CHAPTER FIVE: ACCOUNTING FOR PARTNERSHIPS

5.1. Partnership Form of Organization and Their Characteristics

A partnership is defined as an association of two or more persons who own and manage a company 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, purpose of the business, the capital
contributions of each partner, duties of each partner, the methods of income and loss division,
admission or withdrawal of partner(s), 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 the purposes of accounting, partnerships are treated as separate economic entities. Then we explain
the principal characteristics of partnerships in the following sections.

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 within 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.

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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. 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.

Advantages and Disadvantages of Partnership

Advantages:

A partnership form of business organization has the following advantages:

1. 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.

2. 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.

3. 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

4. Not required to observe on many restrictive laws unlike a corporation.

Disadvantages:

Partnership forms of business organization have the following disadvantages:

1. 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).

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2. Disadvantageous if each partner does not exercise his/her good judgment because one partner’s act can
bind a partnership into a contract.

3. Limited life. Partnerships are subject to possible termination due to many uncontrollable circumstances
such as the death of a partner.

4. The transfer of ownership from one partner to another person is difficult unless the remaining partners
approve of this.

5.2 Recording the Formation of a Partnership

In forming a partnership, the investments of each partner are recorded in separate entries. The assets
contributed by a partner are debited to the partnership asset accounts. If any liabilities are assumed by the
partnership, the partnership liability accounts are credited. The partner’s capital account is credited for
the net amount.

Illustration

Dr. Abebe and Dr.Seid 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. Abebe Dr. Seid

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, 2010 to record the investment of each partner and the formation of the
partnership would be:

2010, Jan.1: Cash ………………………………..6, 500

A/R ………………………………...…8, 600
Supplies ……………………..…….…21, 000
Medical Equipment…….……….............3, 000
A/p …………………………...…2, 300
Abebe, Capital ………………...36, 800

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2010, Jan.1: Cash …………………………………...3, 300
A/R ………………………………...…….4, 300
Supplies …………………………………12, 000
Building ………………………………..150, 000
Accounts Payable …………….…………3, 200
Seid, Capital ………………………...166, 400
5.3 Division of Partnership Income and Losses
A partnership’s income and losses can be distributed according to whatever method the
partners specify 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:
(1) Return to the partners for the use of their capital – called interest on partners’ capital,
(2) Compensation for direct services the partners have rendered – called partners’ salaries,
and
(3) 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:
1. Net income divided in a stated ratio such as:
A) Equally
B) Agreed upon ratio (other than equally)
C) Ratio based on beginning capital balances
2. Net Income divided by allowing interest on the capital investments, salaries, or both
with the remaining net income divided in an agreed ratio.
Example 1
Assume that Dr. Abebe and Dr. Seid partnership had a net income of Birr 60,000.
Case 1: 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. Abebe capital-----------------------------------30,000
Dr. Seid capital--------------------------------------30,000

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 Case 2: Net income is divided in ratio of 3:2 to Dr. Abebe and Dr. Seid respectively.
Income summary-------------------------------------60,000
Dr. Abebe capital (3/5 X 60,000) ------------------------36,000
Dr. Seid capital (2/5 X 60,000) ---------------------------24,000
Case 3: Net income is divided in a ratio of partners’ capital account balances at the
beginning of the fiscal period.
Income summary ------------------------------- 60,000
Dr. Abebe capital [(36,800/203,200)60,000] ---------------10,860
Dr. Seid capital [(166,400/203,200)60,000] ---------------- 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. Abebe and the remainder is divided equally.

Net Income Division: Income to be

Dr. Abebe Dr. Seid Total distributed

Net income Br. 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. Abebe capital ---------------------------- 29,260

Dr. Seid capital -------------------------------- 30,740

5.4 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 owner’s equity for Abebe and Seid using
assumed data and the income division shown above is illustrated below:

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 Dr. Abebe and Dr Seid

Statement of partners’ Capital

For the year ended Dec, 31, 2017

Dr. Abebe Dr. Seid

Capital Bal. January 1, 2017: 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, 2017: Br. 65,260 Br. 196,440

Hence, 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.

5.5 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.

Then, 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 to the partnership or an existing partner withdraws from the
partnership is called partnership dissolution.

5.5.1 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.

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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 the following two ways:

(1) By purchasing ownership right from one or more of the original partners, or

(2) 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. Abebe and Dr. Seid by buying ownership
right of Br. 8000 from Dr. Seid. The entry to record the admission of Sister Helen and the transfer of the
ownership right from the capital account of Dr. Seid to the capital account of Sister Helen in the
partnership books shown below.

Journal entry

Dr. Seid ---------------------------------- 8,000

Sr. Helen --------------------------------------8,000

The price that Sister Helen paid to Dr. Seid 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:

1- Sister Helen receives a 50% ownership right in the partnership. Assume also that Dr. Abebe and Dr.
Seid’s capital balance were Br. 25,000 and Br. 55,000 respectively. Dr. Abebe and Dr. Seid 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

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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. Abebe capital --------------------- 26,667

Dr. Seid capital --------------------- 13,333

5.5.2 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. Seid withdraws from the partnership because of a disagreement. He sells his Br. 38,333
ownership right to Dr. Abebe.

Journal entry

Dr. Seid, Capital----------------------------- 38,333

Dr. Abebe, Capital ----------------------------- 38,333

The amount paid by Dr. Abebe is not recorded on the partnership books, because the transaction involves
no flow of assets to or from the partnership.

5.6 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:
I) Assume Dr. Seid was paid Br. 50,000 cash when he withdraws from the partnership of S, A & H. The
capital balances of each partner were as follows as of that date:

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Dr. Abebe capital ---------------------------Br. 100,000
Dr. Seid capital --------------------------- --- 50,000
Sister Helen capital ----------------------------- 35,000
Total Equities Birr 185,000

Journal entry

Dr,Seid, capital -------------------------------- 50,000

Cash -----------------------------------------------------------50,000

Assume Dr. Seid 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 Abebe Dr. Seid and Sister Helen respectively).

Journal entry

Dr. Seid capital ------------------------------50,000

Sister Helen capital ---------------------------- 1,500

Dr. Abebe capital ------------------------------ 4,500

Cash ----------------------------------------------------56,000

 The Birr 6,000 excess is shared on the basis of a 3:1 ratio, i.e., Dr. Abebe would be charged for 6,000 X
3/4 = birr 4500, and Sister Helen would be charged for Birr 6000 X ¼= Birr 1500.

5.7 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:

A. The objectives sought in forming the partnership have been achieved.

B. The time period for which the partnership was formed expires (ends)

C. Newly enacted laws have made the partnerships activities illegal,

D. The partnership becomes bankrupt.

The partnership agreement should indicate the procedures to be followed in case 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.

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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 R, S, and T is liquidated on September 1, 2010. The income and loss sharing ratio of
the partners is: R 40%, Sultan 35%, and T 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

September 1, 2017

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 R, S, and T sell all non-cash assets for Birr 95,000, realizing a gain of birr 5000, (Birr
95,000 – Birr 90,000). The gain is divided among R, s and T 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:

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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 R, S, and T 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

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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, capital. 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

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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

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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. 1-15,2017

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 -

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