In the business world, a partnership is an association of two or more persons to carry on a business as co-owners for profit.
Many aspects of accounting for a partnership are same as for a corporation but there are unique features. For example: each partner has a separate capital account, the total of which replaces the stockholders’ equity section of the balance sheet.
Through this post I am going to quickly overview “basic” partnership accounting. As usually I will provide some illustrations for easier understanding. Enjoy!
Admitting a New Partner
When a new partner is admitted into a partnership, any contributions are recorded by partnership at market value but original book value is retained for tax purposes.
A computation can be made so that new partner invests an amount that will be equal to the capital balance set up. This eliminates the need to record either goodwill or a bonus:
- The new partner’s investment (NPI) can be set equal to the percentage of the business being acquired (%A) multiplied times the total capital of the business.
- Total capital would be the previous capital (PC) balance plus the new partner’s investment. Thus, equation would be set up and the new investment determined algebraically. NPI = %A X (PC + NPI) and solve for NPI.
Mr. Lie contributes land to help create a business as a partnership. The land had a book value to Mr. Lie of $8,000 but was worth $11,000 on the date of the transfer.
How the business should record the land?
For financial reporting purposes, the conveyance of property to a partnership is recorded by the business at the fair market value of the item. Consequently, this land will be recorded by the partnership at the $11,000 value on that date. In contrast, for taxation purposes, the land would retain its book value of $8,000. However, in financial accounting, tax laws have no authority.
When a New Partner Contributes Assets Worth More Than the Percentage Being Acquired
A new partner may have to contribute assets worth more than the percentage being acquired of the total capital, especially if it is a profitable partnership.
- This difference can be recorded by bonus method. Partner is given a set capital balance or a percentage of total capital. Any difference from contribution (either positive or negative) is recorded to original partners’ Capital accounts based on previous method of allocating profits and losses.
- This difference can also be recorded using goodwill method. The new partner re-ceives a capital balance exactly equal to the contribution. The new partner’s payment is then used to compute an implied value for the business as a whole. The investment is divided by the percentage acquired to get this valuation. The difference between this implied value and total capital (including the new investment) is viewed as goodwill and recorded along with an offsetting entry to the Capital accounts of the original partners based on the previous method of allocating profits and losses.
Bonus Method Case Examples
Mr. Lie and Ms. Lou are partners who share profits and losses on a 70:30 basis respectively. Currently, Mr. Lie has a capital balance of $40,000 and Ms. Lou has a capital balance of $20,000. The decision has been made to admit Mr. Yoo as a third partner upon payment to the business of cash of $30,000. Mr. Yoo will start with a 30% ownership in the business.
If the bonus method is to be used, what is the total capital after the admission of Mr. Yoo be?
Under the bonus approach, total capital after an admission or departure of a partner is simply the prior capital plus or minus any change in net assets. In this case, the capital was $60,000 and Mr. Yoo added in cash of $30,000. Total capital has increased to $90,000.
Using the same method [bonus method], what is the beginning capital account of Mr. Yoo?
The bonus method does not adjust the total capital figure. Total capital prior to the admission of Mr. Yoo was $60,000 ($40,000 plus $20,000). The payment to the business of $30,000 increases total capital to $90,000. Mr. Yoo is entitled to 30% of this new business so his beginning capital balance is recorded as $27,000 ($90,000 times 30%). In the bonus method, total capital is determined after the addition or subtraction of assets and liabilities. The new partner is then assigned the appropriate percentage of that total.
Goodwill Method Case Example
Two partners have capital balances of $60,000 and $50,000. They admit a new partner into the business. This new partner pays $60,000 to the business in order to acquire a 30% ownership. The goodwill method (sometimes referred to as the revaluation method) is to be applied.
If all assets of the business are properly valued, what is goodwill to be recognized?
Under the goodwill approach, after an admission of a partner, total capital is found by applying the price paid to the business as a whole. In this case, paying $60,000 for a 30% ownership share indicates an implied worth for the entire business of $200,000 ($60,000 divided by 30%). Without adjustment, total capital would be $170,000 ($110,000 capital for the old partners plus the $60,000 contribution of the new partner). Goodwill of $30,000 must be recognized to increase the capital from $170,000 to the implied value of $200,000.
Closing Out Revenues and Expenses at the Year-end Of Partnerships
When revenues and expenses are closed out at the end of the year, the net profit or loss must be assigned to the partners’ Capital accounts. The actual amount paid to a partner is usually set by agreement and can differ from this allocation process.
- If there is no agreement, split is always done on an even basis.
- If there is an agreement as to profit allocation but losses are not mentioned, the same method is used.
- Any agreements must be followed specifically. It can include several factors such as a salary allowance, interest, and a ratio. If more than one factor is included, the ratio is computed last.
Samantha and Julianne are partners with capital balances of $80,000 and $50,000 respectively. Samantha works 40 hours per week in the business and Julianne works 25 hours per week. Samantha and Julianne have an agreement whereby they will split all profits with 80% going to Samantha and 20% going to Julianne. In the current year, the business has a net loss of $20,000.
At the end of the year, what will Julie’s capital balance be?
If an agreement exists in order to structure the allocation of profits but no mention is made of possible losses, the same process will be used in both cases. Thus, since the business lost $20,000, 80% of that amount ($16,000) is attributed to Sam with the remaining 20% to Julie ($4,000). After that, Julie’s capital account will have been reduced from $50,000 to $46,000.
Liquidation of a Partnership
At some point, a partnership may be liquidated, the assets sold off and the debts paid with any residual amounts going to the partners.
In liquidating noncash assets, any gains and losses are assigned to the partners based on normal profit and loss allocation. Any residual cash goes to the partners based on the final balances in their capital accounts.
If enough money is set aside to pay all debts, available cash can be distributed to the partners before all noncash assets are sold. To determine distribution, maximum losses are assumed for all remaining noncash assets. If a partner has a negative capital balance after these simulated losses, that amount is also viewed as a loss to be absorbed by the remaining partners using their relative profit and loss percentages. When all remaining capital accounts have positive balances, those amounts are the safe capital amounts that can be distributed immediately.
A partnership has been liquidated and cash of $30,000 remains to be distributed.
How this cash will be given to the partners?
A final distribution after liquidation is based on the ending capital balances of the partners, assuming that each partner has a positive balance remaining. If one or more partners report a deficit, that amount must be contributed by that partner or the deficit must be assumed as an additional loss to be absorbed by the remaining partners.