Hope Enterprise University College

Department of Accounting & Finance

Principles of Accounting II

Chapter Five: Accounting for Partnership Form Business Organization

Definitions of Partnership?
A partnership is an agreement in which you and one or more people combine resources in a
business with a view to making a profit. The first requirement that must be fulfilled to form
partnership is to have agreement among partners.
Their agreement is known as a partnership agreement or articles of a partnership or partnership
deed. The partnership agreement does not have to be in writing. However, good business
practice calls for a written document.
 The articles of partnership should make the following points clear;
1. Name, location, and nature of the business
2. Name, capital investment, and duties of each partner
3. Method of sharing profits and losses among the partners
4. Withdrawals of assets allowed to the partners
5. Procedures for admitting new partners and withdraws from the firm
6. Procedures for liquidating the partnership - selling the assets, paying the liabilities, and
disbursing remaining cash to the partners
There is also partnership law, which governs the basic relationships between partners and which
they may use to resolve their disputes in a court of law if there is no partnership deed, or if the
partnership deed has not covered some aspect of the partnership.

4.2 Characteristics of Partnership

A partnership differs in many ways from the other forms of business. The following characteristics
distinguish partnerships from sole proprietorships and corporations
1. Voluntary Association
A person cannot be forced to join a partnership, and partners cannot be forced to accept another
person as a partner.
2. 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 when a new partner is
admitted or a partner withdraws, retires, dies or becomes bankrupt.
3. Mutual Agency
Each partner is an agent of the partnership within the scope of the business. This means that a
partner’s act to any contract is binding the remaining partners as long as it is within the scope of
the business’ operations and become the obligations of all partners.
 4. 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, partnership’s creditor claims are not limited to the assets of the business, but is
extends to the personal property of the partners. If one partner’s personal assets are used up
before the debts are paid, the creditors can claim additional assets from the remaining partners
who are able to pay.
5. Co- ownership of partnership property
The property invested in a partnership by a partner becomes the joint property of all the partners.
The partner who invested the asset is no longer its sole owner.
6. No partnership income taxes
A partnership pays no income tax on its business income. Instead, the net income of the
partnership becomes the taxable income of the partners. The firm would pay no income tax as a
business entity.
7. Partners’ owner’s equity accounts
A partnership has more than one owner, so every partner in the business has an individual
owner’s equity account. Often these accounts carry the name of the particular partner and the
word capital. Similarly, each partner has a withdrawal account.

Closing Entries
As in the case of a Sole-proprietorship, a partnership must make four entries in preparing closing
entries. The entries are:
1. Debit each revenue account for its balance, and credit Income Summary for total revenues.
2. Debit Income Summary for total expenses, and credit each expense account for its balance.
3. Debit Income Summary for its balance, and credit each partner’s capital account for his or her
share of net income. Or, credit Income Summary, and debit each partner’s capital account for
his or her share of net loss.
4. Debit each partner’s capital account for the balance in that partner’s drawing account, and
credit each partner’s drawing account for the same amount. The first two entries are the same
as in a Sole-proprietorship.
The last two entries are different because (1) there are two or more owners’ capital and drawing
accounts, and (2) it is necessary to divide net income (or net loss) among the partners.
Formation of Partnership
Contribution of Cash (Funds)
When a partner invests funds in a partnership, the transaction involves a debit to the cash
account and a credit to a separate capital account. A capital account records the balance of the
investments from and distributions to a partner. Record the entries of capital account on a
separate capital account for each partner.
Contribution of Other than Funds

When a partner invests some other asset in a partnership, the transaction involves a debit to
whatever asset account most closely reflects the nature of the contribution, and a credit to the
partner's capital account. The valuation assigned to this transaction is the market value of the
contributed asset.
Each partner invests cash, other assets, or both in the partnership according to the partnership
agreement. Noncash assets valued and recorded at an agreed upon value between partners or
current market value on the date transferred to the partnership. The assets invested by a partner
are debited to the proper account, and the total amount is credited to the partner’s Capital
account.
 Note that after each partner’s investment is recorded properly, the capital of the
partnership can be determined.

Division of Net Income or Net Loss

If each partner is to contribute equal services and amounts of capital, an equal sharing in
partnership Net Income would be equitable. But if one partner is to contribute a larger portion of
capital or capital or the services of one partnership, provision for this should be given recognition
in the division on net income or net loss, it should be noted that division on net income or net loss
among the partners in exact accordance with their partnership agreement is of the utmost
importance, if the agreement is silent on the division on net income or net loss, the law provides
that all partners share equally, regardless of differences in amounts of capital contributed, or
special skill possessed or of time devoted to the business. The partners may however, make any
agreement they wish in regard to the division of net income and net losses.
Salaries and interest here are not salaries expense or interest expense in the ordinary sense of the
terms. They refer to ways of determining each partner’s share of net income or net loss on the
basis of time spent and money invested in the partnership.
Generally, the partnership recognizes a partner’s share of net income or net loss in the accounts
through closing entries. These are;
1. Debit each revenue account for its balance, and credit Income Summary for total revenues.
2. Debit Income Summary for total expenses, and credit each expense account for its balance.
3. Debit Income Summary for its balance, and credit each partner’s capital account for his or
her share of net income. Or, credit Income Summary, and debit each partner’s capital
account for his or her share of net loss.
4. Debit each partner’s capital account for the balance in that partner’s drawing account, and
credit each partner’s drawing account for the same amount.

Dissolution of a Partnership
The admission of a new partner, withdrawal, retirement or death of existed partners results
dissolution of a partnership, the end of the former partnership and formation of a new
partnership. Dissolution is not liquidation; rather it is the change in number of partners.

Admission of a new partner

A new partner may be admitted to the partnership with the consent of all old partners through
either purchase of an interest (ownership right) from one or more of partners or contributing
(investing) assets to the partnership.
A. Admission by purchasing the capital of the existing partners
It is a personal transaction between one or more of old partners and the new partner. Therefore,
the partnership asset and liability remain unchanged. An entry is needed in the partnership only
to transfer the purchased capital from the capital account of the selling partner to the capital
account of the new partner regardless of the amount paid by entering partner.
B. Admission by investing assets
It is a transaction between the new partner and the partnership which increase the partnerships
total asset and capital. To record such admissions the invested assets debited by its current
market value and the capital of entering (new) partner will be credited.

Recognition Goodwill
When a new partner is admitted to partnership goodwill attributable either to the old partnership
or the incoming partner may be recognized.
3. Withdrawal (retirement) of partner
An existing partner can be withdraw from the partnership through either of the following
alternatives of partner withdraw;
1. Selling his / her ownership right to the remaining partner or outsider
2. Withdraw assets from the partnership
The partner can withdraw assets equal to his or her capital balance, less than his or her capital
balance (in this case, the remaining partners receive a bonus), or greater than his or her capital
balance (in this case, the withdrawing partner receives a bonus).
 1. Sales of interest
It is sales of ownership interest to existing partner or to an outsider (new partner). It is personal
transaction and does not change the partnership total asset or the partners’ total equity. Its effect
limited to changes in the partners’ capital balances.
2. Withdraw of interest
Withdrawal of Cash (Funds)

When a partner extracts Cash (funds) from a business, it involves a credit to the cash account
and a debit to the partner's capital account.
Withdrawal of Assets
When a partner extracts assets other than cash from a business, it involves a credit to the
account in which the asset was recorded, and a debit to the partner's capital account.

This is a transaction between the partnership and the leaving partner i.e. the drawing partner’s
interest paid by the business. It is the reverse of admitting a partner through the investment of
assets in the partnership. As a result, both partnership assets and total capital decreases.

Liquidation of Partnership

It is the process of ending (terminating) the business, of selling non cash assets to pay the
partnership’s liabilities and distributing any remaining assets among the partners. This may be by
mutual agreement of partners or bankruptcy.
Before the liquidating process begins, the accounting cycle should be completed. That is,
adjustments should be made, financial statements prepared, and closing entries recorded and
posted.
 The four steps in liquidating the partnership;
1. Sell all non-cash assets of the partnership for cash and recognize the resulting gain or loss
2. Allocate the gain or loss on non-cash assets sale to the partners based on their income and
loss sharing ratio
3. Pay the partnership liabilities in cash
4. Distribute the remaining cash to the partners on the basis of their capital balances.
The final step in liquidation is the distribution of the remaining cash to the partners based on their
capital balances. However, two possibilities exist with regard to the partners’ capital accounts: No
capital deficiency, all partners have zero or credit balance in their capital accounts for final
distribution of cash or Capital deficiency, at least one partner has a debit balance (deficit) in his /
her capital account for final distribution of cash. The capital deficiency can be handled in two
ways; the deficient partner may repay or the partners share it based on their income or loss
sharing ratio.
Example 1:
Rahel and Dereje agreed on January 1, 2021 to form a partnership named RD Company. Rahel
invested Br. 8,000 Cash, Br. 35,000 Furniture, Br. 12,000 Merchandise and Br. 15,000 Notes
Payable is assumed by the partnership which is related to Rahel. Dereje invested Br. 30,000 Cash
and Br. 20,000 Accounts Receivable with the provision for uncollectible accounts of Br. 8,000.
Required: Record the investment by the two owners.

Example 2:
The articles of partnership of Rahel and Dereje provides for monthly Salary Allowances of
Br. 2,500 and Br. 1,500, respectively with the balance of the Net Income is Br. 80,000.
Required:
Prepare a schedule of income division and record the income division and show the entry.

Example 3:
If they had withdrawn their Salary Allowances monthly, show the entry of withdrawal.

Example 4:
At the end of the year, annual drawing account of Rahel and Dereje. Show the Closing Entry.

Example 5: The Net Income of Rahel and Dereje for the year is Br. 80,000. Further assume that
Rahel and Dereje:
 are allowed a monthly salary of Br. 2,500 and Br. 1,500, respectively
 are allowed interest at a rate of 10%.
Instruction: prepare a schedule of income division and show the entry.

Example 6: Assume that instead of Net Income of Br. 80,000 is Br. 50,000. Further assume that
Rahel and Dereje agreed show the entry.

Example 7: Getahun, Tibebu, and Abraham were operating a partnership called GTA Partnership.
Asfaw purchased 20% Capital Interest of Getahun at Br. 20,000, ¼ Capital interest of Tibebu at
Br. 30,000 and 30% capital interest of Abraham at Br. 40,000. The capital of Getahun, Tibebu and
Abraham is Br. 50,000, Br. 80,000 and Br. 70,000, respectively.
Required:
Record the transaction to transfer the capital interest from the current partners to the incoming
partner
Example 8: Beza and Ruth are partners with capital accounts Balance of Br. 50,000 and
Br. 40,000, respectively. On January 1, Zerhin invested Br. 30,000 Cash and Br. 10,000 Equipment
in the business.
Required:
Record the admission of the new partner.
Example 9: Leila is admitted to the partnership of Tesfa and Rebecca by Investing Br. 35,000. If
the existing partners agreed to recognize Br. 5,000 Goodwill attributable to Leila, record the
recognition of goodwill.

Example 10: The Income sharing ratio Michael and Birihanu is 3:7. Maeza is admitted to the
Partnership by Investing Br. 30,000 Cash and the incoming partner agreed to recognize Goodwill
of Br. 5,000 which is attributable to the existing partners.
Required:
Record the transaction

Example 11: Shalom, Mesfin and Tigist agreed to liquidate their partnership named SMT
Partnership. The income sharing ration is 2:3:5, respectively. After discontinuing the ordinary
business operations of their partnership and closing the accounts, the following summary of the
general ledger is prepared:
 Cash Br. 13,000
 Non Cash Assets 62,000
 Liabilities 20,000
 Shalom, Capital 22,000
 Mesfin, Capital 22,000
 Tigist, Capital 11,000
Assuming that all Non- Cash Assets are sold from November 1, 2021 to November 30, 2021 and all
Liabilities are paid at one time and the Non-Cash Assets are sold:
Case 1: Br 80,000
Case 2: Br 50,000
Case 3: Br 30,000
Instruction: Prepare Statement of Partnership Liquidation and record the following circumstances