14 CHAPTER Partnership Accounting LEARNING OBJECTIVES When you have completed this chapter, you should 1. have a better understanding of accounting terminology. 2. understand the general characteristics of a partnership and the importance of each one. 3. be able to calculate the division of profits, prepare the proper journal entries, and prepare the financial statements for a partnership. 4. be able to calculate and prepare the journal entries for the sale of a partner- ship interest, the withdrawal of a partner, and the addition of a partner. 5. be able to calculate and prepare the journal entries for a partnership that is going out of business. VOCABULARY account form a balance sheet that shows assets on the left-hand side and liabilities and balance sheet owner’s equity on the right-hand side deficit a deficiency in amount; i.e., in this chapter, a deficit balance in the capital account is an abnormal, or a debit, balance liquidation to settle the accounts and distribute the assets of a business mutual agency the legal ability of a partner to bind the partnership to contracts within the scope of the partnership partnership a voluntary association of two or more legally competent persons who agree to do business as co-owners for profit profit-loss ratio the method chosen by partners for dividing the profits or losses; also called the income and loss sharing ratio realization the conversion of noncash assets to cash unlimited liability each partner is personally liable for the business debts Introduction The three common types of business are the proprietorship, the corporation, and the partnership. It is important to note that corporations, though fewer in number than proprietorships or partnerships, transact at least 10 times the business of all other busi- ness forms combined. There are advantages and disadvantages to each type of business organization.
Transcript
14CHAPTER
Partnership AccountingL E A R N I N G O B J E C T I V E S
When you have completed this chapter, you should
1. have a better understanding of accounting terminology.
2. understand the general characteristics of a partnership and the importanceof each one.
3. be able to calculate the division of profits, prepare the proper journal entries,and prepare the financial statements for a partnership.
4. be able to calculate and prepare the journal entries for the sale of a partner-ship interest, the withdrawal of a partner, and the addition of a partner.
5. be able to calculate and prepare the journal entries for a partnership that isgoing out of business.
VO C A B U L A RYaccount form a balance sheet that shows assets on the left-hand side and liabilities and
balance sheet owner’s equity on the right-hand side
deficit a deficiency in amount; i.e., in this chapter, a deficit balance in the capital
account is an abnormal, or a debit, balance
liquidation to settle the accounts and distribute the assets of a business
mutual agency the legal ability of a partner to bind the partnership to contracts within the
scope of the partnership
partnership a voluntary association of two or more legally competent persons who agree to
do business as co-owners for profit
profit-loss ratio the method chosen by partners for dividing the profits or losses; also called the
income and loss sharing ratio
realization the conversion of noncash assets to cash
unlimited liability each partner is personally liable for the business debts
Introduction
The three common types of business are the proprietorship, the corporation, and thepartnership. It is important to note that corporations, though fewer in number thanproprietorships or partnerships, transact at least 10 times the business of all other busi-ness forms combined. There are advantages and disadvantages to each type of businessorganization.
Accounting for a partnership is similar to accounting for a proprietorship exceptthere is more than one owner.
General Partnership Characteristics
General partnerships and limited partnerships are recognized by Canadian law. In thischapter, we will concentrate on general partnerships, which are governed by provinciallaw and registration requirements, and which have certain characteristics. Following is adiscussion of each.
Voluntary AssociationA partnership is a voluntary association of two or more legally competent persons (per-sons who are of age and sound mental capacity) to carry on as co-owners a business forprofit. Because a partnership is based on agreement, no person can be a partner againsther or his will. Doctors, accountants, and lawyers frequently form partnerships, and thisform of business organization is common in small service and retail businesses.
Partnership AgreementTwo or more legally competent people may form a partnership. It is best if their agree-ment is in writing, but it may be expressed verbally. The partnership contract is preparedby a lawyer, though an acccountant may review it. The contract will stipulate, amongother things, how partnership income and losses are to be divided among the partners.
TaxationA partnership is taxed like a proprietorship. In other words, the partners are taxed basedupon the partnership’s net income, not on their withdrawals from the business.
Limited LifeA partnership is a business carried on by individuals and can not exist separate and apartfrom those individuals. Should something happen to take away the ability of a partnerto contract (death, bankruptcy or lack of legal capacity), the partnership may be termi-nated. Also, the life of a partnership may be limited by terms in the partnership contract,or it may be terminated by any one of the partners at will.
Mutual AgencyMutual agency is the legal ability of each partner, acting as an agent of the business, toenter into and bind it to contracts within the scope of the partnership. For example,Alyce, Ben, and Charlie are partners in an accounting firm. Ben may bind the partner-ship by contracting to buy a computer for the business, even if the other two partnersknow nothing of the purchase. They are bound to the contract because a computer is anexpected and necessary piece of equipment for an accounting firm. However, the firmwould not be bound if Ben should contract to buy land with the expectation that itsvalue would increase because this transaction is considered to be outside the purpose ofan accounting business.
Partners may agree to limit the power of one or more of the partners to negotiate con-tracts for the business. Outsiders are bound by this agreement only if they are aware of it.
Unlimited LiabilityMuch like in a proprietorship, partners have unlimited liability for their business.Unlimited liability means that each partner is personally liable for the debts of the
P a r t n e r s h i p A c c o u n t i n g 377
business. When a partnership business is unable to pay its debts, the creditors may sat-isfy their claims from the personal assets of any of the partners. If any one partner cannot pay her or his share of the debt, creditors may make their claims against any of theother partners.
Advantages and Disadvantages of a Partnership
A partnership has advantages over other forms of business. By combining the abilitiesand capital of two or more persons, business potential may be greatly expanded. Also, apartnership is much easier to form than a corporation because an agreement betweenparties is all that is required. However, there are several disadvantages—limited life,unlimited liability, and mutual agency are among these and pose potential legal prob-lems that must be considered when forming any new partnership.
The Drawing Account
Partnership accounting is the same as accounting for a proprietorship except there areseparate capital and drawing accounts for each partner. The fundamental accountingequation (Assets = Liabilities + Owner’s Equity) remains unchanged except that totalowners’ equity is the sum of the partners’ capital accounts. Similar to a proprietorship,the partners (owners) do not receive salaries but withdraw assets from the business fortheir personal needs. Generally, the rules for withdrawals are decided beforehand by thepartnership agreement. For example, assume that Partner Arnold withdraws $5,000from a partnership firm of which he is a member. The journal entry to show this with-drawal is as follows:
At the end of the accounting period, the drawing accounts of each partner are closedto their individual capital accounts. Following is the journal entry to close the drawingaccount of Partner Arnold to his capital account.
378 C H A P T E R f o u r t e e n
GENERAL JOURNAL PagePOST
DATE DESCRIPTION REF. DEBIT CREDIT
20XXJan. 15 Arnold, Drawing 5 0 0 0 00
Cash 5 0 0 0 00To Record the Withdrawal of Cash
GENERAL JOURNAL PagePOST
DATE DESCRIPTION REF. DEBIT CREDIT
20XXJan. 31 Arnold, Capital 5 0 0 0 00
Arnold, Drawing 5 0 0 0 00To Record the Closing of Arnold’s DrawingAccount to Capital
Accounting for a partnership requires calculations be made for the division of prof-its and losses and the preparation of journal entries for the addition or withdrawal of apartner. In addition, special problems must be solved when a partnership is going out ofbusiness. Each of these will be discussed in the following paragraphs.
Dividing the Net Income
Remember that partners are owners of the business, not employees, and as such, maydivide their net income as they choose. The partnership contract, however, must statehow the net income or loss is to be divided. If there is no contract, the law states thatprofits and losses will be divided equally. The method chosen by the partners for divid-ing the profits or losses is called the profit-loss ratio. This chapter will discuss a num-ber of methods that may be used. Profits and losses:
1. may be divided equally
2. may be distributed on a fractional basis
3. may be distributed based on amounts invested
4. may be distributed using a fixed ratio
5. may be distributed using a salary allowance with any remaining profits dividedequally or using a ratio
Dividing Net Income EquallyPartners may divide profits equally. For example, M. Saar, J. Loretto, and S. Abdullah arepartners. Saar invested $50,000 in cash and other assets, Loretto invested $30,000 cash,and Abdullah invested $40,000 cash in their accounting firm. The following balancesheet was prepared on December 31 before adjusting and closing entries for the year hadbeen prepared.
P a r t n e r s h i p A c c o u n t i n g 379
Saar, Loretto, and Abdullah, AccountantsBalance Sheet
Revenues were $96,000 and expenses were $60,000, leaving $36,000 net income to bedistributed to the three partners’ capital accounts. Once the amount to be allocated is deter-mined, a closing entry crediting the capital accounts is required. If net income is to bedivided equally, the Income Summary account is closed to the capital accounts as follows:
Dividing Net Income Based on Amounts InvestedThe partners may agree to divide net income using a fraction determined by using theamounts of the original capital investment. The following shows the steps involved inthis calculation:
1. Determine the amounts originally invested.
Saar $ 50,000Loretto 30,000Abdullah 40,000Total $120,000
2. Determine fractions. (The denominator is the total amount invested, $120,000,and each partner’s individual investment becomes the numerator.)
Profits to be TotalRatio Divided Allocated
Saar50,000
=5
� $36,000 = $15,000120,000 12
Loretto30,000
=3
� 36,000 = 9,000120,000 12
Abdullah40,000
=4
� 36,000 = 12,000120,000 12
Total to be allocated $36,000
The general journal entry to close the Income Summary to the capital accounts is asfollows:
380 C H A P T E R f o u r t e e n
GENERAL JOURNAL PagePOST
DATE DESCRIPTION REF. DEBIT CREDIT
20XXDec. 31 Income Summary 3 6 0 0 0 00
Saar, Capital 1 2 0 0 0 00Loretto, Capital 1 2 0 0 0 00Abdullah, Capital 1 2 0 0 0 00
To Close Income Summary to Capital
Dividing Net Income Using a Fixed RatioIn the partnership agreement, the contract may specify a fixed ratio to be used to dividethe profits or losses. For example, Saar, Loretto, and Abdullah decide to use a ratio of3:2:1, respectively. To use this ratio, convert the ratio into a fraction and multiply it bythe net income or loss of the period. The steps for using the ratio to divide the profit areas follows:
1. Determine the fraction from the ratio. Add: 3 + 2 + 1 = 6. Thus, 6 becomes thedenominator of the fraction. The numerators are the numbers in the ratio.
The general journal entry to close the Income Summary to the capital accounts is asfollows:
P a r t n e r s h i p A c c o u n t i n g 381
GENERAL JOURNAL PagePOST
DATE DESCRIPTION REF. DEBIT CREDIT
20XXDec. 31 Income Summary 3 6 0 0 0 00
Saar, Capital 1 5 0 0 0 00Loretto, Capital 9 0 0 0 00Abdullah, Capital 1 2 0 0 0 00
To Record the Closing of the Income Summary to Capital
GENERAL JOURNAL PagePOST
DATE DESCRIPTION REF. DEBIT CREDIT
20XXDec. 31 Income Summary 3 6 0 0 0 00
Saar, Capital 1 8 0 0 0 00Loretto, Capital 1 2 0 0 0 00Abdullah, Capital 6 0 0 0 00
To Record the Closing of the Income Summary to Capital
Dividing Net Income by Paying Interest onInvestments and Salary AllowancesAnother common way to divide profits is to pay interest on the original capital invest-ments, give a salary allowance, and divide any remainder equally or according to a fixedratio. The following example assumes 5 percent (.05) interest on the original invest-ment, salary allowances of $10,000 to each partner, and any remainder to be dividedequally. The following shows the calculations made to determine the distribution.
Share to Share to Share toSaar Loretto Abdullah Total
Total Amount to Be Divided $36,000Allocated as Interest:Saar (5% � $50,000) $ 2,500Loretto (5%� $30,000) $ 1,500Abdullah (5%� $40,000) $ 2,000Total Interest –6,000
Balance $30,000Salary Allowances 10,000 10,000 10,000 –30,000Totals to Each $12,500 $11,500 $12,000 0
There is no remainder to be divided in this instance. The following is the journalentry to close the Income Summary to the capital accounts.
Now assume the same facts except that Saar will receive $10,000 salary allowance, Lorettowill receive $8,000, and Abdullah will receive $9,000. The remainder, if any, will be divid-ed equally. The calculation to determine the distribution would then be as follows:
Share to Share to Share toSaar Loretto Abdullah Total
Total Amount to Be Divided $36,0005% Interest $ 2,500 $ 1,500 $ 2,000 –6,000Balance $30,000Salary Allowance 10,000 8,000 9,000 –27,000Balance 3,000Remainder Divided by 3 1,000 1,000 1,000 –3,000Totals $13,500 $10,500 $12,000 0
382 C H A P T E R f o u r t e e n
GENERAL JOURNAL PagePOST
DATE DESCRIPTION REF. DEBIT CREDIT
20XXDec. 31 Income Summary 3 6 0 0 0 00
Saar, Capital 1 2 5 0 0 00Loretto, Capital 1 1 5 0 0 00Abdullah, Capital 1 2 0 0 0 00
To Record the Closing of the Income Summary to Capital
The general journal entry to close the Income Summary to the capital accounts is asfollows:
The methods illustrated thus far are used for calculating the proper allocation of profitsto the partners. The use of the salary allowance method does not require the partners towithdraw a certain amount as salary. The salary allowances are used solely for calculat-ing the distribution of net income. The closing of the Income Summary account to thecapital accounts of the partners is the end result of the method used to share profits orlosses.
Partnership Financial Statements
The financial statements of a partnership business are similar to those of a proprietor-ship. The income statement, statement of changes in partners’ equity and the balancesheet follow. Assume that each partner has withdrawn $8,000 during the year.
P a r t n e r s h i p A c c o u n t i n g 383
GENERAL JOURNAL PagePOST
DATE DESCRIPTION REF. DEBIT CREDIT
20XXDec. 31 Income Summary 3 6 0 0 0 00
Saar, Capital 1 3 5 0 0 00Loretto, Capital 1 0 5 0 0 00Abdullah, Capital 1 2 0 0 0 00
To Record the Closing of the Income Summary to Capital
384 C H A P T E R f o u r t e e n
Saar, Loretto, and Abdullah, AccountantsStatement of Changes in Partners’ Equity
Interest at 5% (.05 � $50,000) $ 2 5 0 0 00Salary Allowance 1 0 0 0 0 001/3 of Remaining Net Income 1 0 0 0 00
Total $ 1 3 5 0 0 00
LorettoInterest at 5% (.05 � $30,000) $ 1 5 0 0 00Salary Allowance 8 0 0 0 001/3 of Remaining Net Income 1 0 0 0 00
Total $ 1 0 5 0 0 00
AbdullahInterest at 5% (.05 � $40,000) $ 2 0 0 0 00Salary Allowance 9 0 0 0 001/3 of Remaining Net Income 1 0 0 0 00
Total $ 1 2 0 0 0 00
Net Income Allowed $ 3 6 0 0 0 00
Accounting for a Deficit When Distributing Net IncomeIn the event the method used for distribution of net income results in a deficit amount(negative) after interest and salary allowances, the deficit must be subtracted in the calcu-lation rather than added. Assume for the partnership of Saar, Loretto, and Abdullah thatthe method for distributing net income or loss is to calculate interest at 5 percent of theoriginal investment, give salary allowances of $10,000, $8,000, and $9,000, respectively, anddivide any remainder equally. The following example will show the use of this methodwhen profits are $24,000. The calculation to determine the distribution is as follows:
Share to Share to Share toSaar Loretto Abdullah Total
The general journal entry to close the Income Summary to the capital accounts willdebit income summary for $24,000 and credit the individual capital accounts.
Distributing a Net LossThe above examples cover only net income. Should a loss occur, the procedure for dis-tributing the loss to the partners’ capital accounts is the same as distributing net incomeunless the partners agree otherwise. Losses will reduce both assets and capital. Assumingthat the partners share profits and losses equally, and assuming a $36,000 loss, the clos-ing entry debits the individual partner’s capital accounts $12,000 each and creditsIncome Summary for $36,000.
P a r t n e r s h i p A c c o u n t i n g 385
Saar, Loretto, and Abdullah, AccountantsBalance Sheet
The Account Form Balance SheetAn account form balance sheet shows the assets on the left-hand side and liabilities andowner’s equity on the right-hand side. The account form balance sheet will be used inthis chapter to demonstrate changes in the balance sheet as they occur from the with-drawal of a partner, the addition of a partner, or a partnership going out of business. Thereport form balance sheet has been used in previous chapters. Following are illustrationsof various possibilities for changes in the composition of the partnership.
Withdrawing or Adding a New PartnerA partnership is based on a contractual agreement among individuals and ends when apartner withdraws from the firm or a new partner is added. The business, however, maycontinue with a new partnership agreement. A partner may withdraw by selling his orher interest or equity in cash or other assets. If all the partners agree, a new partner mayjoin the firm either by buying the interest of a present partner, by contributing addi-tional assets equal to the equity he or she is acquiring, or by investing either more or lessthan the equity he or she will receive.
The partnership agreement should outline the procedure governing a partner whowishes to withdraw from the business. Withdrawal may occur when a partner wants toretire or does not wish to continue under the present business arrangements. For exam-ple, assume that Abdullah, with an equity of $40,000, wants to retire. The partnershipcontract provides that an audit be performed which includes having all assets appraisedto determine market value. In addition, a determination must be made of all liabilitiesof the partnership. Should the audit reveal that assets and liabilities are different thanreflected on the books of the partnership, adjustments are made to the record to deter-mine the true equities of the partners. Once this is accomplished, the contract may pro-vide that assets be distributed to the retiring partner if it does not jeopardize the futureprofitability of the remaining partners.
Sale of Partnership Interest for More Than Partner’sEquityAssume that M. Saar wants to sell his interest to B. Knight. The balance sheet before thissale is as follows:
386 C H A P T E R f o u r t e e n
Saar, Loretto, and Abdullah, AccountantsBalance Sheet
Knight has agreed to pay Saar $60,000 for his equity in the business. Loretto andAbdullah agree to accept Knight as a partner. The general journal entry to record thetransfer is as follows:
After this entry, the old partnership is ended and a new partnership is formed. The onlychange in the balance sheet will be the substitution of Knight for Saar. After the newpartnership is formed, a new contract is written.
Two points should be noted. First, the $60,000 Knight paid Saar was a personaltransaction between the two and does not affect the partnership records. The $50,000equity of Saar is transferred to Knight with the approval of the other two partners.Remember, the business entity concept requires that personal transactions be kept sep-arate from business transactions. The second point to note is that Loretto and Abdullahmust agree to have Knight as a partner since a partnership is based on agreement of allparties.
Partner Admitted with Investment Same as EquityAssume that Knight is to invest $40,000 in cash to receive a one-fourth interest in thepartnership. The following shows the equity of the present owners:
Saar $ 50,000Loretto 30,000Abdullah 40,000Total $120,000
After Knight’s investment of $40,000, the total equity is $160,000. One-fourth of$160,000 is $40,000, the equity of the new partner. The journal entry to illustrate theaddition of Knight under this assumption is as follows:
P a r t n e r s h i p A c c o u n t i n g 387
GENERAL JOURNAL PAGE POST
DATE DESCRIPTION REF. DEBIT CREDIT
20XXAug. 31 Saar, Capital 5 0 0 0 0 00
Knight, Capital 5 0 0 0 0 00To Record the Transfer of Saar’s Equityin the Partnership to Knight
GENERAL JOURNAL PAGE POST
DATE DESCRIPTION REF. DEBIT CREDIT
20XXAug. 31 Cash 4 0 0 0 0 00
Knight, Capital 4 0 0 0 0 00To Record the Addition of Knight as a Partner with a One-Fourth Interest
After the entry is posted, the assets and equities of the new partnership will appear asfollows:
Withdrawal of a PartnerAssume that Abdullah wants to retire and will accept cash equal to her equity. Assumefurther that assets and liabilities are the same as presented on the balance sheet on page386 and that the withdrawal of cash by Abdullah will not jeopardize the firm’s cash posi-tion. The general journal entry to record the withdrawal of Abdullah is as follows.
Sometimes when a partner retires, the remaining partners may not wish to give anamount equal to the retiring partner’s equity. The retiring partner may then agree totake an amount less than the value of his or her capital account. If this is the situation,the profit-loss sharing ratio is used to adjust the capital accounts of the remaining part-ners. Assume that the profits and losses are to be divided equally, and Abdullah agrees totake $30,000 in cash for her $40,000 equity. The entry to show the withdrawal ofAbdullah for $30,000 cash is as follows:
388 C H A P T E R f o u r t e e n
Saar, Loretto, and Abdullah, AccountantsBalance Sheet
Cash 4 0 0 0 0 00To Record the Withdrawal of Rose whoReceives Cash Equal to Her Equity
Bonus to Old PartnersA new partner may be expected to invest more assets than the equity he or she is toreceive. This might occur because the equities of the present partners may not reflect thetrue worth of an already successful business. If this is the case, the partnership is worthmore than the records indicate. For example, assume that the present equities are thesame as previously indicated and that Knight is to invest cash of $36,000 for a one-fifthinterest. The amount to be credited to Knight’s capital account for a 1/5 interest is deter-mined as follows:
Equities of the present partners $120,000Investment of the new partner 36,000Total equities of the new partnership 156,000Equity of Knight (1/5 � $156,000 = $31,200) $ 31,200
Providing the present partners share equally, the bonus of $4,800 (the differencebetween the cash given, $36,000, and the equity received, $31,200) will be divided by 3and the capital accounts of the present partners will each be increased by $1,600. Thefollowing is the journal entry to admit Knight as one-fifth partner.
P a r t n e r s h i p A c c o u n t i n g 389
GENERAL JOURNAL PagePOST
DATE DESCRIPTION REF. DEBIT CREDIT
20XXAug. 31 Cash 3 6 0 0 0 00
Saar, Capital 1 6 0 0 00Loretto, Capital 1 6 0 0 00Abdullah, Capital 1 6 0 0 00Knight, Capital 3 1 2 0 0 00
To Record the Addition of Knight asPartner with a One-Fifth Interest
GENERAL JOURNAL PagePOST
DATE DESCRIPTION REF. DEBIT CREDIT
20XXAug. 31 Abdullah, Capital 4 0 0 0 0 00
Cash 3 0 0 0 0 00Saar, Capital 5 0 0 0 00Loretto, Capital 5 0 0 0 00
To Record the Withdrawal of Abdullah whoReceives Cash Less Than Her Equity
After the entry is posted, the assets, liabilities, and owners’ equity are as follows:
Bonus to New PartnerA bonus may be given to a new partner when the new partner is given more equity thanhis or her current capital balance. Assume that Knight invests $20,000 for a one-fourthinterest. The equity given to Knight in this case is greater than his equity. Thus Saar,Loretto, and Abdullah, who share net income and losses equally, must give up an equal-portion of their equity to Knight as determined below.
Equities of the present partners $120,000Add investment of new partner 20,000Total equities of the new partnership 140,000Equity of Knight (1/4 � $140,000 = $35,000) $ 35,000
There is $15,000 difference between the $20,000 cash investment of Knight and totalequity of $35,000 he received. The $15,000 is a bonus to Knight. However, the differencemust be shared by the present partners as a reduction in their capital accounts. Thereduction in the capital accounts is $5,000 each. The entry to record the addition ofKnight under these circumstances is as follows.
390 C H A P T E R f o u r t e e n
Saar, Loretto, and Abdullah, AccountantsBalance Sheet
Saar, Capital 5 0 0 0 00Loretto, Capital 5 0 0 0 00Abdullah, Capital 5 0 0 0 00Knight, Capital 3 5 0 0 0 00To Record the Addition of Knight as aPartner with a One-Fourth Interest
After the entry is posted, the assets, liabilities, and owners’ equity appear as follows.
This type of situation might occur when a new partner has a special talent or busi-ness skill that will increase the profitability of the firm. However, there are times when abonus is not recorded at all. Rather, goodwill is recorded and the old partners’ capitalaccounts are increased. This method is seldom used; the bonus method is the preferredmethod.
In the event the two remaining partners are eager to see Abdullah retire, they may abewilling to give more than Abdullah’s equity. Assume that they agree to give Abdullah$40,000 in cash and a note payable for $10,000 for her $40,000 equity. The entry torecord this situation is as follows:
The remaining partners share the additional equity given to Abdullah as a loss to them-selves. Many other variations similar to these can be used. However, whatever method isused, assets must equal liabilities and owners’ equity at all times.
P a r t n e r s h i p A c c o u n t i n g 391
Saar, Loretto, and Abdullah, AccountantsBalance Sheet
Saar, Capital 5 0 0 0 00Loretto, Capital 5 0 0 0 00
Cash 4 0 0 0 0 00Notes Payable 1 0 0 0 0 00
To Record the Withdrawal of AbdullahWho Receives Cash and a Note Payablefor Her Equity
Going Out of Business—Liquidation
Partners may determine that it is no longer possible to continue in business. This mayoccur if the partners have unsettled disputes or the business is no longer profitable andliquidation becomes necessary. Liquidation is the total process of going out of business,or the legal process of converting assets to cash, paying all creditors, and making finaldistribution of cash to the partners. This legal process also means that each partner isliable to pay the creditors whether or not there is sufficient cash remaining. Althoughmany different circumstances occur in liquidation, only two are discussed here. In eachcase, there are four steps to be followed.
1. Convert all noncash assets to cash and record the gain or loss on liquidation.
2. Distribute the gains or losses to the partners’ capital accounts according to theprofit-loss ratio.
3. Pay the liabilities.
4. Distribute the remaining cash according to the equities (capital balances) of thepartners.
A temporary account called Loss or Gain from Liquidation is opened to assemble thegains or losses that may occur when selling the assets. It is credited for a gain and debitedfor a loss. The conversion of noncash assets to cash is called realization. Partners will nor-mally share losses and gains from liquidation using their income and loss sharing ratio.
Assets Sold for a GainThe liquidation of a partnership may be illustrated using the following information.Saar, Loretto, and Abdullah, the partners in the accounting firm in previous illustrations,have had a bitter dispute over business policies. They decide to dissolve the partnership.To illustrate a liquidation where assets are sold for a gain, assume the following balancesheet before liquidation.
Assume that the other assets are sold for $109,000 and the partners share profits andlosses equally. The four steps necessary upon liquidation are shown as journal entries.
392 C H A P T E R f o u r t e e n
Saar, Loretto, and Abdullah, AccountantsBalance Sheet
20XXDec. 31 Loss or Gain on Realization 9 0 0 0 00
Saar, Capital 3 0 0 0 00Loretto, Capital 3 0 0 0 00Abdullah, Capital 3 0 0 0 00
To Record the Closing of the Loss or Gainon Realization Account to the Partners’Capital Accounts
3. Pay the liabilities.
4. Distribute the remaining cash according to the equities of the partners.
Once the above entries are posted, every account in the partnership records will have azero balance, signifying the termination of this business.
It is important to remember that cash remaining after liquidation is distributed topartners according to their capital balances while gains and losses from liquidation areallocated according to the income and loss sharing ratio.
Assets Sold for a LossMany times a business cannot sell its other assets at the amount carried in the records.Assets will deteriorate with age and therefore are not as marketable as when they werenew. Assume that other assets are listed on the balance sheet at $100,000 and that theyare sold for $91,000. This is a $9,000 loss to the partners and will result in reducing boththeir assets and capital accounts. Each of the four steps are presented as journal entriesas follows.
1. Convert all noncash assets to cash and record the gain or loss on liquidation.
394 C H A P T E R f o u r t e e n
GENERAL JOURNAL PAGE POST
DATE DESCRIPTION REF. DEBIT CREDIT
20XXDec. 31 Accounts Payable 1 0 0 0 0 00
Cash 1 0 0 0 0 00To Record Payment to the Creditors
GENERAL JOURNAL PagePOST
DATE DESCRIPTION REF. DEBIT CREDIT
20XXDec. 31 Saar, Capital 5 3 0 0 0 00
Loretto, Capital 3 3 0 0 0 00Abdullah, Capital 4 3 0 0 0 00
Cash 1 2 9 0 0 0 00To Record the Closing of the PartnershipBooks
GENERAL JOURNAL PAGE POST
DATE DESCRIPTION REF. DEBIT CREDIT
20XXDec. 31 Cash 9 1 0 0 0 00
Loss or Gain on Realization 9 0 0 0 00Other Assets 1 0 0 0 0 0 00
To Record the Sale of Other Assets
2. Distribute the gains or losses to the partners’ capital accounts according to theprofit-loss ratio.
3. Pay the liabilities.
After the above entries are posted, the T-accounts will appear as follows:
There is $111,000 left in the Cash account, and the total remaining capital account bal-ances equal $111,000. In step four, the amount of cash to be distributed to each partneris determined by the balance in each partner’s capital account.
4. Distribute the remaining cash according to the equities of the partners.
P a r t n e r s h i p A c c o u n t i n g 395
GENERAL JOURNAL PagePOST
DATE DESCRIPTION REF. DEBIT CREDIT
20XXDec. 31 Saar, Capital 3 0 0 0 00
Loretto, Capital 3 0 0 0 00Abdullah, Capital 3 0 0 0 00
Loss or Gain on Realization 9 0 0 0 00To Record the Closing of the Loss toPartners’ Capital Accounts
GENERAL JOURNAL PAGE POST
DATE DESCRIPTION REF. DEBIT CREDIT
20XXDec. 31 Accounts Payable 1 0 0 0 0 00
Cash 1 0 0 0 0 00To Record the Payment of the Creditors
After this entry is posted, all the accounts have a zero balance and the partnership is ter-minated.
A problem may occur if one partner’s share of the loss is greater than the balance ofhis or her capital account. If this is the case, the partner must cover the deficit by payingcash into the partnership. In this situation, a deficit is a debit balance in a partner’s cap-ital account. This could occur from liquidation losses, losses from previous periods, orwithdrawals before liquidation. For example, assume the partners Saar, Loretto, andAbdullah share profits and losses in a 2:2:1 ratio. If the other assets are shown at$100,000 on the balance sheet and sold for $20,000, a loss of $80,000 must be distrib-uted. The four steps, presented as journal entries, will illustrate this problem and are asfollows.
1. Convert all assets to cash.
2. Distribute the gains or losses to the partners’ capital accounts according to theprofit-loss ratio.
396 C H A P T E R f o u r t e e n
GENERAL JOURNAL PagePOST
DATE DESCRIPTION REF. DEBIT CREDIT
20XXDec. 31 Saar, Capital 4 7 0 0 0 00
Loretto, Capital 2 7 0 0 0 00Abdullah, Capital 3 7 0 0 0 00
Cash 1 1 1 0 0 0 00To Record the Closing of the PartnershipBooks
GENERAL JOURNAL PAGE POST
DATE DESCRIPTION REF. DEBIT CREDIT
20XXDec. 31 Cash 2 0 0 0 0 00
Loss or Gain on Realization 8 0 0 0 0 00Other Assets 1 0 0 0 0 0 00
To Record the Sale of the Other Assets
3. Pay the creditors.
After the above entries are posted, the T accounts will appear as follows:
Loretto has a debit balance of $2,000 in his capital account and is liable to the partner-ship for his deficit. If Loretto has sufficient personal assets and contributes $2,000 to thefirm to cover his debit balance, step four can be completed as follows:
4. Distribute the remaining cash according to the equities of the partners.
a. Payment of cash by Loretto.
P a r t n e r s h i p A c c o u n t i n g 397
GENERAL JOURNAL PagePOST
DATE DESCRIPTION REF. DEBIT CREDIT
20XXDec. 31 Saar, Capital * 3 2 0 0 0 00
Loretto, Capital 3 2 0 0 0 00Abdullah, Capital 1 6 0 0 0 00
Loss or Gain on Realization 8 0 0 0 0 00To Record the Closing of the Loss to thePartners’ Capital Accounts on a 2:2:1 Ratio
*Calculation of division of loss:Saar 2/5 � $80,000 = $32,000Bagwell 2/5 � $80,000 = 32,000Abdullah 1/5 � $80,000 = 16,000
GENERAL JOURNAL PAGE POST
DATE DESCRIPTION REF. DEBIT CREDIT
20XXDec. 31 Accounts Payable 1 0 0 0 0 00
Cash 1 0 0 0 0 00To Record the Payment of the Creditors
b. Distribute remaining cash.
After posting these two entries, all the accounts have a zero balance and the partnershipis terminated. However, if Loretto has no personal assets and cannot pay his debt,because of unlimited liability Saar and Abdullah must share this additional loss accord-ing to their portion of the profit-loss ratio, without Loretto, which is 2:1. The journalentries for step four under these circumstances are as follows.
4. Distribute the remaining cash according to the equities of the partners.
a. Distribute the $2,000 loss.
398 C H A P T E R f o u r t e e n
GENERAL JOURNAL PAGE POST
DATE DESCRIPTION REF. DEBIT CREDIT
20XXDec. 31 Cash 2 0 0 0 00
Loretto, Capital 2 0 0 0 00To Record the Cash Contribution of Lorettoto Cover His Liability
GENERAL JOURNAL PagePOST
DATE DESCRIPTION REF. DEBIT CREDIT
20XXDec. 31 Saar, Capital 1 8 0 0 0 00
Abdullah, Capital 2 4 0 0 0 00Cash 4 2 0 0 0 00
To Record the Closing of the PartnershipBooks
GENERAL JOURNAL PagePOST
DATE DESCRIPTION REF. DEBIT CREDIT
20XXDec. 31 Saar, Capital * 1 3 3 3 00
Abdullah, Capital 6 6 7 00Loretto, Capital 2 0 0 0 00
To Record Loretto’s Liability as a Loss tothe Remaining Partners
*Calculation of division of loss:Saar 2/3 � $2,000 = $1,333Abdullah 1/3 � $2,000 = 667
P a r t n e r s h i p A c c o u n t i n g 399
GENERAL JOURNAL PagePOST
DATE DESCRIPTION REF. DEBIT CREDIT
20XXDec. 31 Saar, Capital 1 6 6 6 7 00
Abdullah, Capital 2 3 3 3 3 00Cash 4 0 0 0 0 00
To Record the Closing of the PartnershipBooks
b. Distribute the remaining cash.
After posting of the above entries, all the accounts have a zero balance and the partner-ship is terminated.
Even though the partner with the deficit cannot pay at the present time, the liabilityis not eliminated. If the deficit partner becomes able to pay at some time in the future,he or she must do so.
Summary
A partnership is a voluntary association of two or more legally competent persons tocarry on as co-owners a business for profit. It is best if they have a written partnershipagreement, but their contract may be a verbal one. Partnerships are characterized bylimited life, which means that the partnership cannot exist separate from the individualpartners, thus it may end when one partner becomes unable, through death, bankrupt-cy or lack of legal capacity, to contract. Partners, through mutual agency, have the legalability to enter into contracts within the scope of the partnership. Such contracts arebinding on the other partners. Unlimited liability, which also characterizes partnerships,refers to the fact that each partner is personally liable for the debts of the business.Though there are many advantages to forming a partnership, limited life, unlimited lia-bility, and mutual agency are disadvantages that should be considered before forming anew partnership.
Partnership accounting is the same as proprietorship accounting, except that eachpartner has his or her own drawing account. Partners are owners of the business and donot receive salaries; rather, their drawing accounts are debited when cash is taken for per-sonal use and income taxes are based on their share of the net income of the business.
Partners will decide upon a profit-loss ratio which will be used to determine howprofits and losses are to be allocated. Profits and losses may be distributed: (1) equally;(2) on a fractional basis; (3) based on amounts invested; or (4) using a fixed ratio.Should there be a loss, it will be distributed to the partners’ capital accounts the sameway as a net income unless there is an agreement to the contrary.
A new partnership may be created when a new individual buys the interest of one ofthe existing partners, or if an additional person is admitted as a partner. In such a case,the old partnership is dissolved. In addition to adding a new partner, an existing partnermay wish to withdraw from the partnership. In such a case, the value of all assets andliabilities of the partnership must be determined by an audit.
Partners may decide, because, for example, of unsettled disputes or lack of prof-itability, to liquidate. When this occurs: (1) all noncash assets must be converted to cash(called realization) and the gain or loss on liquidation recorded; (2) gains or losses mustbe distributed to the partners’ capital accounts according to their profit-loss ratio; (3)liabilities must be paid; and (4) any remaining cash must be distributed to the partnersaccording to their capital balances. Partners normally share gains and losses from liqui-dation according to their profit-loss sharing ratio.
Vocabulary Review
Here is a list of the words and terms for this chapter:
account form balance sheet partnership
deficit profit-loss ratio
liquidation realization
mutual agency unlimited liability
Fill in the blank with the correct word or term from the list.
1. The total process of going out of business is __________.
2. A/an __________ is an association of two or more competent persons who agreeto do business as co-owners for profit.
3. The ability of each partner, acting as an agent of the business, to enter into andbind it to contracts within the apparent scope of the business is __________.
4. __________ is the conversion of noncash assets to cash.
5. The method used by the partners to divide profits or losses in the __________.
6. A/an __________ is an abnormal balance in a capital account.
7. The principle that each partner is personally liable for the debts of the business iscalled __________.
8. __________ shows the three major categories—assets, liabilities, and owner’sequity—in a horizontal manner.
400 C H A P T E R f o u r t e e n
Match the words and terms on the left with the definitions on the right.
9. account form balance sheet
10. deficit
11. liquidation
12. mutual agency
13. partnership
14. profit-loss ratio
15. realization
16. unlimited liability
Exercises
E X E R C I S E 1 4 . 1Morton and Long plan to enter into a law partnership, investing $30,000 and $20,000,respectively. They have agreed on everything but how to divide the profits. Calculateeach partner’s share of the profit under each of the following independent assumptions.
a. If the first year’s net income is $50,000 and they cannot agree, how should theprofits be divided?
b. If the partners agree to share net income according to their investment ratio, howshould the $50,000 be divided?
c. If the owners agree to share net income by granting 10 percent interest on theiroriginal investments, giving salary allowances of $10,000 each, and dividing theremainder equally, how should the $50,000 be divided?
E X E R C I S E 1 4 . 2Assume Morton and Long from Exercise 14.1 use method c to divide profits and netincome is $20,000. How should the income be divided?
E X E R C I S E 1 4 . 3After a number of years, Long, from Exercise 14.1, decided to go with a large law firmand wishes to sell his interest to Brown. Long’s equity at this time is $35,000. Mortonagrees to take Brown as a partner, and Long sells his interest to Brown for $40,000.Prepare the general journal entry on December 31, 20XX to record the sale of Long’sinterest to Brown.
P a r t n e r s h i p A c c o u n t i n g 401
a. the method used by the partners to divideprofits or losses
b. each partner is personally liable for the debtsof the business
c. an association of two or more competentpersons who agree to do business as co-owners for profit
d. an abnormal balance in a capital account
e. the conversion of noncash assets to cash
f. the total proces of going out of business
g. the ability of each partner, acting as an agentof the business, to enter into and bind it tocontracts within the apparent scope of thepartnership
h. the format of a balance sheet that shows theassets, liabilities, and owners’ equity in ahorizontal manner
E X E R C I S E 1 4 . 4Smith, White, and Saint are partners owning the Book Nook. The equities of the part-ners are $60,000, $50,000, and $40,000, respectively. They share profits and losses equal-ly. White wishes to retire on May 31, 20XX. Prepare the general journal entries to recordWhite’s retirement under each independent assumption.
a. White is paid $50,000 in partnership cash.
b. White is paid $40,000 in partnership cash.
c. White is paid $55,000 in partnership cash.
E X E R C I S E 1 4 . 5Hall and Mason share profits and losses equally and have capital balances of $60,000 and$40,000, respectively. Taylor is to be admitted on January 2, 20XX, and is to receive aone-third interest in the firm. Prepare the general journal entries to record the additionof Taylor as a partner under the following unrelated circumstances.
a. Taylor invests $50,000.
b. Taylor invests $62,000.
c. Taylor invests $47,000.
E X E R C I S E 1 4 . 6Martin, Pearson, and Henderson are partners sharing profits and losses in a 2:1:1 ratio.Their capital balances are $30,000, $25,000, and $20,000, respectively. Because of an eco-nomic turndown, they have decided to liquidate. After all assets are sold and the credi-tors paid, $43,000 cash remains in the business chequing account.
a. Determine the amount of their losses by using the accounting equation.
b. Using the profit-loss ratio, determine the amount of loss to be distributed to eachpartner, and determine their new capital balances.
c. Determine the amount of cash each partner will receive in the final distribution.
E X E R C I S E 1 4 . 7Baker, Marshall, and Perryman share profits and losses equally and begin their businesswith investments of $20,000, $15,000, and $8,000, respectively. They have been unprof-itable in their business venture and decide they must liquidate. After all the assets aresold and all debts paid, $16,000 cash remains in the business chequing account.
a. Determine the amount of their losses by using the accounting equation.
b. Using the profit-loss ratio, determine the amount of loss allocated to each partner,and determine their new capital balances.
c. Calculate the amount of cash, if any, each partner will receive under the differentassumptions below.
(1) Perryman has personal assets and pays the amount she owes to thepartnership.
(2) Perryman has no personal assets and does not pay the amount she owes to thepartnership.
402 C H A P T E R f o u r t e e n
Problems
P R O B L E M 1 4 . 1Jones, Brady, and Bell formed a partnership making investments of $40,000, $60,000,and $80,000, respectively. They believe the net income from their business for the firstyear will be $81,000. They are considering several alternative methods for sharing thisexpected profit, which are: (1) divide the profits equally; (2) divide the profits accordingto their investment ratio; (3) divide the profits by giving an interest allowance of 10 per-cent on original investments, granting $10,000 salary allowance to each partner, anddividing any remainder equally. Round to the nearest dollar where required.
I n s t r u c t i o n sa. Prepare a schedule showing distribution of net income under methods 1, 2, and 3.
It should have the following headings.
Share to Share to Share to TotalPlan Calculations Jones Brady Bell Allocated
b. Using method 3 above, prepare a partial income statement showing the allocationof net income to the partners (see income statement on page 384 for example).
c. Journalize the closing of the Income Summary account on December 31, 20XXusing the information from b above.
P R O B L E M 1 4 . 2Abner, Black, and Cobb share profits and losses equally and have capital balances of$60,000, $50,000, and $50,000, respectively. Cobb wishes to sell his interest and leave thebusiness on July 31 of this year. Cobb is to sell his interest to Williams with the approvalof Abner and Black.
I n s t r u c t i o n sPrepare the general journal entries, without explanations, to record the followingindependent assumptions.
a. Cobb sells his interest to Williams for $50,000.
b. Cobb sells his interest to Williams for $40,000.
c. Cobb decides to stay in the partnership but sell one-half of his interest to Williamsfor $30,000. (Hint: What is the value of half of Cobb’s capital account?)
d. If Williams is admitted as a new partner, must a new partnership agreement bewritten? Why?
P R O B L E M 1 4 . 3Coleman and Simmons are partners and own the ABC Gift Shop. They formed theirpartnership on January 2, 20XX, with investments of $50,000 and $25,000. Simmonsinvested an additional $5,000 on July 7. They share profits giving 10 percent interestallowance on beginning investments and dividing the remainder on a 2:1 ratio.Following is their trial balance before closing.
P a r t n e r s h i p A c c o u n t i n g 403
a. Prepare the general journal entries, without explanations, to record the closing ofall the nominal accounts (revenue and expense) using the Income Summaryaccount.
b. Prepare a schedule showing the distribution of net income to the partners. Itshould have the following headings.
Share to Share to TotalCalculations Coleman Simmons Allocated
c. Prepare the general journal entries to record the closing of the Income Summaryaccount to the capital accounts, and close the drawing accounts to the capitalaccounts.
d. Prepare the partnership income statement showing the allocation of net income.
e. Prepare the statement of owners’ equity.
f. Prepare a balance sheet.
P R O B L E M 1 4 . 4Arnold, Cole, and Yamaguchi are partners, owning Pizza Plus and sharing profits andlosses in a 3:2:1 ratio. The balance sheet, presented in account form format for this busi-ness, is as follows.
Arnold wishes to withdraw from the firm. Cole and Yamaguchi agree.Prepare the general journal entries, without explanations, to record the June 30 with-
drawal of Arnold under the following independent assumptions.
a. Arnold withdraws taking partnership cash of $60,000.
b. Arnold withdraws taking cash of $32,000 and truck #2 (debit AccumulatedAmortization and credit Truck).
c. Arnold withdraws taking cash of $51,000
d. Arnold withdraws taking cash of $25,000 and a $44,000 note given by the partner-ship.
e. Arnold withdraws taking cash of $25,000, a $20,000 note, and truck #1.
P R O B L E M 1 4 . 5Garcia, Keller, and Henley are partners who share profits and losses in a 3:1:2 ratio. Theircapital account balances are $60,000, $25,000, and $35,000, respectively. Watts is to beadmitted to the firm on March 31, 20XX with a one-fourth interest.
I n s t r u c t i o n sPrepare the general journal entries to record the following unrelated assumptions.Omit explanations.
a. Watts is to be admitted by investing cash of $40,000.
b. Watts is to be admitted by investing cash of $30,000.
c. Watts is to be admitted by investing cash of $50,000.
P R O B L E M 1 4 . 6Bentley, Colby, and Musharaf plan to liquidate their partnership. They share profits andlosses on a 3:2:1 ratio. At the time of liquidation, the partnership balance sheet appearsas follows:
P a r t n e r s h i p A c c o u n t i n g 405
Arnold, Cole, and YamaguchiBalance SheetJune 30, 20XX
Prepare the general journal entries, without explanations, to record (1) the sale of theother assets; (2) the distribution of the loss or gain on realization; (3) the payment tothe creditors; and (4) the final distribution of cash. Each of the following are unrelatedassumptions.
a. The other assets are sold for $115,000.
b. The other assets are sold for $79,000.
c. The other assets are sold for $55,000.
P R O B L E M 1 4 . 7Irby, Jalisco, and Whitehorse are partners in a video rental business, sharing profits andlosses in a 2:1:1 ratio. Business has decreased due to the number of other rental stores intheir area. They decide it would be best to liquidate. Their December 31, 20XX balancesheet information is as follows.
Balance Sheet Information
Cash $15,000Video Inventory 75,000Accounts Payable 25,000Irby, Capital 25,000Jalisco, Capital 20,000Whitehorse, Capital 20,000
I n s t r u c t i o n sPrepare the general journal entries, without explanations, to show: (1) the sale of thenoncash assets; (2) the distribution of the losses or gains; (3) the payment to the credi-tors; and (4) the final distribution of cash under each of the following independentassumptions.
a. The video inventory is sold for $63,000.
b. The video inventory is sold for $25,000
c. The video inventory is sold for $20,000 and the partner with the deficit can anddoes pay from personal assets.
d. The same assumption as c above, except the partner with the deficit cannot pay.
406 C H A P T E R f o u r t e e n
Bentley, Colby, and MusharafBalance SheetJune 30, 20XX
