Chapter 9: Partnerships - Formation and Operation
I. Defined: a partnership is an association of two or more people or organizations
formed to engage in some economic activity. Most accounting firms, legal firms, and
many medical practices are partnerships.
II. Advantages:
A. Partners’ abilities: A partnership can take advantage of the abilities of many
different individuals. For example, some partners might have special product or
service development skills, while other partners might have marketing skills,
while others might possess sufficient cash resources to allow the business to
operate effectively.
B. Ease of formation: A partnership can be formed simply by two or more people or
organizations agreeing to engage in some activity. There is no need to register
with a state (as required of corporations) or to file with the Securities and
Exchange Commission. There is no legal requirement for a written contract,
although it is strongly recommended that a partnership agreement be prepared. A
partnership agreement should be prepared in order to clarify the roles and
responsibilities of the various partners and to specify how partnership income is to
be allocated among the partners.
C. No partnership income taxes: Unlike corporations, which are separate taxable
entities, partnerships do not pay income taxes. All income of the partnership is
allocated to the partners and they are taxed on their share. Thus, the partnership is
not taxed, but the partners are. The fact that corporations are taxed as separate
entities and then the owners are taxed when they receive cash dividends usually
makes the tax effect on corporation income greater than on partnership income.
III. Disadvantages:
A. Unlimited legal liability: Partnership law allows each partner to legally represent
the partnership in business transactions (mutual agency). In addition, partnership
law specifies that any partner can be held personally responsible for all debts of
the partnership (unlimited liability). As a result, the major disadvantage of a
partnership is that a partner could be held financially responsible for any other
partner’s action on behalf of the partnership. Thus, even though a partner
invested only $10,000 in a partnership, that partner could be legally responsible
(at risk) for significantly more than the $10,000 if the partnership experiences
severe financial difficulties. In contrast, if an individual invests $10,000 in a
corporation, that individual is at risk for only $10,000, no matter how much
financial difficulty the corporation experiences.
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B. Obtaining resources: Due to the unlimited legal liability of partners, partnerships
often find it much more difficult than corporations to raise large dollar amounts
from investors.
IV. Owner’s Investments: Owners’ investments are important sources of partnership
resources. Unlike corporation owners’ investments that are recorded in stockholders’
equity accounts, owners’ investments in partnerships are recorded in capital accounts.
For example, assume that Chen and Khan form a partnership to provide internet art
services. Chen is an internet expert and Khan has a significant amount of cash
available from his previous business experience. To start the partnership, Chen
invests $10,000 and Khan invests $40,000. The effects of their investments could be
as follows.
Date
Accounts
Cash
Chen, Capital
Khan, Capital
Debits
50,000
Credits
10,000
40,000
In the above example, each partner received credit for the dollar amount of cash he
invested. Although it was necessary to increase cash by the $50,000 received by the
partnership, the partners could have agreed to give a different amount of credit to
each partner. For example, if the partners agreed to give equal credit to each partner,
the effects would be as follows.
Date
Accounts
Cash
Chen, Capital
Khan, Capital
Debits
50,000
Credits
25,000
25,000
It is important to note that partners may agree to treat each other in any way they
desire, as long as the arrangement is legal.
If partners invest resources other than cash, such resources are usually recorded at
their fair market value.
It is also important to note in the above examples that the accounting terminology for
partnerships differs from that of corporations. Owners’ investments in partnerships
are recorded in capital accounts, which are parts of a general classification called
owners’ equity. Owners’ investments in corporations are recorded in contributed
capital accounts, which are parts of a general classification called stockholders’
equity.
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V. Withdrawals: Partners receive assets from a partnership by withdrawing them. Unlike
corporations in which such distributions of assets to owners are usually recorded as
dividends, asset withdrawals by partners are recorded in partner withdrawal accounts.
For example, if Chen withdrew $500 and Khan withdrew $400 from their partnership,
the effects would be as follows.
Date
Accounts
Debits
500
400
Chen, Drawing
Khan, Drawing
Cash
Credits
900
Each partner’s drawing account is a contra owners’ equity account (similar to the
dividends account in a corporation). At the end of each accounting period, each
partner’s drawing account is closed to the partner’s capital account. For example, if
Chen’s drawing account were closed to his capital account, the effects would be as
follows.
Date
Accounts
Debits
500
Chen, Capital
Chen, Drawing
Credits
500
VI. Income Allocation: Similar to corporations, at the end of each accounting period,
partnership revenues and expenses are closed to income summary. Unlike
corporations, however, in which income summary is closed to retained earnings,
partnership income summary is closed to individual partners’ accounts. This process
of income allocation depends upon the requirements detailed in the partnership
agreement. In the absence of a partnership agreement, partners share income equally.
The allocation of partnership income often takes into consideration such things as
investments, partner efforts, and special talents. For example, assume that the
partnership agreement of Chen and Khan specifies that (1) each partner is to receive
interest of 1% per month on his capital balance at the beginning of the month, (2)
Chen is to receive a monthly salary of $6,000 and Khan is to receive $4,000, and (3)
any remaining income is to be split equally between the partners. Assume that on
April 1, 2006, Chen’s capital balance was $12,000 and Khan’s was $45,000. Assume
also that the partnership’s income for April was $18,000. Based on this data, the
partnership’s income would be distributed as shown below.
Item
Interest
$12,000 x .01
$45,000 x .01
Salary
Remaining income: $18,000 - $10,570
Totals
Chen
$120
$0
$6,000
$3,715
$9,835
Khan
$0
$450
$4,000
$3,715
$8,165
Totals
$120
$450
$10,000
$7,430
$18,000
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The above income allocation affects the partnership as follows.
Date
Accounts
Debits
18,000
Income Summary
Chen, Capital
Khan, Capital
Credits
9,835
8,165
Assume that instead of $18,000, the partnership’s income for April was $9,000.
Based on this data, the partnership’s income would be distributed as shown below.
Item
Chen
Interest
$12,000 x .01
$45,000 x .01
Salary
Remaining income: $9,000 - $10,570
Totals
$120
$0
$6,000
($785)
$5,335
Khan
$0
$450
$4,000
($785)
$3,665
Totals
$120
$450
$10,000
($1,570)
$9,000
The above income allocation affects the partnership as follows.
Date
Accounts
Debits
9,000
Income Summary
Chen, Capital
Khan, Capital
Credits
5,335
3,665
Assume that instead of $18,000, the partnership’s income for April was a $1,000 loss.
Based on this data, the partnership’s income would be distributed as shown below.
Item
Interest
$12,000 x .01
$45,000 x .01
Salary
Remaining income: - $1,000 - $10,570
Totals
Chen
Khan
$120
$0
$6,000
($5,785)
$335
$0
$450
$4,000
($5,785)
($1,335)
Totals
$120
$450
$10,000
($11,570)
($1,000)
The above income allocation affects the partnership as follows.
Date
Accounts
Khan, Capital
Income Summary
Chen, Capital
Debits
1,335
Credits
1,000
335
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VII. Dissolution: Technically, a partnership is dissolved whenever there is a change in
partners. For example, the admission of another partner dissolves the old
partnership and creates a new one. Similarly, when a partner leaves a partnership,
the partnership is dissolved. Both these methods of dissolution are examined
below.
A. Admission of a new partner: A new partner can be admitted to a partnership in
two ways: (1) the purchase of an existing partner’s interest directly from the
partner or (2) the investing of resources directly in the partnership.
1. Purchase of existing partner’s interest: When a new partner purchases an
interest in a partnership by buying it directly from a current partner, the
current partner’s capital interest is eliminated from the partnership’s
accounting records and the new partner’s interest is recorded. In its
simplest terms, the old partner’s capital interest is replaced by an equal
dollar amount of capital interest of the new partner. For example, assume
that Khan sells his $65,000 capital interest to Powell for $78,000. In this
case, Khan receives $78,000 cash and Powell receives a $65,000 capital
interest in the partnership. This method is called the book value method
and the effects on the partnership would be as follows.
Date
Accounts
Debits
65,000
Khan, Capital
Powell, Capital
Credits
65,000
2. New partner investing resources directly in the partnership: When a new
partner purchases an interest in a partnership by making payment directly
to the partnership, the new partner’s capital interest is recorded. In its
simplest terms, the new partner’s capital interest is recorded at that dollar
amount equal to the new partner’s percentage interest in the partnership.
For example, assume that Powell pays $30,000 to the Chen and Khan
partnership for a 15% interest in the firm. Assume that immediately prior
to the admission of Powell, the partners’ capital interests were as follows.
Partner
Chen
Khan
Totals
Partner’s Capital
$35,000
$65,000
$100,000
%
35%
65%
100%
Powell’s $30,000 payment increases the partnership’s net assets to
$130,000. Powell’s 15% capital interest would be $19,500 ($130,000 x
.15). Since Powell paid $30,000 for a $19,500 interest in the partnership,
the $10,500 excess payment ($30,000 - $19,500) would be allocated to the
other partners according to their income sharing percentages. In this case,
the capital balances of Chen and Khan would each increase by $5,250
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($10,500 / 2), since they share income equally. The effects on the
partnership would be as follows.
Date
Accounts
Debits
30,000
Cash
Chen, Capital
Khan, Capital
Powell, Capital
Credits
5,250
5,250
19,500
After the admission of Powell, the partners’ capital interests would be as
follows.
Partner
Chen
Khan
Powell
Totals
Partner’s Capital
$40,250
$70,250
$19,500
$130,000
%
31%
54%
15%
100%
B. Withdrawal of a partner: When a partner withdraws from a partnership, the
partnership is dissolved according to the partnership agreement. If other
partners remain in the partnership, a new partnership is formed.
Assume that Chen decides to withdraw from the partnership. Immediately
prior to his withdrawal, the partners’ capital interests were as follows.
Partner
Chen
Khan
Powell
Totals
Partner’s Capital
$60,000
$100,000
$50,000
$210,000
Income Sharing %
40%
40%
20%
100%
If the partnership agreement requires an appraisal of the partnership’s value
before a partner withdraws and such an appraisal indicates that the
partnership’s value is $300,000, Chen would receive $96,000 when he
withdraws. The $96,000 was calculated as follows.
Item
Chen capital balance
Chen share of excess partnership value: ($300,000 - $210,000) x .40
Total
Amount
$60,000
$36,000
$96,000
The payment of $96,000 cash to Chen upon his withdrawal results in him
receiving $36,000 more than his capital interest in the partnership. A simple
way to account for this difference is to reduce the other partners’ capital
interests by a total of $36,000, according to their income sharing percentages.
Since Khan’s income sharing percentage was 40%, and Powell’s was 20%,
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Khan’s capital balance would be reduced by $24,000 {$36,000 x [.40 / (.40 +
.20)]} and Powell’s capital balance would be reduced by $12,000 {$36,000 x
[.20 /(.40 + .20)]}. Chen’s withdrawal would affect the partnership as
follows.
Date
Accounts
Chen, Capital
Khan, Capital
Powell, Capital
Cash
Debits
60,000
24,000
12,000
Credits
96,000