Chapter 3

Accounting for Partnerships

 Conceptual Chapter Objectives

C1: Identify characteristics of

partnerships and similar organizations
 Analytical Chapter Objectives

A1: Compute partner return on equity and use

it to evaluate partnership performance
 Procedural Chapter Objectives

P1: Prepare entries for partnership

formation
P2: Allocate and record income and loss
among partners
P3: Account for the admission and
withdrawal of partners
P4: Prepare entries for partnership
liquidation
C1 Partnership Form of
Organization
Voluntary
Voluntary Limited
Limited
Association
Association Partnership
Partnership Life
Life
Agreement
Agreement

Taxation
Taxation

Mutual
Mutual Unlimited
Unlimited
Agency
Agency Co-
Co- Liability
Liability
Ownership
Ownership
of
of Property
Property
C1 Organizations with Partnership
Characteristics
Limited
Limited Limited
Limited
Limited
Limited Liability
Liability Liability
Liability
Partnerships
Partnerships Partnerships
Partnerships Corporations
Corporations
(LP)
(LP) (LLP)
(LLP) (LLC)
(LLC)

••General
General partners
partners ••Protects
Protects innocent
innocent ••Owners
Owners have
have same
same
assume
assume management
management partners
partners from
from limited
limited liability
liability feature
feature
duties
duties and
and unlimited
unlimited malpractice
malpractice oror as
as owners
owners of of aa
liability
liability for
for partnership
partnership negligence
negligence claims.
claims. corporation.
corporation.
debts.
debts.
••Limited
Limited partners
partners have
have ••Most
Most states
states hold
hold all
all ••AA limited
limited liability
liability
no
no personal
personal liability
liability partners
partners personally
personally corporation
corporation typically
typically
beyond
beyond invested
invested liable
liable for
for partnership
partnership has
has aa limited
limited life.
life.
amounts.
amounts. debts.
debts.
 C1

Choosing a Business Form

Proprietorship Partnership LLP LLC S Corp. Corporation
Business entity yes yes yes yes yes yes
Legal entity no no no yes yes yes
Limited liability no no limited* yes yes yes
Business taxed no no no no no yes
One owner allowed yes no no yes yes yes
*A partner's personal liability for LLP debts is lim ited. Most LLPs carry insurance to protect
against m alpractice.

Many
Many factors
factors should
should be
be considered
considered when
when
choosing
choosing the
the proper
proper business
business form.
form.
P1

Organizing a Partnership
Partners
Partners can
can invest
invest both
both assets
assets and
and liabilities
liabilities in
in the
the
partnership.
partnership.

Assets
Assets and
and liabilities
liabilities are
are recorded
recorded atat an
an agreed-
agreed-
upon
upon value,
value, normally
normally fair
fair market
market value.
value.

Asset
Asset contributions
contributions increase
increase the
the partner’s
partner’s capital
capital
account.
account.

Withdrawals
Withdrawals from
from the
the partnership
partnership decrease
decrease the
the
partner’s
partner’s capital
capital account.
account.
P1

Organizing a Partnership
On
On 2/15/08,
2/15/08, Smith
Smith and
and Jones
Jones form
form aa
partnership.
partnership. Smith
Smith contributes
contributes $80,000
$80,000
cash.
cash. Jones
Jones contributes
contributes land
land valued
valued atat
$40,000.
$40,000.
Feb. 15 Cash 80,000
Land 40,000
Smith, Capital 80,000
Jones, Capital 40,000
To record initial investment in partnership
 P2

Dividing Income or Loss

Partners are not employees of the partnership but are its
owners. This means there are no salaries reported as
expense on the income statement. Profits or losses of
the partnership are divided on some agreed upon ratio.

Three frequently used methods to divide

income or loss are allocation on:
1. Stated ratios.
1.

2. Capital balances.
2.

3. Services, capital and stated ratios.

3.
P2 Allocation Based on
Stated Ratios
Smith and Jones agree to divide profits or
losses ¾ for Smith and ¼ for Jones. For
2008, the partnership reported net income
of $60,000.
Dec. 31 Income Summary 60,000
Smith, Capital 45,000
Jones, Capital 15,000
To record division of 2008 net income.

$60,000 × ¾ = $45,000
P2 Allocation Based on
Capital Balances
Smith’s capital balance, before division of profits or
losses is $80,000 and Jones’s capital balance is
$40,000. The partnership agreement calls for
income or loss to be allocated based on the
relative capital balances. Net income for 2008 is
$60,000.

Balance Ratio Income Allocation

Smith, Capital $ 80,000 66.67% $ 60,000 $ 40,000
Jones, Capital 40,000 33.33% 60,000 20,000
Totals $ 120,000 100.00% $ 60,000
P2 Allocation Based on
Capital Balances
Smith’s capital balance, before division of profits or
losses is $80,000 and Jones’s capital balance is
$40,000. The partnership agreement calls for
income or loss to be allocated based on the
relative capital balances. Net income for 2008 is
$60,000.

Dr. Cr.
Dec. 31 Income Summary 60,000
Smith, Capital 40,000
Jones, Capital 20,000
To record division of 2008 net income.
P2 Allocation Based on Services,
Capital, and Stated Ratios
Smith and Jones have a partnership agreement with
the following conditions:

 Smith receives $15,000 and Jones receives $10,000
as annual salaries.

 Each partner is allowed an annual interest
allowance of 5% on the beginning-of-year capital
balance.

 Any remaining balance of income or loss is
allocated equally.

 Smith’s capital balance, before division of profits or
losses is $80,000 and Jones’s capital balance is $40,000.
Net income for 2008 is $60,000.
P2 Allocation Based on Services,
Capital, and Stated Ratios
Income Distribution
Smith Jones Remainder
Net income $ 60,000
Salaries $ 15,000 $ 10,000 35,000
Interest 4,000 2,000 29,000
Equal allocation 14,500 14,500 -
Income to each partner 33,500 26,500

$80,000 × 5% = $4,000

$29,000 × ½ = $14,500
 Dr Cr
Dec .31 Income summary 60,000
Smith , Capital 33,500
Jones , Capital 26,500
P2 Partnership Financial
Statements
Assume that during 2008, Smith withdrew $5,000 cash
from the partnership and Jones withdrew $1,000.
Smith and Jones Partnership
Statement of Partners' Equity
For the Year Ended December 31, 2008
Smith Jones Total
Beginning capital balances $ - $ - $ -
Investments by owners 80,000 40,000 120,000
Net income
Salary allowances $ 15,000 $ 10,000
Interest allowances 4,000 2,000
Balance allocated 14,500 14,500
Total net income 33,500 26,500 60,000
Less partners' withdrawals (5,000) (1,000) (6,000)
Ending capital balances $ 108,500 $ 65,500 174,000
P2 Allocation Based on Services,
Capital, and Stated Ratios
Smith and Jones have a partnership agreement with the
following conditions:

 Smith receives $15,000 and Jones receives $10,000 as
annual salaries.

 Each partner is allowed an annual interest allowance of
5% on the beginning-of-year capital balance.

 Any remaining balance of income or loss is allocated
equally.

 Smith’s capital balance, before division of profits or
losses is $80,000 and Jones’s capital balance is
$40,000.
Net income for 2008 is $30,000.
P2 Allocation on Services,
Capital, and Stated Ratios
Income Distribution
Smith Jones Remainder
Net income $ 30,000
Salaries $ 15,000 $ 10,000 5,000
Interest 4,000 2,000 (1,000)
Equal allocation (500) (500) -
Income to each partner 18,500 11,500

($1,000) × ½ = $500
 Dr Cr
Dec .31 Income summary 30,000
Smith , Capital 18,500
Jones , Capital 11,500
P3 Admission and Withdrawal of
Partners
 When
When the
the makeup
makeup ofof the
the partnership
partnership
changes,
changes, the
the partnership
partnership is is dissolved.
dissolved.
 AA new
new partnership
partnership may
may be be immediately
immediately
formed.
formed.
 New
New partner
partner acquires
acquires partnership
partnership interest
interest
by:
by:
1.
1. Purchasing
Purchasing itit from
from the
the other
other partners,
partners, or
or
2.
2. Investing
Investing assets
assets in in the
the partnership.
partnership.
P3

Admission of a Partner
Purchase of Partnership Interest
 AA new
new partner
partner can
can purchase
purchase
partnership
partnership interest
interest directly
directly
from
from the
the existing
existing partners.
partners.

 The
The cash
cash goes
goes to
to the
the partners,
partners,
not
not to
to the
the partnership.
partnership.
 To
To become
become aa partner,
partner, the
the new
new
partner
partner must
must be
be accepted
accepted by by
the
the current
current partners.
partners.
 Purchase of Partnership Interest
P3

On January 2, 2009, Jones agrees to sell Johnson

$10,000 of her partnership interest for $25,000 cash.
Smith agrees with this Arrangement . Capital
balances before admission is Smith $108,500 , Jones
$ 65,500.
Smith Jones Johnson Total
Capital balances before new partner $ 108,500 $ 65,500 $ - $ 174,000
Allocation to new partner (10,000) 10,000 -
Capital balances after new partner $ 108,500 $ 55,500 $ 10,000 $ 174,000

Jan 2 Jones, Capital 10,000

Johnson, Capital 10,000
To record admission of new partner
P3 Investing Assets in a
Partnership
 The
The new
new partner
partner can
can gaingain
partnership
partnership interest
interest by by
contributing
contributing assets
assets to to the
the
partnership.
partnership.
 The
The new
new assets
assets will
will increase
increase
the
the partnership’s
partnership’s netnet assets.
assets.
 After
After admission,
admission, both
both assets
assets
and
and equity
equity will
will increase.
increase.
 P3
Investing Assets in a Partnership
On January 2, 2009, Smith and Jones agree to
accept Johnson as a partner upon his investment
of $30,000 cash in the partnership. Capital
balances before admission is Smith $108,500 ,
Jones $ 65,500.
Smith Jones Johnson Total
Capital balances before new partner $ 108,500 $ 65,500 $ - $ 174,000
Allocation to new partner 30,000 30,000
Capital balances after new partner $ 108,500 $ 65,500 $ 30,000 $ 204,000

Jan 2 Cash 30,000

Johnson, Capital 30,000
To record admission of new partner
P3

Bonus to Old or New Partners

When
When the
the current
current value
value of
of aa
partnership
partnership isis greater
greater than
than the
the
Bonus
Bonus to
to Old
Old recorded
recorded amounts
amounts of of equity,
equity, the
the old
old
Partners
Partners partners
partners usually
usually require
require aa new
new partner
partner
to
to pay
pay aa bonus
bonus when
when joining.
joining.

The
The partnership
partnership may may grant
grant aa bonus
bonus to to
Bonus
Bonus to
to New
New aa new
new partner
partner ifif the
the business
business is is in
in
Partners
Partners need
need of
of cash
cash or
or ifif the
the new
new partner
partner has has
exceptional
exceptional talents.
talents.
P3
Bonus to Old Partners
On January 2, 2009, Smith and Jones agree to
accept Johnson as a partner upon his investment of
$60,000 cash in the partnership. Johnson is to
receive a 20% ownership interest in the new
partnership. Any bonus is attributable to the existing
partners and is shared equally. Capital balances
before admission is Smith $108,500 , Jones $ 65,500.

Equity of Smith and Jones $174,000

Investment by Johnson 60,000
Total partnership equity 234,000
Johnson's ownership percent 20%
Johnson's equity balance $ 46,800
P3

Bonus to Old Partners

On January 2, 2009, Smith and Jones agree to
accept Johnson as a partner upon his investment of
$60,000 cash in the partnership. Johnson is to
receive a 20% ownership interest in the new
partnership. Any bonus is attributable to the existing
partners and is shared equally.
Dr. Cr.
Jan 2 Cash 60,000
Johnson, Capital 46,800
Smith, Capital 6,600
Jones, Capital 6,600
To record admission of new partner
$60,000 - $46,800 = $13,200 × ½ = $6,600
P3 Bonus to New Partner
On January 2, 2009, Smith and Jones agree to
accept Johnson as a partner upon his investment of
$60,000 cash in the partnership. Johnson is to
receive a 30% ownership interest in the new
partnership. Any bonus is attributable to the new
partner and is shared equally by the existing
partners. Capital balances before admission is Smith
$108,500 , Jones $ 65,500.
Equity of Smith and Jones $174,000
Investment by Johnson 60,000
Total partnership equity 234,000
Johnson's ownership percent 30%
Johnson's equity balance $ 70,200
P3

Bonus to New Partner

On January 2, 2009, Smith and Jones agree to accept
Johnson as a partner upon his investment of $60,000
cash in the partnership. Johnson is to receive a 30%
ownership interest in the new partnership. Any
bonus is attributable to the new partner and is
shared equally by the existing partners.
Dr. Cr.
Jan 2 Cash 60,000
Smith, Capital 5,100
Johnson, Capital 5,100
Johnson, Capital 70,200
To record admission of new partner

$70,200 - $60,000 = $10,200 × ½ = $5,100

P3

Withdrawal of a Partner
A
A partner
partner can
can withdraw
withdraw
in
in two
two ways:
ways:

 The
The partner
partner can
can sell
sell
his/her
his/her partnership
partnership
interest
interest to
to another
another
person.
person.

 The
The partnership
partnership can can
distribute
distribute cash
cash and/or
and/or
other
other assets
assets toto the
the
withdrawing
withdrawing partner.
partner.
P3

Withdrawal of a Partner
Jones has a capital balance of $65,500. She decides to
withdraw from the partnership of Smith, Jones, and
Johnson for $50,000 cash. Any bonus is attributable to
the remaining partners and is divided equally.

Dr. Cr.
Jan 2 Jones, Capital 65,500
Cash 50,000
Smith, Capital 7,750
Johnson, Capital 7,750
To record withdrawal of partner

$65,500 - $50,000 = $15,500 × ½ = $7,750

P4

Liquidation of a Partnership
When
When aa partnership
partnership is
is dissolved,
dissolved, four
four steps
steps are
are required:
required:

 Noncash
Noncash assets
assets are
are sold
sold for
for cash
cash and
and aa gain
gain or
or loss
loss
on
on liquidations
liquidations is
is recorded.
recorded.

 Gain
Gain or
or loss
loss on
on liquidation
liquidation is
is allocated
allocated to
to partners
partners
using
using their
their income-and-loss
income-and-loss ratio.
ratio.

 Liabilities
Liabilities are
are paid
paid or
or settled.
settled.

 Any
Any remaining
remaining cash
cash is
is distributed
distributed to
to partners
partners based
based
on
on their
their capital
capital balances.
balances.
P4 No Capital Deficiency
No capital deficiency means that all partners have a zero or credit
balance in their capital accounts.

Smith, Jones, and Johnson agree to dissolve their partnership.

They sell all of their assets for a net gain of $10,000. Profits and losses are
shared as follows: Smith, ½; Jones, ¼; and Johnson, ¼.Beginning Capital
balances , Smith 108,500 , Jones 65,500 , Johnson 30,000

Smith Jones Johnson Total

Beginning capital balances $ 108,500 $ 65,500 $ 30,000 $ 204,000
Allocation of $10,000 net gain 5,000 2,500 2,500 10,000
Capital balances for dissolution $ 113,500 $ 68,000 $ 32,500 $ 214,000

Dr. Cr.
Dec 2 Smith, Capital 113,500
Jones, Capital 68,000
Johnson, Captial 32,500
Cash 214,000
P4 Capital Deficiency

Capital deficiency means that at least one partner

has a debit balance in his/her capital account. A
partner with a deficit must, if possible, cover the
deficit by paying cash into the partnership.

Smith, Jones, and Johnson agree to dissolve their partnership.

They sell all of their assets for a net loss of $10,000. Profits and losses are
shared as follows: Smith, ½; Jones, ¼; and Johnson, ¼. Beginning Capital
balances , Smith 25,000 , Jones 10,000 , Johnson 2,000

Smith Jones Johnson Total

Beginning capital balances $ 25,000 $ 10,000 $ 2,000 $ 37,000
Allocation of $10,000 net loss (5,000) (2,500) (2,500) (10,000)
Subtotal 20,000 7,500 (500) 27,000
Contribution by Johnson 500 500
Capital balances for dissolution $ 20,000 $ 7,500 $ - $ 27,500
P4

Capital Deficiency
Smith Jones Johnson Total
Beginning capital balances $ 25,000 $ 10,000 $ 2,000 $ 37,000
Allocation of $10,000 net loss (5,000) (2,500) (2,500) (10,000)
Subtotal 20,000 7,500 (500) 27,000
Contribution by Johnson 500 500
Capital balances for dissolution $ 20,000 $ 7,500 $ - $ 27,500

Dec 2 Cash 500

Any partner’s unpaid
Johnson, Capitaldeficiency
500 is
To make-up deficiency
absorbed by the remaining partners
Dec 2 Smith, Capital 20,000
with credit
Jones,balances
Capital in 7,500
accordance
Cash 27,500
with the partnership agreement.
To liquidate partnership
P4

Death of a Partner
 A partner’s death dissolves a
partnership.
 A deceased partner’s estate is entitled
to receive the equity.
 This usually requires closing the books
to determine the net income or loss at
the date of death and also recording
market values for assets and liabilities.
A4

Partner Return on Equity

Partner return Partner net income
=
on equity Average partner equity

Boston Celtics
Total LP I LP II Celtics LP
Balance, Beginning of year $ 84 $ 122 $ (307) $ 270
Net income (loss) for year 216 44 61 111
Cash distribution (48) - - (48)
Balance, End of year $ 252 $ 166 $ (246) $ 333
Partner return on equity 128.6% 30.6% NA 36.8%
End of Chapter 12