BACCT1201 • Financial Accounting
LECTURE 3
Introduction to Partnership
Accounts
Issah Hamdu
Faculty of Business Management and Globalization
Tel : 603 8317 8833 (Ext 8403)
Email: issah@limkokwing.edu.my
Learning Objectives
• At the end of the chapter, students would
be able to:
– Explain what a partnership business is
– Differentiate between partnership and
joint venture
– Differentiate between different forms of
partnership
– Illustrate the main features of a
partnership deed
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Learning Objectives
– Explain the procedure to adopt in
sharing profits/losses in a partnership
business in the absence of a
partnership deed.
– Record transactions of, and draw up the
ledger accounts and financial
statements for a partnership business.
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Partnership Defined
• A partnership business is where two or
more individuals jointly set up a business
(usually a long-term commitment) with a
view to earn profit.
• Partnership is defined by the partnership
Act 1890 as ‘the relation which subsists
between carrying on business in common
with a view of profit’.
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A Joint Venture Business
• A business agreement under which two
businesses join together for a set of
activities and agree to share the profit
arising from these activities/ventures.
• Thus, the cooperation in a joint venture is
usually not for a long-term commitment. It
may be for a one-off project/venture.
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Composition of Partnership
• A partnership agreement may be oral or
written
• Individuals who form a partnership are called
partners.
• In most countries, only individuals above the
age of 18 years can become (legal) partners.
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Composition of Partnership
• In Malaysia, the number of partners is
unlimited for certain professional firms (e.g.
accounting and Law firms), but is limited to
10 in a banking business and 20 in other
businesses.
• It is common for partnership business
names to end with ‘& Co. Example, Issah &
Co.
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Accounting for Partnership
• For accounting purposes a partnership is a
separate legal entity.
• Follows same GAAP procedures as
accounting for corporations or sole
proprietorships.
• Primary difference is in the equity section
and the treatment of partner’s capital
accounts
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Contents of the Deed of
Partnership
The 'deed' will often contain some or all of the
following clauses:
• The capital to be contributed by each partner
• The rate of interest to be allowed on partners
capitals
• The rate of interest to be charged on partners
drawings
• Any salaries payable to partners
• The ratio in which the remaining profit / loss is to be
shared
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In the absence of agreed
partnership deed
Should the partners fail to agree on the points
stated in the deed (above) the Partnership Act
1890 states that the following will apply on a
piecemeal basis:
• Partners will receive interest at 5% on excess
capital (i.e. over and above that which they have
agreed to contribute)
• No interest on drawings
• No salaries
• Profits / losses shared equally
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Different Forms of Partnership:
Limited partnership
• A limited partnership is a special form of partnership
in which there are two classes of partners - general
and limited
• A limited partnership must have one or more general
partner(s) and at least one limited partner.
• There must be at least two individuals involved for
the partnership to exist. The limited partner(s) use
the business as an investment. They put money into
the business and have a limited amount of liability.
They can be liable for only the amount they invested,
or an amount agreed upon in the partnership
agreement.
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Partnership Formations
GAAP Accounting
•Assets contributed/debts assumed should
be specified by partnership agreement
•Assets can be cash/noncash and are
recorded at FMV
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Partnership FormationsGAAP Accounting
• Liabilities recorded at FMV
• Capital accounts recorded as FMV of assets
contributed less liabilities assumed by the
partnership
• If differences in asset values and agreed
upon capital interests exist, bonus method
or goodwill method is used to allocate
differences
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Partnership Formations
- Tax
• General rule – non-recognition of g/l on
creation of partnership
• Tax law dictates the basis of assets for tax
purposes with general rule that carryover
basis is used.
• Tacked holding periods generally exist for
capital and Sec. 1231 assets held more than
one year.
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Partnership Formations
- Tax
• Bonus/Goodwill method not used for tax. Any
additional basis, etc will be reconciled upon
the partners departure from partnership or
liquidation of interest.
• Tax capital accounts equal tax value of assets
contributed less PV of liabilities assumed by
the partnership.
• Liabilities are valued at PV as of date of
contribution.
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Allocation of Net Income/Loss
GAAP Accounting
• Partnership agreement specifies profit and
loss sharing arrangement
• Common arrangements for p/l allocations:
fixed ratio, ratio of capital balances at a point
in time, initial capital contributions,
time/talent etc.
• Profits allocation and loss allocations may be
different
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Allocation of Net Income/Loss
GAAP Accounting
• Profits and loss arrangement may provide
for salaries and bonuses to partners which
are deducted from net income before
salary and bonus allocations.
• Partner draws are considered reductions
of capital and are not treated as salary.
Permission or draw procedure should be
enumerated in the partnership agreement
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Allocation of Net Income/Loss
Tax Law
• Partnership agreement is very flexible, can
be changed anytime before return is filed
and should specify allocation rationale.
• All allocations must meet the substantial
economic effect requirements (to be
discussed in Problem Area 7)
• Profit/Loss sharing arrangements may be
similar to GAAP if SEE rules are met.
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Allocation of Net Income/
Loss Tax Law
• Salaries/Bonus are either guaranteed
payments or a special allocations of p/l
depending on facts/circumstances. Sec 707
provides guidance.
• Draws not considered income, but if reduce
basis to negative amounts will trigger gain
and possible at risk recapture.
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Changes in Partnership
Ownership – GAAP ACCT
• Change in ownership requires the partnership
to be valued at the FMV of the date of
change:
– Important for former partners to ensure
that they receive adequate payout for their
interests
– Important to determine purchase price for
new partners etc.
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Changes in Partnership
Ownership – GAAP ACCT
• Revaluation must consider potential
intangible assets such as goodwill.
Bonus method (shift in book capital
accounts for a difference in amounts
contributed or goodwill method used
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Changes in Partnership
Ownership – GAAP ACCT
• Admission of new partner:
– Purchase from another partner outside:
Shift in capital accounts only. No
change for valuation.
– Purchase from partnership: Revalue
partnership, adjust capital accounts of
all partners for change in value of
assets.
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Change in Partnership Ownership
Tax Accounting
• Partnership needs to determine fair value for
purposes of determining payout and new partner
purchase price.
Admission of new partners:
• If purchase outside partnership, no changes to tax
balance sheet. Inside basis and outside basis will
differ. New partner steps into the shoes of the old
partner. If partnership has a Sec. 754 election in
place, the tax basis of assets is written up to
reflect the difference in outside and inside basis.
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Change in Partnership
Ownership: Tax Accounting
• If purchase from partnership, new
partner pays FMV and with Section 754
election, partnership writes up assets to
fair value but only for the portion
attributed to the new partner not for all
partners.
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Change in Partnership Ownership
Withdrawal/Retirement of Partner-GAAP
• Determine FMV of assets and liabilities on the
books.
• If partnership agreement calls for it, a valuation of
intangible should also be made.
• If a payment is made above and beyond the net
equity in recorded assets, bonus or goodwill
method can be used to allocate the difference.
• If payment is less than book value, the bonus
method is used to reallocate the capital to
remaining partners.
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Change in Partnership Ownership
Withdrawal/Retirement - Tax
• If payment is less than book value because
assets are overvalued, the firm should write
down the assets to reflect this change.
• Must recalculate FMV of partnership.
• Payout the FMV of capital account
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Change in Partnership Ownership
Withdrawal/ Retirement - Tax
• Generally, no gain or loss is recognized on
liquidation of partnership interest unless only
cash or hot assets are distributed
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Liquidation: GAAP
• Set partnership to FMV
• Pay out creditors other than partners
• Payout partners other than for capital and
profits
• Payout partners in respect of capital
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Liquidation: Tax
• Payout creditors
• Restore negative capital accounts
• Liquidate partnership based on remaining
capital accounts.
• Payout partners in respect of profits
• Restore any negative capital accounts
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Financial Statements of
Partnership Business
• Trading, Profit and Loss Account: This is
similar to that of a sole proprietor. However,
a partnership has an extra section shown
under the profit & loss account. This section
is known as ‘the profit & loss appropriation
account. This section is used to make
adjustments in respect of the following
before the distribution of profit/loss:
– Interest on partner’s drawings
– Interest on partners capital (if any)
– Partner’s salary (if any)
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Final Accounts: Profit & Loss
Appropriate Accounts: Sample
Steps:
Compute net profit (as usual)
Add: Interest charges on partner’s drawings
Less: Interest paid on partner’s capital
Profit/loss available for distribution
Share of profit (as pre-determined)
Partner A
XX
Partner B
XX
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XXX
(XXX)
XXXX
XXXX
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Partner’s Capital Accounts
• When a partner brings in capital (cash or other
assets) into the business, that amount will be
credited to his capital account. This amount (capital)
will remain in the books at the original figure unless
and until there are further injections (or
withdrawals) of capital:
• Example: Capital Account
A
B
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Partner’s Current Account
• In order to preserve the original capital
intact, a current account is prepared so as
to deal with the following:
–
–
–
–
–
Partner’s drawings
Partner’s salary
Interest on capital
Interest on drawings and
Share of profit
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Partner’s Current Account..
• The current account (balance) fluctuates
often unless the capital account
• The current account balance may be Debit
or Credit. When the amount of drawings
exceeds the balance on a partner’s current
account, the account will show a debit
balance. If vice versa, the current account
will show a credit balance.
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Accounting Entries for
partnership Accounting
Transaction
A/C to be Debited
Account to be Credited
Capital contributed by partner
Cash/Bank/Asset
Capital A/C
Additional capital contribution
Cash/Bank/Asset
Capital A/C
Cash/Goods drawings by partner
Current Account
Cash/Stock/P Account
Interest on drawings is charged
Current Account
Appropriation Account
Interest on capital is allowed
Appropriation Account
Current Account
Partner’s salary entitlement *
Appropriation Account
Partner’s salary account
a) If partner’s salary is paid
Partner’s salary
Cash/Bank
b) If the salary is accrued
Partner’s salary
Current account
Loan by partner’s to the firm
Cash/Bank
Loan account
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Accounting Entries for
partnership Accounting…
Transaction
A/C to be Debited
Account to be Credited
Interest on loan from partner
Profit & Loss
Interest on loan A/C
a) If the interest is paid
Interest on loan A/C
Cash/Bank
b) If the interest is accrued
Interest on loan A/C
Current Account
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Balance Sheet: some
differences for a partnership
• Capital account: the balance (b/d) is taking
from the individual partner’s capital account.
Capital account will most have a credit
balance
• Current account: The balance will be
extracted from the individual partner’s
current account. This balance may be a debit
or credit balance.
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Balance Sheet: some
differences for a partnership
• Credit balance in current account: The
balance will appear under the finance by
(equity) section of the balance sheet.
• Debit balance in the current account: The
balance will appear as a minus in the equity
section of the balance sheet. That is, it will
be in negative (bracket).
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End of lecture 3
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