Partnership accounting

When two or more individuals engage in an 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

Because 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 asset. 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 account

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 received guaranteed payments from the partnership.
*Partnership earned profits, and a share of profits was allocated to the partner.

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 accountof the partner.

To illustrate, assume that a partner received $500 as an interest allowance. The entry is:

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:

Admitting a new partner

A new partner may be admitted by agreement among the existing partners. When this happens, the old partnership is dissolved and a new partnership is created, with a new partnership agreement. 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.

To summarize, there does not exist any standard way to admit a new partner. A new partner can be admitted only by agreement among the existing partners. When this happens, the old partnership is dissolvedand a new partnership is created, with a new partnership agreement.

Partnership bonus

Bonus paid to the partnership.

A new partner may pay a bonus in order to join the partnership. Bonus is the difference between the amount contributed to the partnership and equity received in return.

Assume that Partner A and Partner B have balances $10,000 each on their capital accounts. The partners agree to admit Partner C to the partnership for $16,000. In return, Partner C will receive one-third equity in the partnership. The following table illustrates calculation of the bonus.

In this case, Partner C received $2,000 bonus to join the partnership. The amount of the bonus paid by the partnership is distributed among the partners according to the partnership agreement.

The following table illustrates the distribution of the bonus.It should be noted that debit to Cash increases the account, while debit to a capital account of a partner decreases the account.

If a retiring partner agrees to withdraw less than the amount in his capital account, the transaction will increase the capital accounts of the remaining partners.

For example, if Partner C withdraws only $20,000 in settlement of the interest, the difference between Partner C's equity in the assets of the partnership and the amount of cash withdrawn is $10,000 ($30,000 - $20,000).

This difference is divided between the remaining partners on the basis stated in the partnership agreement.

Assume that the partnership agreement specifies that in such a case the difference is divided according to the ratio of their capital interests after allocating net income and closing their drawing accounts. On this basis, Partner A's capital account is credited for $6,000 and Partner B's is credited for $4,000.

The entry in the books of the partnership is as follows:

The amount paid to Partner C by Partner D is also a personal transaction and has no effect on the above entry.

Death of a Partner

The death of a partner dissolves the partnership. On the date of death, the accounts are closed and the net income for the year to date is allocated to the partners' capital accounts. Most agreements call for an audit and revaluation of the assets at this time. The balance of the deceased partner's capital account is then transferred to a liability account with the deceased's estate.

The surviving partners may continue the business or liquidate. If the business continues, the procedures for settling with the estate are the same as those described earlier for the withdrawal of a partner.

Liquidation of a Partnership

Liquidation of a partnership generally means that the assets are sold, liabilities are paid, and the remaining cash or other assets are distributed to the partners.

When normal operations are discontinued, adjusting and closing entries are made. Thus, only the assets, liabilities and partners' equity accounts remain open.

If noncash assets are sold for more than their book value, a gain on the sale is recognized. The gain is allocated to the partners' capital accounts according to the partnership agreement.

If noncash assets are sold for less than their book value, a loss on the sale is recognized. The loss is allocated to the partners' capital accounts according to the partnership agreement.

As the assets are sold, the cash is applied first to the claims of creditors. Once all liabilities are paid, the remaining cash and other assets are distributed to the partners according to their ownership interests as indicated by their capital accounts.

chedule M-1

Purpose of Schedule M-1

U.S. Return of Partnership Income (IRS Form 1065) [http://www.irs.gov/pub/irs-pdf/f1065.pdf] contains, among others, Schedule M-1.

The purpose of Schedule M-1 is reconciliation of income (loss) per accounting books with income (loss) per Return of the partnership. In other words, it means reconciliation of accounting income with taxable income, because not all accounting income is taxable.

Schedule M-1 starts with Net income (loss) per books. Adjustments are made for guaranteed payments, as well as for depreciation and other expenses. As a result, accounting income of a partnership is adjusted, or reconciled, to taxable income.

chedule K-1

Purpose of Schedule K-1

The partnership uses Schedule K-1 to report a partner's share of the partnership’s income, deductions, credits, etc. The partner must only keep Schedule K-1 for his records, but not file it with his tax return. The partnership must file a copy of Schedule K-1 for each partner with the IRS.

Although the partnership generally is not subject to income tax, every partner is liable for tax on his share of the partnership income, whether or not distributed.

References

Justicejee, J.A., & Parry, R.W. (2001)College Accounting 16/E, chapter 20

IRS Publication 541, Partnershipshttp://www.irs.gov/publications/p541/ar02.html#d0e1119