profit-generating capacity of the partnership. It assumes

that capital is the only factor contributing to the success of the firm.
6. Interest on capital balances.
Distributing partnership income based on interest on capital balances recognizes the

contribution of the partners’ capital investments to the profit-generating capacity of the

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partnership. This interest on capital is not an expense of the partnership; it is a distribution of

profits.

7. Salaries to partners.

If one or more of the partners’ services are important to the partnership, the profit

distribution agreement may provide for salaries or bonuses. Again, these salaries paid to

partners are a form of profit distribution and are not an expense profit or may differ if the

partnership has a loss for the period.

The profit or loss distribution is recorded with a closing entry at the end of each period. The

revenue and expenses are closed in to an income summary account the balance of which is net

income or net loss after the revenue and expense accounts are closed and before the income or

loss is distributed to the partners’ capital accounts.

Illustrations of Profit Allocation

On January 4, 2001 Mr. X and Mr. Y have established a partnership named as XY Partnership.

On that date Mr X & Y invested Br.20, 000 & 10,000 in cash respectively. During 2001, the XY

Partnership earns $45,000 of revenue and incurs $35,000 in expenses, leaving a profit of

$10,000 for the year. X makes additional investments of $ 4,000 on April 1, 2001, but on the

same date, Y withdraws $4,000 in cash for personal use beyond the limit.

Required: Present journal entries to record

A. the initial contributions by partners

B. Additional investments and withdrawals by partners

C. Distributions of income under the following independent methods:

i. X and Y agree to share profits or losses in the ratio of 6: 4 respectiively

ii. The articles of partnership states that partners share profit or loss on the

basis of their weighted-average capital balance for the year

iii. The articles of partnership provides for 10 percent annual interest to

partners on their weighted-average capital balance for the year and the

remaining equally
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iv. The partnership agreement provides for annual salaries of $2,000 to X and

$5,000 to Y. Any remainder is to be distributed in the profit and loss sharing

ratio of 60:40 percent.

v. Multiple Bases of Profit Allocation:-The profit and loss agreement of the

AB Partnership specifies the following Multiple Bases of Profit Allocation

allocation method:

a. Interest of 15 percent on weighted-average capital balances.

b. Annual Salaries of $1,000 for Alt and $3,000 for Blue.

c. Remaining 60% to X &40% to Y

Partnership Financial Statements

A partnership is a separate reporting entity for accounting purposes, and the three financial

statements-income statement, balance sheet, and statement of cash flows- typically are

prepared for the partnership at the end of each reporting period. Interim statements may also

be prepared to meet the information needs of the partners. In addition to the three basic

financial statements, a statement of partners’ capital is usually prepared to present the

changes in the partners’ capital accounts for the period.

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