Accounting For Partnership

Most of the on-going accounting for partnerships is the same as for any other form of business organization. The chart of accounts differs only for the equity accounts where we find a drawing account and a capital account for each partner. There are, however, some areas which are peculiar to partnerships. The formation of a partnership, the distribution of income, the admission of new partners and the dissolution and liquidation of a partnership all require special accounting treatment.
When a partnership is formed, a separate entry is made for each partner's investment. Assets contributed by a partner are debited to the appropriate accounts. If the partnership assumes any liabilities, the proper accounts are credited. The partner's capital account is then credited for the difference. A partner may contribute not only cash and property, but a variety of assets. When two businesses are merged into a partnership, each incoming partner may also contribute inventory and accounts receivable. The partnership may assume the accounts payable as well as other liabilities of the prior businesses. Equipment is valued at current market value, and, therefore, these amounts may differ from the book value of the separate businesses. Receivables are recorded at their face amount. A provision may be made for any potentially uncollectible amounts by crediting an Allowance for Doubtful Accounts.
Partnership agreements provide for the distribution of income in a variety of ways. Income may be divided in proportion to ownership, to time spent in the business, or in any manner decided by the partners. Of course, they must consider any IRS rullings regarding related parties or potential tax avoidance. One or more partners may be guaranteed a fixed amount in the form of a salary or as interest payments. The partners may take regular cash withdrawals. All of these situations must be properly handled so that each partner's equity is correctly maintained.
The standard procedure is to set up a drawing account for each partner This account is debited for any withdrawals during the year. At year end, the division of net income is recorded as a closing entry with the proper amount of income or loss applied to each partner's capital account. The drawing account is also closed to the partner's capital account. In this manner, each partner's capital account will reflect his net activity for the year. If the partner has withdrawn more than his share of income, this will be reflected by a decrease in his capital account.
The admission of one or more new partners is another area peculiar to partnerships. A new partner may be admitted in one of two ways. He may purchase an interest from one or more of the existing partners or he may contribute new assets to the partnership. When an interest is purchased, neither the total assets nor the total equity of the partnership is changed. The transaction merely causes changes in the equity accounts. Assume that a partnership has a total equity of $300,000. If Partner A sells one-third of his interest to a new Partner Z and Partner A has a balance in his capital account of $90,000, Partner Z would be entered on the books with a capital account balance of $30,000 and Partner A would then have a capital account balance of $60,000. If new Partner Z felt that the assets of the partnership were worth more than their book value or that the partnership itself was earning at a high rate, he might have paid Partner A more than the $30,000 for his interest. This fact does not affect the partnership entries in any way. The total partnership equity remains at $300,000. Any increase in asset value is handled by the new partners outside the partnership.
Instead of buying an interest from the existing partners, a new partner may contribute assets to the partnership. In this case both total assets and total equity of the business are changed. If new Partner Y contributes cash and equipment worth $50,000 to the partnership, the entries are similar to the entries when the partnership was formed. The proper asset accounts are debited and a capital account is set up for Partner Y in the amount of $50,000. If the market value of the partnership's assets is not a good reflection of the book value of the partnership assets, the partnership assets may be adjusted accordingly. The assets are revalued and the net amount of any increase or decrease is allocated to the partner's capital accounts in accordance with their income sharing ratio.
When a partner withdraws from a partnership, the accounting treatment is in effect just the reverse of the treatment for an entering partner. The remaining partners may purchase the withdrawing partner's interest. Again in this case, as above, the settlement for the purchase is done by the partners as individuals. The partnership need only debit the capital account of the withdrawing partner and credit the capital account of the partners having purchased his interest.
If the partner merely withdraws and removes any assets equal to the balance of his capital account, then again we have the case where both total assets and total equity are changed. The remaining assets should be adjusted to reflect current market prices and the net adjustment is divided among the remaining partners in accordance with their income sharing ratio.
When a partnership goes out of business, it generally sells the assets, pays off any creditors and then distributes the remaining cash and any other assets
to the partners. The first accounting step in this liquidation is to close all income and expense accounts in the usual year-end manner. Only asset, liability and equity accounts remain open. If the remaining assets are sold at a gain, the gain is divided among the partners based on their income sharing ratio. Liabilities are paid and any remaining cash is distributed to the partners according to the balances in their capital accounts.
If the remaining assets are sold at a loss, the procedure is the same assuming the partner's capital balances are sufficient to absorb the loss. The loss is divided among the partners based on their income sharing ratio and any remaining cash after creditors are paid is distributed in accordance with the balances in the capital accounts. However, in the case where a partner's capital account is not large enough to absorb the loss, a deficiency is created. This is a claim on the partner by the partnership. If the deficiency is not made up by the partner, then this deficiency in turn reduces the capital accounts of the remaining partners. Any remaining cash is then distributed to partners in accordance with their final capital balances.

When a partneship is dissolved, the distribution of cash must be handled correctly. Distribution of cash must not be confused with the allocation of gains or losses on disposal of assets. Gains or losses on sale of assets to outsiders are allocated to the partners in their income sharing ratio. The final distribution of cash is based on their final capital balances.
As stated previously, it is true that accounting for partnerships is not complex and is very much like the accounting for any business enterprise. However, it is very important to handle the equity accounts correctly in order that they may properly reflect each partner's balance.