When two or more individuals engage in enterprise as co-owners, the organization is known as a partnership. This form of organization is popular among personal service enterprises, as well as in the legal and public accounting professions. The important features of and accounting procedures for partnerships are discussed and illustrated below.
Accounting for initial investments
As ownership rights in a partnership are divided among two or more partners, separate capital and drawing accounts are maintained for each partner.
Investment of cash
If a partner invested cash in a partnership, the Cash account of the partnership is debited, and the partner's capital account is credited for the invested amount.
Investment of assets other than cash
If a partner invested an asset other than cash, an asset account is debited, and the partner's capital account is credited for the market value of the assets.
If a certain amount of money is owed for the asset, the partnership may assume liability. In that case an asset account is debited, and the partner's capital account is credited for the difference between the market value of the asset invested and liabilities assumed.
Capital interest
A capital interest is an interest that would give the holder a share of the proceeds in either of the following situations:
The owner withdraws from the partnership. The partnership liquidates.
The mere right to share in earnings and profits is not a capital interest in the partnership. This determination generally is made at the time of receipt of the partnership interest.
Capital accounting
Capital account of each partner represents his equity in the partnership.
Capital account of a partner is increased in the following situations:
The owner made additional investments during the year. The owner made guaranteed payments to the firm. Partnership earned profits, and a share of profits was allocated to the partner.
The increase in the capital will record in credit side of the capital account.
Salary and interest allowances are guaranteed payments, discussed later.
Capital account of a partner is decreased when the owner makes withdrawals of cash or property
Compensation for services and capital
The partnership agreement may specify that partners should be compensated for services they provide to the partnership and for capital invested by partners.
For example, one partner contributed more of the assets, and works full-time in the partnership, while the other partner contributed a smaller amount of assets and does not provide as much services to the partnership.
Compensation for services is provided in the form of salary allowance. Compensation for capital is provided in the form of interest allowance. Amount of compensation is added to the capital account of the partner.
To illustrate, assume that a partner received $500 as an interest allowance. The amount is included in the net income/loss distribution entry when the books are closed to the capital accounts at year end:
Debit Credit Partner A, Capital $500 Income Summary $500
As a result, the above entry Income Summary, which is a temporary equity closing account used for year-end, is reduced by $500, and the capital account is increased by the same amount.
When the partner makes a cash withdrawal of moneys he received as an allowance, it is treated as a withdrawal, or drawing.
Debit Credit Partner A, Drawing $500 Cash $500
As a result, Drawing account increased by $500, and the Cash account of the partnership is reduced by the same account.
At the end of the accounting period the drawing account is closed to the capital account of the partner. The capital account will be reduced by the amount of drawing made by the partner during the accounting period.
Guaranteed payments
Guaranteed payments are those made by a partnership to a partner that are determined without regard to the partnership's income. Compensation for services and capital are guaranteed payments.
A partnership treats guaranteed payments for services, or for the use of capital, as if they were made to a person who is not a partner. This treatment is for purposes of determining gross income and deductible business expenses only.
Allocation of net income
If total revenues exceed total expenses of the period, the excess is the net income of the partnership for the period. If expenses exceed revenues of the period, the excess is a net loss of the partnership for the period.
Management fees, salary and interest allowances are guaranteed payments. The partnership generally deducts guaranteed payments on line 10 of Form 1065 as business expenses.
If partners pay themselves high salaries, net income will be low, but it does not matter for tax purposes. Partner compensation and allocated net income are considered ordinary income for tax purposes and as such are reported on the form 1040. It does not matter whether or not a partner withdrew any amount of money from his capital account. .
Net income or loss is allocated to the partners in accordance with the partnership agreement. In the absence of any agreement between partners, profits and losses must be shared equally regardless of the ratio of the partners' investments. If the partnership agreement specifies how profits are to be shared, losses must be shared on the same basis as profits. Net income does not includes gains or losses from the partnership investment.
Profit and loss account
Closing process Closing process at the end of the accounting period includes closing of all temporary accounts by making the following entries.
Close all revenues accounts to Income Summary. Close all expenses accounts to Income Summary. Close Income Summary by allocating each partner's share of net income or loss to the individual capital account. Close each partner's drawing account to the individual capital accounts.
To illustrate, assume that there are two equal partners, Partner A and Partner B. The partnership agreement specifies that after providing for salary and interest allowances the remaining income is divided equally. Assume also that net income of the partnership was $100,000 and the two partners received allowances as indicated in the table below.
The allocation of net income would be reported on the income statement as shown.
Net Income $100,000
Partner A Partner B Total Net Income of partnership 100,000 Salary allowances 30,000 20,000 50,000 Interest allowances 20,000 10,000 30,000 Remaining income 20,000 Remaining income shares 10,000 10,000 20,000 Allocated shares 60,000 40,000 100,000
Net Income of the partnership is calculated by subtracting total expenses from total revenues. After that salary and interest allowances are subtracted from Net Income, and the result is Remaining Income, which is divided equally in accordance with the partnership agreement.
At the end of the accounting period each partner's allocated share is closed to his capital account. Based on the net income allocation shown above, the closing entry is:
Debit Credit Income Summary $100,000 Partner A, Capital $60,000 Partner B, Capital $40,000
Statements for partnerships
The allocation of net income and its impact on the partners' capital balances must be disclosed in the financial statements. All three financial statements are affected: the income statement, statement of owners (partners') equity, and balance sheet. In addition, the statement of partners' equity reflects the equity of each partner and summarizes the allocation of net income for the year.
Statement of partners' equity
Statement of partners' equity starts with capital balances at the beginning of the accounting period, and reflects additional investments, made by the partners during the year, net income for the period, and withdrawals.
Additional investments and allocated net income increase capital accounts of the partners. All kind of allowances, like salary allowances and capital allowances, are treated as withdrawals. Withdrawals reduce capital accounts. The result is capital balances of the partners at the end of the accounting period.
A sample statement of partners' equity is shown below.
Partner A Partner B Total Capital, Jan. 1 $40,000 $30,000 $70,000 Additional investments $10,000 $20,000 $30,000 Capital plus investments $50,000 $50,000 $100,000 Net Income for the year $60,000 $40,000 $100,000 Balance $110,000 $90,000 $200,000 Withdrawals $30,000 $20,000 $50,000 Capital, Dec. 31 $80,000 $70,000 $150,000
Equity section of the balance sheet
The partners' equity section of the balance sheet reports the equity of each partner, as illustrated below.
Partner A, Capital $80,000 Partner B, Capital $70,000 Total partners' equity $150,000
Admitting a new partner
A new partner may be admitted by agreement among the existing partners. When this happens, the old partnership may or may not be dissolved and a new partnership may be created, with a new partnership agreement. For US tax purposes, a technical termination may be caused if more than 50% of the partnership interests change hands in the same (US) tax year.
A new partner may buy into the business in three ways:
by purchasing an interest directly from existing partners by making an investment in the business, or by contributing assets from an existing business.
Assume that Partner A and Partner B admit Partner C as a new partner, when Partner A and Partner B have capital interests $30,000 and $20,000, respectively.
Partner C pays, say, $15,000 to Partner A for one-third of his interest, and $15,000 to Partner B for one-half of his interest. These payments go to the partners directly, not to the business. The following entry is made by the partnership.
Debit Credit Partner A, Capital 10,000 Partner B, Capital 10,000 Partner C, Capital 20,000
The extra $5,000 Partner C paid to each of the partners, represents profit to them, but it has no effect on the partnership's financial statements.
Now, assume instead that Partner C invested $30,000 cash in the new partnership. In this case, the following entry would be made to admit Partner C.
Debit Credit Cash 30,000 Partner C, Capital 30,000
Finally, let's assume that Partner C had been operating his own business, which was then taken over by the new partnership. In this case the balance sheet for the new partner's business would serve as a basis for preparing the opening entry. The assets listed in the balance sheet are taken over, the liabilities are assumed, and the new partner's capital account is credited for the difference.
Allocation of ownership interest
Equal partners
Example 1. Assume that a sole proprietor agreed to admit a single equal partner for a certain amount of money. The sole proprietor, Partner A, will give the new partner, Partner B, an equal share in the partnership. 100% interest of the sole proprietor will be divided in half, so that each of the two partners will have 50% interest in the partnership. In effect, Partner A sold 50% of his equity to Partner B.
Example 2. Assume that Partner A and Partner B have 50% interest each, and they agreed to admit Partner C and give him an equal share of ownership. Each of the three partners will have 33.3% interest in the partnership. Interests of Partner A and Partner B will be reduced from 50% each to 33.3% each. In effect, each of the two partners sold 16.7% of his equity to Partner C.
Unequal partners
Example 1. Assume there are two unequal partners in the partnership. Partner A owns 60% equity, Partner B owns 40% equity, and they agreed to admit a third partner. Partner C has several options to join the partnership.
He can buy equity from Partner A. He can buy equity from Partner B. He can buy equity from Partner A and Partner B.
Partner A and Partner B may both agree to sell 50% of their equity to Partner C. In that case, Partner A will have 30% interest, Partner B