CHAPTER 1

PARTNERSHIP ACCOUNTING
1.1 PARTNERSHIPS: ORGANIZATION AND OPERATION

A partnership may be defined as an association of two or more persons to carry on, as co-
owners, a business for profit.
1.1.1 Types of partnerships
There are three types of partnerships. The distinctive features of each are described below
while their characteristics are discussed in detail in another section.
1. General partnership
Is a firm in which all the partners are responsible for liabilities of the firm and all have
authority to act for the firm.
2. Limited partnership
Is a firm owned by two types of partners, general partners and limited partners. The former are
responsible for liabilities of the firm while the later are not.
3. Limited liability partnerships (LLPs)
Have features of both general partnerships and professional corporations. Individual partners
of LLPs are personally responsible for their own actions and for the actions of the partnership
employees under their supervision; however, they are not responsible for the action of other
partners.

1.1.2 Characteristics and principles of partnerships

The basic characteristics of each type of partnership are discussed hereunder:
A. General partnership
1. Ease of formation
 A general partnership may be created by an oral or written contract between two or
more persons, or may be implied by their conduct
 This advantage of convenience and minimum cost may be offset by certain
difficulties inherent in such an informal organizational structure
2. Limited life
 A partnership may be ended by the death, retirement, bankruptcy or incapacity of a
partner
 The admission of a new partner also legally ends the former partnership and
establishes a new one.
3. Unlimited liability
 All the partners are responsible for liabilities of the firm and all have authority to act
for the firm.
 Creditors having difficulty in collecting from the partnership would likely turn to
those partners who have other financial resources
4. Co-ownership of partnership assets and earnings
 Individuals retain no claim to specific assets they invest in a partnership but acquire
an ownership equity in all assets of the partnership
 Every member also has an ownership equity in partnership earnings
B. Limited partnership
Among the features of limited partnerships are the following:
 There must be at least one general partner
 Limited partners have no obligation for unpaid liabilities of the limited partnership;
only general partners have such liability
 Limited partners have no participation in the management of the limited partnership

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  Limited partners may invest only cash or other assets in a limited partnership; they
may not provide service as their investment.
 The surname of a limited partner may not appear in the name of the partnership
 The formation of a limited partnership is evidenced by a certificate filed with county
recorder of the principal place of business of the limited partnership
 The certificate includes many of the items present in the typical partnership
contract, in addition it must include:
 The name and residence of each general partner and limited partner
 The amount of cash and other asset invested by each limited partner
 Provision for return of a limited partner’s investment
 Any priority of one or more limited partners over other limited partners
 Any right of limited partners to vote for election or removal of general partners,
termination of the partnership, amendment of the certificate, or disposal of all
partnership assets
Membership in a limited partnership is offered to limited partners in units and a registration
statement of offered units and periodic reports must be filed with the Securities and
Exchange Commission (SEC)
C. Limited Liability Partnership (LLP)
The basic characteristics of an LLP are as follows:
1) Ease of formation
 A limited liability partnership may be created by an oral or written contract between
two or more persons, or may be implied by their conduct
 This advantage of convenience and minimum cost may be offset by certain
difficulties inherent in such an informal organizational structure
 LLPs that are accounting or law firms generally must register with the state
licensing authority
2) Limited life
 An LLP may be ended by death, retirement, bankruptcy, or incapacity of a partner
 The admission of a new partner also legally dissolves the former partnership and
establishes a new one.
3) Mutual agency
 Each partner has the authority to act for the limited LLP and to enter into contracts
on its behalf but within the normal scope of business unless specifically authorized
to enter into certain transactions.
4) Co-ownership of partnership assets and earnings
 Individuals retain no claim to specific assets they invest in a partnership but acquire
an ownership equity in all assets of the partnership
 Every member also has an interest in partnership earnings

The partnership contract

Although general partnerships and LLPs may exist on the basis of an oral agreement or may
be implied by the actions of its members, good business practice demands the partnership
contract be clearly stated in writing.
The most important points in partnership contract are the following:
1. The date of formation of the partnership, the duration of the contract, the names of the
partners, and the name and business activities of the partnership.
2. The assets to be invested by each partner, the procedure for valuing non-cash
investments, and penalties for failure to invest and maintain the agreed amount of
capital.
3. The authority of each partner and the rights and duties of each.

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 4. The accounting period to be used, the nature of accounting records, financial
statements, and audit by independent public accountants.
5. The plan for sharing net income or loss, including the frequency of income
measurement and the distribution of income or loss among the partners.
6. The salaries and drawings allowed to partners and the penalties, if any, for excessive
withdrawals.
7. Insurance on the lives of partners, with partnership or surviving partners named as
beneficiaries.
8. Provisions for arbitration of disputes and liquidation of the partnership
Revision of the partnership contract generally requires the approval of all partners.

1.1.3 Choosing Between Partnership and Corporation

One of the most important considerations in such a decision is the income tax status of the
enterprise and its owners. A partnership pays no income tax but is required to file an
information return showing its revenue and expenses, the amount of net income and its
division among partners. The partners report their respective share of the net income.
A corporation is a separate legal entity subject to corporate income tax. The net income,
when and if distributed to stockholders as dividends, also is taxable income to stockholders. A
partnership may incorporate as a subchapter S corporation to retain the advantages of limited
liability but at the same time elect to be taxed as a partnership.
The other factors that tip the scale towards incorporation are:
 The opportunity for obtaining larger amount of capital
 The limited liability of all stockholders for unpaid debts of the corporation
1.1.4 Partnership Provisions in Ethiopia
Commercial Code
The 1960 Commercial Code of Ethiopia prescribes legal provisions for organization and
operation of partnerships in Ethiopia in Articles 280 to 303.
Accordingly, the code recognizes general and limited partnerships with essentially the same
characteristics and principles discussed above except that a memorandum of association shall
be drawn up by the partners, notice of same published, and entered in the commercial register.
A partnership may acquire rights and liabilities and sue or be sued under its firm name
according Article 286.
Hence, “a general partnership consists of partners who are personally, jointly, severally and
fully liable as between themselves and to the partnership for the partnership firm’s
undertakings. –“ Article 280 sub article 1. Sub article 2 of the same article states that each a
partner of a commercial partnership shall have the status of a trader.
Memorandum of association
According to article 284 of the commercial code of Ethiopia the memorandum of
association drawn up by the partners shall contain:
 The name, address and nationality of each partner
 The firm name
 The head office and branches, if any
 The business purpose of the firm
 The contribution of each partner, their value and the method of valuation
 The services required from persons contributing skill
 The share of each partner in the profits and in the losses and the agreed procedure for
allocation
 The managers and agents of the firm
 The period of time for which the partnership has been established

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  A limited partnership as per Article 296 consists of two types of partners; general
partners in full liable personally, jointly and severally and limited partners who are only liable
to the extent of their contributions.
Income Tax Proclamation
Income tax proclamation No.797/2016 includes registered partnerships under ‘bodies’
along with companies and public enterprises. The income tax rate set for bodies is 30% while
a progressive rate applies to other taxpayers.
Even if the commercial code states that each partner in a commercial partnership shall have
the status of a trader, the income tax proclamation does not have any provision to this effect
except categorizing the partnership with bodies viz. companies and public enterprises. The
taxpayer, therefore, is the partnership not the partners.
From the foregoing discussion, it could be concluded that the tax law treats partnerships in
the same way as companies except that partners’ salary is not a tax deductible expenditure.
Therefore, there is no mach tax consideration to make in deciding between partnership and
incorporation for Ethiopian business people.

1.1.5 Partnership versus Partners

In accounting literature, the legal aspects of partnerships generally have received more
emphasis than the managerial and financial issues. It has been common practice to distinguish
a partnership from a corporation by saying that a partnership is an “association of persons”
and a corporation is a separate entity.
Such distinction stresses the legal form rather than the economic substance of the business
organization. In terms of managerial policy and business objectives, partnerships are as truly
business and accounting entities as are corporations. Partnerships are guided by long range
plans not likely to be affected by admission or withdrawal of a single member. In these firms
accounting policies should reflect the fact that the partnership is an entity apart from its
owners.
Treating the partnership as a business and accounting entity often will aid in developing
financial statements that provide the most meaningful picture financial position and results of
operation. Among the accounting policies to be stressed is continuity in asset valuation,
despite changes in the income sharing ratio and changes in personnel.
Another helpful step may be recognition as expenses of the value of personal services
rendered by partners who also hold managerial position. In theoretical discussions,
considerable support is found for treating every business enterprise as an accounting entity,
apart from its owners, regardless of the form of organization. A managing partner under this
view is both an employee and an owner, and the value of the personal services rendered by a
partner is an expense of the partnership.
The inclusion of partners’ salaries among expenses has been opposed by some accountants
on grounds that partners’ salaries may be set at unrealistic levels and that a partnership is an
association of individuals who are owners and not employees of the partnership.
A partnership has the characteristics of a separate entity in that it may hold title to property,
may enter into contracts, and sue or be sued as an entity. In practice, most accountants treat
partnerships as separate entities with continuity of accounting policies and asset valuations not
interrupted by changes in partnership personnel.

1.2 Accounting for Partnership Formation and Operation

1.2.1 Partners’ Accounts
Accounting for partnership differs from accounting for a sole proprietorship or a
corporation with respect to the sharing of net income and loss and maintenance of the
partners’ ledger accounts. Although it might be possible to maintain partnership accounts with

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only one ledger for each partner, the usual practice is to maintain three types of accounts for
each partner:
 Capital accounts
 Drawing or personal accounts
 Accounts for loans to and from partners
Capital accounts
Are used to record:
o The initial investment of a partner
o Any subsequent capital contributions
o Profit or loss distributions
o Any withdrawals are ultimately recorded in the partner’s capital account
 Each partner has one capital account. This account usually has a credit balance
representing the partner’s share in the net assets of the partnership.
 A partner’s capital account may have a debit balance in some occasions called a
deficit. Such a deficit should be eliminated by additional capital contribution.
Drawing accounts
 Used to record the periodic withdrawals of cash or other assets by a partner in
anticipation of profit
 The balance of this account is closed to the partner’s capital account at the end of
the period
Loan accounts
 The partnership may borrow from or lend money to its partners. Such transactions
are recorded in loan accounts opened in the name of each partner like any other loan.

1.2.2 Loans to and from Partners

A partner may withdraw cash from the partnership with the intension of repaying the
amount. Such a transaction may be debited to the Loans Receivable from Partner account
rather than the drawing account.
Conversely, a partner may make a cash advance to the partnership that is considered a loan
than a capital contribution. This transaction may also be credited to Loan Payable to Partner
than the capital account and accompanied by a promissory note. Amounts due from partners
are reported as assets in the balance sheet and amounts owing to partners shown as liabilities.
If a substantial unsecured loan is made to a partner and repayment appears doubtful, it is
preferable to offset the receivable against the partner’s capital account. A separate listing of
any receivables from partners should be made as per the disclosure principle.

1.2.3 Valuation of Investment by Partners

Investment by partners in the firm often includes assets other than cash. It is imperative
that partners agree on the current fair value of assets at the time of investment and that the
assets be recorded at such values.
Equitable treatment of individual partners requires a starting point of current fair values
recorded for all non cash assets invested by each partner.

1.2.4 Income Sharing Plans

The equity of a partner in the net assets of the partnership should be distinguished from a
partner’s share in earnings as partners may agree of income sharing plan regardless of their
respective capital account balances. If partners fail to specify a profit sharing plan, it shall be
assumed that they intend to share equally.

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 The many possible plans for sharing of net income or loss may be summarized in the
following four categories:
 Equally or in some other ratio
 In the ratio of partners’ capital account balances in particular date, or in the ratio of
average capital account balances during the year.
 Allowing salaries to partners and dividing the remaining net income or loss in a
specified ratio
 Allowing salaries to partners, allowing interest on capital account balances, and
dividing the remaining net income or loss in a specified ratio.
These variations of income sharing plans emphasize that the value of personal services
rendered by individual partners may vary widely, as may the amounts of capital invested by
each partner. The amount and quality of managerial service rendered and the amount of capital
invested often are important factors in the success or failure of a partnership. Therefore,
provisions may be made for salaries to partners and interest on their respective capital as
preliminary step in the division of net income or loss.
Other factors contributing to the success of the partnership like personal financial resources
of partners and popularity in profession or industry may also be considered while selecting an
income sharing ratio.

Illustration
An illustration of partnership formation and operation follows
Example 1: Partnership Formation
A, a sole proprietor, has been developing software for several types of microcomputers.
The business has the following account balances as of Dec. 31, 20X0:
Cash 3,000
Inventory 7,000
Equipment 20,000
Accumulated Dep.-Equipment 5,000
Liabilities 10,000
A, Capital 15,000

A needs additional technical assistance to meet the increasing sales and offers B an interest in
the business. A and B agree to form a partnership. A’s business is audited, and its net assets
appraised. The audit and appraisal disclosed that:
 Br. 1,000 of liabilities has not been recorded
 Inventory has a market value of Br. 9,000
 Equipment has a fair value of Br. 19,000
A and B prepare and sign articles of partnership that include all significant operating
policies. Accordingly, B will contribute Br. 10,000 for a one-third capital interest. The AB
partnership is to acquire all of A’s business and assume its debts.
Required: Prepare a journal entry to record the initial capital contribution of AB
partnership.
January 1, 20X1
Cash 13,000
Inventory 9,000
Equipment 19,000
Liabilities 11,000
A, Capital 20,000
B, Capital 10,000

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 Example 2: Cash withdrawal by a partner
Partner B made cash withdrawal of Br. 3,000 on May 1, 20X1. The journal entry for this
transaction would be:
B, Drawing 3,000
Cash 3,000
Example 3: Loan from a partner
A Br. 4,000, 10 % one year loan agreement is signed by the partnership with partner A and
cash received on July 1, 20X1. The entry to record this transaction would be:
Cash 4,000
Loan Payable, A 4,000

Example 4: Profit allocation

During 20X1, the AB partnership earned a profit of Br. 10, 000. A maintained a capital
balance of Br. 20, 000 during the year, but B’s capital made the movements shown below:
Date Debit Credit Balance
January 1 10, 000
May 1 3, 000 7,000
September 1 500 7,500
November 1 1,000 6,500
December 1 6,500

The debits of Br. 3, 000 and Br. 1, 000 are recorded in B’s drawing account, while the
Additional investment of 500 is credited to the partner’s capital account.
Case 1: If A and B agree upon a profit share ratio of 60 % to A and 40% to B, the net income
is to be distributed as follows:
A B Total
Net income 10,000
Allocation 60: 40 6,000 4,000 (10,000)
Total 6,000 4,000 -0-

This schedule shows the allocation of net income to the partners, the actual distribution is
accomplished by closing the Income Summary account to partners’ capital accounts. The
drawing accounts are also closed to capital accounts. The following are the closing entries.
December 31, 20X1
B, Capital 4, 000
B, Drawing 4,000
To close B’s drawing account
Income Summary 10,000
A, Capital 6,000
B, Capital 4,000
To close income summary account
Case 2: A and B agreed to allow interest of 15 % on the weighted-average capital balances
with any remaining profit to be distributed in 60: 40 ratio.
A’s capital was 20,000 throughout the year; the average capital of B is computed as
follows:
Date Debit Credit Balance Month Month times Birr
Maintained Balance
January 1 10,000 4 40,000
May 1 3,000 7,000 4 28,000

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 September 1 500 7,500 2 15,000
November 1 1,000 6,500 2 13,000
Total 12 96,000
Average capital (96,000/12 months) 8,000
Distribution of the Br. 10,000 profit under this alternative would be as follows:
A B Total
Net income 10,000
Interest on average cap (15%) 3, 000 1,20 (4,200)
Residual income 3:2 3,480 2,320 (5,800)
Total 6,480 3,520 -0–
Journal entry to record the profit allocation is:
Income Summary 10,000
A, Capital 6,480
B, Capital 3,520
To close income summary account
Case 3: The partnership agreement provides for salaries of Br. 2,000 to A and Br. 5,000 to B.
Any remainder is to be distributed at 60: 40 ratio. The profit distribution, under this
alternative, is computed as follows:
A B Total
Net income 10,000
Salary 2, 000 5,000 (7,000)
Residual income 3:2 1,800 1,200 (3,000)
Total 3,800 6,200 -0–
Case 4: The income sharing agreement provides that a bonus of 10 % on income in excess of
Br. 5,000 is to be credited to B before distributing the remaining profit in 60: 40 ratio. In this
case, there are two alternatives to compute the bonus:
 As a percentage of income before subtracting bonus, or
 As a percentage of income after subtracting bonus

Case 5: The income sharing plan of AB partnership specifies the following profit or loss
allocation method:
 Interest of 15% on weighted average capital balances
 Salaries of Br. 2,000 for A and Br. 5,000 for B
 A bonus of 10% to B on income exceeding Br. 5,000
 Any residual income to be allocated 60% to A and 40% to B
Income distribution as per the above would be:
A B Total
Net income 10,000
Interest (15%) 3,000 1,200 (4,200)
Remaining balance 5,800
Salary 2,000 5,000 (7,000)
Deficiency (1,200)
Bonus 500 (500)
Deficiency (1,700)
Allocation 60: 40 (1,020) (680) 1,700
Total 3,980 6,020 -0–

Partnership Financial Statements

The three financial statements viz. income statement, balance sheet, and statement of cash
flows are typically prepared for the partnership at the end of each reporting period. A

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statement of partners’ capital is also prepared in addition to present the changes in the
partners’ capital accounts during the period. The statement of partners’ capital account for
the AB Partnership for the year ended December 31, 20X1 under the multiple base profit
distribution described above would be as follows:
AB Partnership
Statement of Partners’ Capital
For the Year Ended December 31, 20X1
A B Total
Balance, Jan. 1, 20X1 20,000 10,000 30,000
Add: Additional invest 500 500
Net income distribution 3,980 6,020 10,000
23,980 16,520 40,500
Less: Withdrawal - (4,000) (4,000)
Balance Dec. 31, 20X1 23,980 12,520 36,500

2.2.5 Changes in Personnel\Changes in Ownership

Most changes in ownership of partnerships are accomplished without interruption of its
operations and there is usually no significant change in the finances or operating routines of
the partnership. However, from a legal view point a partnership is dissolved by the retirement
or death of a partner or by the admission of a new partner.

Admission of a New Partner

Adjustment of the partnership accounting records may be necessary to restate the carrying
amounts of assets and liabilities to current fair value before a new partner is admitted. As an
alternative to revaluation of the existing partnership assets, it may be preferable to evaluate
any discrepancies between the carrying amounts and current fair values and adjust the terms of
admission of a new partner. In this way, the amount invested by the incoming partner may be
set at a level that reflects the current fair value of the partnership, even though the carrying
amounts of existing partnership assets remain unchanged in the accounting records.
The admission of new partner to a partnership may be effected either by an acquisition of
all or part of the interest of one or more of the existing partners or by an investment of assets
by the new partner with a resultant increase in the net assets of the partnership.

Acquisition of an Interest by Direct Payment to One or More Partners

If a new partner acquires an interest from one or more of the existing partners, the event is
recorded by establishing a capital account for the new partner and decreasing the capital
account balances of the selling partners by the same amount. No assets are received by the
partnership; the transfer ownership is a personal transaction between the partners.
Illustration: L and M are partners of L&M Partnership sharing earnings equally and each
has a capital account balance of 60,000. Partner N (with the consent of M) acquires one half of
L’s interest in the partnership. The journal entry to record this change would be:
L, Capital (1/2of 60,000) 30,000
N, Capital 30,000
To record transfer of one-half of L’s capital to N
 This transfer has caused no change in the assets, liabilities or total partners’ capital.

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  The price paid for a partnership interest by a new partner to an existing partner does
not provide sufficient evidence to support changes in the carrying amounts of the partnership’s
assets.

Investment in Partnership by a New Partner

A new partner may gain admission by investing assets in the partnership, thus increasing the
total assets and partners’ capital of the partnership.
Assume that X and Y, partners of the X&Y Partnership, share net income or net loss
equally and that each has a capital account balance of Br. 60,000. Assume also that the
carrying amounts of the partnership assets are approximately equal to current fair values and
that Z owns land that could be used for expansion of partnership operations. X and Y agree to
admit Z to the partnership by investment of the land; net income and loss of the new firm are
to be shared equally. The land had cost Z
Br. 50, 000, but has a current fair value of 80,000. The admission of Z to the partnership is
recorded as follows:
Land 80,000
Z, Capital 80,000
To record admission of Z to partnership.
Z has 80,000 capital account balance and owns 40% interest in the firm.

Bonus or Goodwill Allowed to Existing Partners

In a profitable well-established firm, the partners may insist that a portion of the investment
by a new partner be allocated to them as bonus or that goodwill be recorded and credited to
existing partners.
Bonus to Existing Partners
In the C&D Partnership, C and D share net income or losses equally and have capital
account balances of Br. 45,000 each. The carrying amounts of the partnership net assets
approximate current fair values. The partners agree to admit E to a one third in capital and a
one third interest in earnings for a cash investment of Br. 60,000. The total capital of the new
firm amounts to Br. 150,000 (45,000+45,000+60,000) and one third of that is Br. 50,000
resulting in bonus of 10,000 to the existing partners. Hence, the following entry:
Cash 60,000
C, Capital (10,000*1/2) 5,000
D, Capital (10,000*1/2) 5,000
E, Capital (150,000*1/3) 50,000
To record investment by E for one third interest in capital, with bonus of 10,000 divided
equally between C and D.
Goodwill to Existing Partners
In the previous illustration, E might prefer that the full amount invested, 60,000, be credited
to his account. That could be done while still allotting E a one third interest if goodwill is
recorded by the partnership, with the offsetting credit divided between the two existing
partners.
If a one third interest given to E is represented by a capital account balance of 60,000, the
total capital of the partnership is Br. 180,000 (60,000*3) and the total capital of C and D must
equal 120,000. A write up of 30,000 is required as their present combined capital balance is
Br. 90,000. Journal entry;
Cash 60,000
Goodwill 30,000
C, Capital (30,000*1/2) 15,000
D, Capital (30,000*1/2) 15,000

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 E, Capital 60,000
To record investment by E for a one third interest in capital, with credit offsetting goodwill
of 30,000 divided equally between C and D.

Evaluation of Bonus and Goodwill Methods

When a new partner invests an amount larger than the carrying amount of the interest
acquired, the transaction should be recorded by allowing bonus to the existing partners. The
bonus method adheres to the valuation principle and treats the partnership as a going concern
while use of the goodwill method signifies the substitution of estimated current fair value of
an asset rather than valuation on a cost basis. The existence of goodwill is implied by the
amount invested by the new partner.
The presence of goodwill created in this manner is likely to evoke criticism of the
partnership’s financial statements, and such criticism may cause the partnership to write off
the goodwill.
Does the recording of goodwill and its subsequent write off injure one partner and benefit
another? The net results to the individual partners will be the same under the bonus and
goodwill methods only if two specific conditions are met:
 the new partner’s share of net income or losses must be equal to the percentage
equity in net assets the new partner receives at the time of admission
 the existing partners must continue to share net income or loss between themselves
in the same ratio as in the original partnership
Assume, however, that C, D, &E agreed to share net income or losses 40%, 40%, and 20%
respectively. The goodwill method would benefit E and injure C and D as compared with the
bonus method.

Partner C Partner D Partner E Combined

Capital a\c balance:
Bonus method 50,000 50,000 50,000 150,000
Capital a\c balance:
Goodwill method 60,000 60,000 60,000 180,000
Write off of goodwill (40%, 40%, 20%)
(12,000) (12,000) (6,000) (30,000)
Capital a/c balance after write off
48,000 48,000 54,000 150,000

From the above analysis we can conclude that: when the new partner’s share of net income
or loss is less than the new partner’s share of assets, the new partner will benefit from the use
of the goodwill method.
Under the above illustration it is assumed that the carrying amounts of assets in the original
partnership approximated current fair values. But if the current fair values some assets like
land building is different from the book values, write up of such assets with a corresponding
increase in the capital account balances of the existing partners would avoid the necessity for a
bonus or the recognition of goodwill to record the admission of the new partner.

Bonus or Goodwill Allowed to New Partner

The present firm may offer a new partner a larger equity in net assets than the amount invested
by the new partner in recognition of the new partner’s skill and business contacts or its cash
needs.

Bonus to New Partner

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F and G, who share net income and losses equally and have capital account balances of Br.
35,000 each, offer H a one-third interest in net assets and a one-third share of net income or
losses for an investment of Br. 20,000 cash. The investment by H when added to the existing
capital of Br. 70,000 brings the total capital to Br. 90,000 and H’s interest there in is Br.
30,000 (90,000*1/3). The difference between H’s investment and interest in capital (30,000-
20,000 = 10,000) represents bonus allowed to H by F and G. the journal entry to record
admission of H to the partnership would be:

Cash 20,000
F, Capital (10,000*1/2) 5,000
H, Capital (10,000*1/2) 5,000
H, Capital 30,000
To record admission of H, with bonus of Br.10,000 from F and G.
 In the above illustration it is assumed that the net assets of the partnership were
valued properly
 Writing down of the assets to 40, 000 should be considered especially if trade
accounts receivable included doubtful accounts or if inventories were obsolete.

Goodwill to New Partner

Assume all the other data is the same as above except that H is the owner of a successful
single partnership that H invests in the partnership rather than a cash investment. The
identifiable tangible and intangible net assets of the proprietorship are worth 20,000 but a
current fair value for the assets is agreed to be 35,000. The admission of H to the partnership
is recorded as follows:

Identifiable tangible and intangible net assets 20,000

Goodwill 15,000
H, Capital 35,000
To record admission of H; goodwill is assigned to single proprietorship invested by H.
 Goodwill is recognized as part of the investment of a new partner only when the
new partner invests in the partnership a business enterprise of superior earning power.

Retirement of a Partner
A partner has always the authority to withdraw, as distinguished from the right to withdraw.
A partner who withdraws in violation of the terms of the partnership contract, and without
consent of the other partners, may be liable for damages to the other partners.
In measuring the equity of a retiring partner:
 The partner’s capital account is the starting point. Adjustments for correction of
errors or for differences between the carrying values and current fair values of net assets may
be necessary.
 The partnership contract should be referred to for provisions regarding computation
of the amount to be paid a retiring partner. The contract may require audit by independent
auditors or valuation of the partnership as a going concern.
 If the partnership doesn’t contain provisions for the computation of retiring
partner’s equity, the accountant may obtain authorization from the partners to use a specific
method to determine an equitable settlement price.
 The equity of a retiring partner is computed on the basis of current fair values of
partnership net assets with gain or loss arising from the difference between the current fair
value and carrying value divided in the income sharing ratio.

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  The partners may agree to settle by payment of the computed amount or a different
amount.

Payment of Bonus to Retiring Partner

Assume that L is to retire from the J, K &L Partnership. Each partner has a capital account
balance of Br. 60,000, and net income and losses are shared equally. The partnership contract
provides that a retiring partner is to receive the balance of his\her capital account plus a share
of any goodwill. At the time of L’s retirement, goodwill in the amount of Br. 30,000 is
computed to the mutual satisfaction of the partners.
But there is no reliable evidence to record such goodwill in the accounts except estimate of
the partners. Therefore, it is not appropriate to enter this goodwill in the accounting records of
the partnership. The portion paid to the retiring partner would, however, be treated as bonus as
shown in the following journal entry.
L, Capital 60,000
J, Capital (10,000*1/2) 5,000
K, Capital (10,000*1/2) 5,000
Cash 70,000
To record payment to retiring partner L, including bonus of Br. 10,000.

Settlement with Retiring Partner for Less than Carrying Amount

A retiring partner may accept less than his\her equity on retirement due to:
o Anxiety to escape from an unsatisfactory business situation
o Personal problems
o Consideration that the partnership assets are overvalued
o Anticipation of less net income in future years
The preferred accounting treatment under such circumstances is to leave net asset valuation
undisturbed unless a large amount of goodwill is carried in the accounting records. The
difference between the retiring partner’s capital account and the amount paid in settlement
should be credited as a bonus to the continuing partners.
M, N and P share net income or losses equally, and that each has a capital account balance
of Br. 60,000. N retires from the partnership and receives Br. 50,000. The journal entry to
record N’s retirement is:
N, Capital 60,000
Cash 50,000
M, Capital (10,000*1/2) 5,000
P, Capital (10,000*1/2) 5,000
To record retirement of partner N for an amount less than carrying amount of N’s equity.
The final settlement with retiring partner is often differed for some time to permit:
o The accumulation of cash
o Measurement of net income to date of withdrawal
o Obtaining of bank loans
o Or other acts needed to complete the transaction
The retirement of a partner doesn’t terminate the retiring partner’s responsibility for general
partnership liabilities existing on the retirement date.

Death of a Partner
A partnership contract often provides:
o Partners shall acquire life insurance policies on each others’ lives so that cash will
be available for settlement with the estate of a deceased partner.

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 o A buy-sell agreement wherein the surviving partners acquire equities of the
deceased partner
o The surviving partners are given an option to buy, or right of first refusal, rather
than imposing on the partnership an obligation to acquire the deceased partner’s equity.

1.3 Accounting for Dissolution and Liquidation of Partnerships

1.3.1 Conditions for Dissolution and Liquidation

Dissolution is a term used to describe events ranging from a minor change of ownership
interest not affecting operations of the partnership to a decision by the partners to terminate a
partnership.
Conditions for dissolution of a partnership may, therefore, be:
 Bankruptcy of the firm or any partner
 The expiration of the time period stated in the partnership contract
 Mutual agreement of the partners to end their association
Accountants are concerned with the economic substance of a transaction than its legal form
and evaluate all the circumstances of the individual case and determine how the change should
be recorded.
Liquidation means winding up partnership activities, usually by selling assets, paying
liabilities and distributing any remaining cash to partners.
A business enterprise that has ended normal operations and is in the process of converting
its assets to cash and making settlement with its creditors is said to be in liquidation, or in the
process of being liquidated.
Another commonly used term in liquidation is realization, which means the conversion of
assets to cash.

1.3.2 Distribution of Loss or Gain

When the decision to liquidate the partnership is made, the accounting records of the
partnership should be adjusted and closed, and the net income or loss for the final period of
operations entered in the accounts of the partners.
The losses or gains from realization of assets are divided among the partners in the income
sharing ratio and entered in their capital accounts. The underlying theme under the
circumstances is:
Divide the loss or gain from realization before distributing the cash.
The income sharing ratio used during the operation is applicable upon liquidation also unless
the partners have a different agreement.
When the net loss or gain from liquidation is divided among the partners, the final balance of
the partner’s capital and loan ledger accounts will be equal to the cash available for
distribution. Payments are then made in the amounts of the partner’s respective equities in the
partnership.

1.3.3 Distribution of Cash

The Uniform Partnership Act lists the order for distribution of cash by a liquidating
partnership as:
 Payment of creditors in full
 Payment of loans from partners
 Payment of partners’ capital account credit balances

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 The indicated priority of partners’ loan over partners’ capital appears to be a legal provision
which is usually nullified for practical purposes by an established legal doctrine called the
right of offset. If a partner’s capital account has a debit balance or even a potential debit
balance depending upon possible future realization of losses, any credit balance in the
partner’s loan account must be offset against the deficit or potential deficit in the capital
account. However, if a partner with a loan account receives any cash, it is debited to the loan
account to the extent of the balance of that account. Furthermore, the existence of a partner’s
loan account will not advance the time of payment to any partner during liquidation.
The amount of cash, if any, that a partner is entitled to receive in liquidation can not be
determined until the partners’ capital accounts have been adjusted for any loss or gain on the
realization of the assets.
1.3.4 Settlement of Partners’ Capital Balances
The amount each partner receives from the liquidation of a partnership will be equal to:
 The capital invested, whether recorded in a capital or loan account
 A share of operating net income or loss minus drawings
 A share of loss or gain from realization of assets
If the negative factors are larger, the partner will have a capital deficit (a debit balance in
the capital account), and must pay the amount of such deficit. Failure to effect such payment
would mean the partner had not complied with provisions of the partnership contract for
sharing net income or loss and cause the other partners to receive less than their equity in the
partnership. Illustration follows:
Equity of Each Partner is Sufficient to Absorb Loss from Realization
Assume that A and B, who share net income and losses equally, decide to liquidate their
partnership.

A balance sheet on 30 June 1999, just prior to liquidation follows:

A & B Partnership
Balance Sheet
June 30, 1999
Assets
Cash 10,000.00
Other assets 75,000.00
Total 85,000.00

Liabilities and Partners’ Capital

Liabilities 20,000.00
Loan Payable to B 20,000.00
A, Capital 40,000.00
B, Capital 5,000.00
Total 85,000.00

 Non cash assets with a carrying amount of Br. 75,000.00 realized cash of Br.
35,000.00, with the resultant loss absorbed by A and B.
 The accountant exercises the right of offset by transferring Br. 15,000.00 from B’s
loan account to his capital account.

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 A & B Partnership
Statement of Realization and Liquidation
July 1-15, 1999
Assets Partners’ Capital
Cash Other Liabilities B Loan A (50%) B (50%)

Balances before liquid 10,000 75,000 20,000 20,000 40,000 5,000

Realization at a loss of 40,000 35,000 (75,000) (20,000) (20,000)
Balances 45,000 20,000 20,000 20,000 (15,000)
Payment to Creditors (20,000) (20,000)
Balance 25,000 20,000 20,000 (15,000)
Offset B’s loan (15,000) 15,000
Balance 25,000 5,000 20,000
Payments to Partners (25,000) (5,000) (20,000)

From the above it is apparent that partner’s loan account has no special significance in the
liquidation process. Therefore, in succeeding illustrations, whenever a partner’s loan account
is involved its balance will be combined with the partner’s capital account balance.

Equity of One Partner Not Sufficient to Absorb Loss From Realization

In this case, distribution of loss on realization of assets as per the income sharing ratio
results in debit balance in capital account of one of the partners. The partner must pay
sufficient cash to the partnership to eliminate any capital deficit. If the partner is unable to do
so, the deficit must be absorbed by the other partners as an additional loss in the same
proportion as they have previously shared net income or loss among themselves. To illustrate,
assume the following balance sheet for DEF Partnership just prior to liquidation:
D, E &F Partnership
Balance Sheet
May 20, 1999

Assets Liabilities & Partners’ Capital

Cash 20,000 Liabilities 30,000

D, Capital 40,000
Other assets 80,000 E, Capital 21,000
F, Capital 9,000
Total 100,000 Total 100,000

 The income sharing ratio is 20%, 40%, and 40% to D, E, and F respectively.
 The other assets with carrying amount of Br. 80,000 realized Br. 50,000 cash.

D,E &F Partnership

Statement of Realization and Liquidation
May 21 to 31, 1999

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 Assets Partners’ Capital
Cash Other Liabilities D (20%) E(40%) F(40%)

Balance before liquidation 20,000 80,000 30,000 40,000 21,000 9,000

Realization 50,000 (80,000) (6,000) (12,000) (12,000)
Balances 70,000 30,000 34,000 9,000 (3,000)
Payment to creditors (30,000) (30,000)
Balance 40,000 34,000 9,000 (3,000)
Cash from F 3,000 3,000
Balances 43,000 34,000 9,000 0
Payment to partners (43,000) (34,000) (9,000) 0

Change one condition of the following illustration by assuming that partner F was not able to
pay the 3,000 capital deficit to the partnership. If the cash available is to be distributed without
delay, the statement of realization and liquidation would appear as:

D,E &F Partnership

Statement of Realization and Liquidation
May 21 to 31, 1999

Assets Partners’ Capital

Cash Other Liabilities D (20%) E(40%) F(40%)

Balance before liquidation 20,000 80,000 30,000 40,000 21,000 9,000

Realization 50,000 (80,000) (6,000) (12,000) (12,000)
Balances 70,000 30,000 34,000 9,000 (3,000)
Payment to creditors (30,000) (30,000)
Balance 40,000 34,000 9,000 (3,000)
Payment to partners (40,000) (33,000) (7,000) 0
Balance 1,000 2,000 (3,000)

The cash payments made to D and E leaves both with a sufficient capital account balance to
share their share of the additional loss if F is unable to pay the Br. 3,000 to the partnership.
If the Br. 3,000 is later collected from F, this amount will be divided Br. 1,000 to D and Br.
2,000 to E. However, if the 3,000 from F is uncollectible the statement of realization and
liquidation is completed with the write off of F’s capital deficit as additional loss to D and E.

Equities of Two Partners Are Not Sufficient to Absorb Their Shares of Loss From Realization
One capital deficit, if uncollectible, may cause a second capital deficit that may or may not be
collectible. In other words, a partner may have sufficient credit balance in his capital and loan
accounts to cover losses from realization but may not have sufficient equity to absorb loss
caused by inability of the partnership to collect the deficit in another partner’s capital account.
Assume that J, K, L and M share net income and loss 10%, 20%, 30%, and 40%
respectively.

J, K, L &M Partnership
Statement of Realization and Liquidation
August 1 to 15, 1999

Assets Partners’ Capital

Cash Other Liab. J (10%) K(20%) L(30%) M(40%)

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 Balance before liquid. 20,000 200,000 120,000 30,000 32,000 30,000 8,000
Realization 120,000 (200,000) (8,000) (16,000) (24,000) (32,000)
Balances 140,000 120,000 22,000 16,000 6,000 (24,000)
Payment to creditors (120,000) (120,000)
Balance 20,000 22,000 16,000 6,000 (24,000)
Payment to partners (20,000) (16,000) (4,000)
Balance 6,000 12,000 6,000 (24,000)

J, K, L &M Partnership
Statement of Realization and Liquidation
August 1 to 15, 1999
Partners’ Capital J (10%) K(20%) L(30%) M(40%)

Balance before cash dist 22,000 16,000 6,000 (24,000)

Additional loss to J, K, l, &M
(10: 20: 30) (4,000) (8,000) (12,000) 24,000
Balance 18,000 8,000 (6,000)
Additional loss to J & K (2,000) (4,000 6,000
Amount that may be paid to partner 16,000 4,000

Partnership is Insolvent but Partners Are Solvent

A partnership is insolvent means it is unable to pay all outside creditors. In such cases, the
total of the capital account debit balances exceeds the total of the credit balances. If the
partner\partners with deficit pay the required cash, the partnership will be able to pay its
liabilities. However, the partnership creditors may demand payment from any solvent partner
whose actions caused the partnership’s insolvency, regardless of whether the partner’s capital
account has a debit or a credit balance.
Any partner who makes payments to partnership creditors receives credit to his or her
capital account.
 N, O, & P partnership is liquidated on May 10,1999
 Other assets with Br. 85,000 carrying amount realize Br. 40,000 cash
 Total cash available of Br. 55,000 is paid to creditors leaving unpaid balance of Br.
10,000

N, O & P LLP
Statement of Realization and Liquidation
May 11 to 31, 1999

Assets Partners’ Capital

Cash Other Liabilities N (1/3) O(1/3) P(1/3)

Balance before liquidation 15,000 85,000 65,000 18,000 10,000 7,000

Realization 40,000 (85,000) (15,000) (15,000)
(15,000)

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 Balances 55,000 65,000 3,000 (5,000)
(8,000)
Partial Pmt to creditors (55,000) (55,000)
Balance 0 10,000 3,000 (5,000) (8,000)
Cash by O & P 13,000 5,000 8,000
Balance 13,000 10,000 3,000
Final Pmt to creditors (10,000) (10,000)
Balance 3,000 3,000
Payment to N (3,000) (3,000)

General Partnership is Insolvent and Partners Are Insolvent

In an insolvent general partnership with one or more insolvent partners, the relative right of
the following groups would be:
 Assets of the general partnership are first available to partnership creditors
 Assets of the partners are first available to their creditors
o After full payment to the partner’s creditors assets of the partner are
available to partnership creditors whether that partner’s capital account has a debit or a credit
balance
To illustrate, R, S & T Partnership is a general partnership whose partners share net income
or loss equally. On 30 Nov. the partners have the following assets and liabilities other than
their equities in the partnership.
Partner Personal Personal
Assets Liabilities
R 100,000 25,000
S 50,000 50,000
T 5,000 60,000
 Realization of other assets results in Br. 60,000 loss

R, S & T PARTNERSHIP
Statement of Realization and Liquidation
December 1 to 12, 1999
Other Partners’ Capital
Cash Assets Liabilities R (1/3) S (1/3) T (1/3)
Balance before liquidation 10,000 100,000 60,000 5,000 15,000 30,000
Realization 40,000 (100,000) (20,000) (20,000) (20,000)
Balances 50,000 60,000 (15,000) (5,000) 10,000
Partial Pmt to creditors (50,000) (50,000)
Balance 0 10,000 (15,000) (5,000) 10,000
Pmt to PP creditors by R (10,000) 10,000
Balance 0 (5,000) (5,000) 10,000
Cash by R 5,000 5,000
Balances 5,000 (5,000) 10,000
Payment to T (5,000) (5,000)
Balance (5,000) 5,000
Write-off of S’s Deficit (2,500) 5,000 (2,500)
Balances (2,500) 2,500
Cash by R 2,500 2,500
Balances 2,500 2,500
Payment to T/T’s Creditors (2,500) (2,500)

Installment Payment to Partners

Occurs when realization of non cash assets takes longer periods and the partners want to
receive cash as it becomes available rather than waiting until all non cash assets are realized.
Liquidation in installment is, therefore, a process of realizing some assets, paying creditors,
paying the remaining available cash to partners, realizing additional assets, and making

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additional cash payment to partners until all non cash assets are realized and all cash
distributed.

General Principles Guiding Installment Payments

The only safe policy for determining cash payments to partners is assuming the worst case
scenario:
 Assume a total loss on all remaining non cash assets, and provide for all possible
losses, including potential liquidation costs and unrecorded liabilities
 Any partner with a potential capital deficit will be unable to pay anything;
Thus, distribute each installment of cash as if no more cash will be forthcoming.
To illustrate, assume that the partners of UVW Partnership who share net income or loss in a
4:3:2 ratio decide to liquidate the partnership and distribute cash in installments. The balance
sheet just prior to liquidation on July 5, 1999 is as follows:
UVW Partnership
Balance Sheet
July 5, 1999
Assets Liabilities & Partners’ Capital
Cash 8,000 Liabilities 61,000
Other Assets 192,000 U, Capital 40,000
V, Capital 45,000
W, Capital 54,000
Total 200,000 Total 200,000

UVW Partnership
Realization of Other Assets
July 6 to September 30, 1999
Date Book Value Proceed Loss

July 31 62,000 48,500 13,500

August 31 66,000 30,000 30,000
September 30 64,000 32,500 31,500
Total 192,000 111,000 81,000

 Cash distribution is to be made monthly

UVW PARTNERSHIP
Statement of Realization and Liquidation
July 6 to September 30, 1999
Other
Cash Assets Liabilities Partners’ Capital
U (4) V (3) W (2)

Balance before liquida 8,000 192,000 61,000 40,000 45,000 54,000

Realization July, 31 48,500 (62,000) (6,000) (4,500) (3,000)
Balances 56,500 130,000 61,000 34,000 40,500 51,000
Partial Payment to Creditors (56,500) (56,500)
Balances 130,000 4,500 34,000 40,500 51,000
Realization August, 31 30,000 (66,000) (16,000) (12,0000 (8,000)
Balances 30,000 64,000 4,500 18,000 28,500 43,000

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 Final Pmt to Creditors (4,500) (4,500)
Balances 25,500 64,000 18,000 28,500 43,000
Pay to Partners (Sch.2) (25,500) (900) (24,600)
Balances 64,000 18,000 27,600 18,400
Realization 32,500 (64,000) (14,000 (10,500) (7,000)
Balances 32,500 4,000 17,100
11,400
Final pmt to Partners (32,500) (4,000) (17,100) (11,400)

UVW PARTNERSHIP
Schedule of Safe Payment to Partners
Schedule 1: July 31
U (4) V (3) W (2)

Balance before cash distribution 34,000 40,500 51,000

No cash distribution to partners
as creditors are not fully paid yet

Schedule 2: August 31
Balance before cash distribution 18,000 28,500 43,000
Full loss of Br. 64, 000 assets (28,445) (21,333) (14,222)
Balances (10,445) 7,167 28,778
Full absorption of U’s deficit (3:2) 10,445 (6,267) (4,178)
Balances to be distributed 900 24,600

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