1 Partnership

Chapter
12-1
CHAPTER 12
ACCOUNTING FOR
PARTNERSHIPS
Chapter
12-2
PARTNERSHIP FORM OF
ORGANIZATION
A partnership is an association of two or
more persons to carry on as co-owners of a
business for profit.
Type of Business:
Small retail, service, or manufacturing
companies.
Accountants, lawyers, and doctors.
Chapter
12-3
CHARACTERISTICS OF
PARTNERSHIPS
Association of Individuals
Legal entity.
Accounting entity.
Net income not taxed as a separate entity.
Mutual Agency
Chapter
12-4
Act of any partner is binding

on all other partners, so long
as the act appears to be
appropriate for the partnership.
CHARACTERISTICS OF
PARTNERSHIPS
Limited Life
Dissolution occurs whenever

a partner withdraws or a new
partner is admitted.
Dissolution does not mean the business
ends.
Unlimited Liability
Chapter
12-5
Each partner is personally

and individually liable for
all partnership liabilities.
CHARACTERISTICS OF
PARTNERSHIPS
Co-ownership of Property
Each partner has a claim
on total assets.
This claim does not attach
to specific assets.
All net income or net loss is shared equally
by the partners, unless otherwise stated in
the partnership agreement.
Chapter
12-6
ORGANIZATIONS WITH
PARTNERSHIP CHARACTERISTICS
Special forms of business organizations are
often used to provide protection from
unlimited liability.
Special partnership forms are:
1. Limited Partnerships,
2. Limited Liability Partnerships, and
3. Limited Liability Companies.
Chapter
12-7
ADVANTAGES AND DISADVANTAGES

OF A PARTNERSHIP
Chapter
12-8
PARTNERSHIP AGREEMENT
(Articles of Co-partnership) Should specify
relationships among the partners:
1. Names and capital contributions of partners.
2. Rights and duties of partners.
3. Basis for sharing net income or net loss.

4. Provision for withdrawals of assets.
5. Procedures for submitting disputes to arbitration.
6. Procedures for the withdrawal or

addition of a partner.
7. Rights and duties of surviving partners
Chapter
in the event of a partners death.
12-9
FORMING A PARTNERSHIP
Each partners initial investment in a
partnership is entered in the partnership
records.
The partnership should record these
investments at the fair value of the assets
at the date of their transfer to the
partnership.
All partners must agree to the values
assigned.
Chapter
12-10
Illustration: Assume that A. Rolfe and T. Shea
combine their proprietorships to start a
partnership named U.S. Software. Rolfe and Shea
have the following assets prior to the formation of
the partnership.
Chapter
12-11
Illustration: Prepare the entry to record the
investment of A. Rolfe.
Cash
8,000
Office equipment
4,000
A. Rolfe, Capital
12,000
Prepare the entry to record the investment of
T. Shea.
Chapter
12-12
Cash
9,000
Accounts receivable
4,000
Allowance for doubtful accounts 1,000
T. Shea, Capital
12,000
After formation of the partnership, the
accounting for transactions is similar to
any other type of business organization
The steps in the accounting cycle for a
proprietorship also apply to a
partnership.
There are only minor differences in
journalizing and posting closing entries
and in preparing financial statements,
Chapter
12-13
DIVIDING NET INCOME OR

NET LOSS
Partners equally share net income or net loss

unless the partnership contract indicates
otherwise.
Closing Entries:
Close all Revenue and Expense accounts to
Income Summary.
Close Income Summary (Debit or Credit) to
each partners Capital account for his or her
share of net income or loss.
Chapter
12-14
Close each partners Drawing account to his

or her respective Capital account.

NET LOSS
Illustration: Assume that AB Company has net

income of $32,000 for 2012. The two partners,
L. Arbor and D. Barnett, share net income and
net loss equally. Drawings for the year were
Arbor $8,000 and Barnett $6,000. The last two
closing entries are:
Chapter
12-15

NET LOSS
Chapter
12-16

NET LOSS
Assume that the beginning capital balance is $47,000

for Arbor and $36,000 for Barnett. After posting the
closing entries, the capital and drawing accounts will
appear as shown as below:
Chapter
12-17

NET LOSS
Income Ratios
Partnership agreement should specify the basis for

sharing net income or net loss. The typical income
ratios are:
1. Fixed ratio (A proportion, percent, or fraction).
2. Ratio based on capital balances (Beginning/average)
3. Salaries to partners and remainder on a fixed ratio
4. Interest on partners capital balances and the
remainder on a fixed ratio.
5. Salaries to partners, interest on partners capital,
Chapter
and the remainder on a fixed ratio.
12-18

NET LOSS
Fixed Ratio:
Easy to apply
May be an equitable basis in some circumstances
Assume, for example, that Hughes and Lane are

partners. Each contributes the same amount of
capital, but Hughes expects to work full-time in
the partnership and Lane expects to work only
half-time. Accordingly, the partners agree to a
fixed ratio of 2/3 to Hughes and 1/3 to Lane
Chapter
12-19

NET LOSS
Ratio based on capital balances:

Appropriate when the funds invested in the
partnership are considered the critical factor
May also be equitable when the partners hire a
manager to run the business and do not plan to
take an active role in daily operations.
Salaries to partners and Interest on partners
capital are not expenses of the partnership.
So, these items do not enter into the matching of
expenses with revenues and determination of net
income or net loss.
Chapter
12-20

NET LOSS
Salaries, Interest, and Remainder on a Fixed
Ratio:
Chapter
12-21
The partnership must apply salaries and

interest before it allocates the remainder on
the specified fixed ratioeven if the provisions
exceed net income, or the partnership has
suffered a net loss for the year
The partnerships income statement should show,

below net income, detailed information
concerning the division of net income or net loss.

NET LOSS
Illustration: Sara King and Ray Lee are co-partners in

the Kingslee Company. The partnership agreement
provides for: (1) salary allowances of $8,400 to King
and $6,000 to Lee, (2) interest allowances of 10% on
capital balances at the beginning of the year, and (3)
the remainder equally. Capital balances on January 1,
2012 were King $28,000, and Lee $24,000. In 2012,
partnership net income is $22,000.
Instructions:
a) Prepare a schedule showing the distribution
of net income.
Chapter
12-22
b) Journalize the allocation of net income.

NET LOSS
Division of net income schedule
Chapter
12-23

NET LOSS
Journalizing the allocation of income.
Dec. 31 Income summary
Sara King, Capital
Ray Lee, Capital
(To close net income to
partners capital)
Chapter
12-24
22,000
12,400
9,600

NET LOSS
Illustration: Prepare a schedule showing the
distribution of net income assuming net income is
only $18,000.
Chapter
12-25
PARTNERSHIP FINANCIAL
STATEMENTS
The financial statements of a partnership are
similar to those of a proprietorship.
The differences are due to the number of
owners involved.
The owners equity statement for a partnership
is called the partners capital statement.
It explains the changes in each partners
capital account and in total partnership
capital during the year.
Chapter
12-26
STATEMENTS
Chapter
12-27
As in a proprietorship, partners capital

may change due to (1) additional investment,
(2) drawing, and (3) net income or net loss.
STATEMENTS
Chapter
12-28
The balance sheet for a partnership is the

same as for a proprietorship except for the
owners equity section.
LIQUIDATION OF A
PARTNERSHIP
Ends both the legal and economic life of the entity.
In liquidation, sale of noncash assets for cash is
called realization.
To liquidate, it is necessary to:
1. Sell noncash assets for cash and recognize a
gain or loss on realization.
2. Allocate gain/loss on realization to the partners
based on their income ratios.
3. Pay partnership liabilities in cash.
4. Distribute remaining cash to partners on the

Chapter
12-29
basis of their capital balances.
LIQUIDATION OF A
PARTNERSHIP
Each of the steps must be performed in sequence.
The partnership must pay creditors before
partners receive any cash distributions.
Also, an accounting entry must record each
step.
When a partnership is liquidated, all partners may
have credit balances in their capital accounts.
This situation is called no capital deficiency.

Chapter
12-30
LIQUIDATION OF A
PARTNERSHIP
No Capital Deficiency
Illustration: Assume that the Ace Company is
liquidated when its ledger shows following assets,
liabilities, and owners equity accounts.
Chapter
12-31
LIQUIDATION OF A
PARTNERSHIP
Assume that the partners of Ace Company

agree to liquidate the partnership on the
following terms:
1. The partnership will sell its noncash assets to

Jackson Enterprises for $75,000 cash.
2. The partnership will pay its partnership
liabilities.
3. The income ratios of the partners are 3: 2: 1,
respectively.
Chapter
12-32
LIQUIDATION OF A
PARTNERSHIP
Ace sells noncash assets (accounts receivable,
inventory, and equipment) for $75,000. The book
value of these assets is $60,000 ($15,000 +
$18,000 + $35,000 -$8,000). Thus, Ace realizes a
gain of $15,000 on the sale. The entry is:
Chapter
12-33
LIQUIDATION OF A
PARTNERSHIP
Ace allocates the $15,000 gain on realization to
the partners based on their income ratios,
which are 3:2:1. The entry is:
Chapter
12-34
LIQUIDATION OF A
PARTNERSHIP
Partnership liabilities consist of Notes Payable
$15,000 and Accounts Payable $16,000. Ace pays

creditors in full by a cash payment of $31,000.
The entry is:
Chapter
12-35
LIQUIDATION OF A
PARTNERSHIP
Ace distributes the remaining cash to the
partners on the basis of their capital balances.
After posting the entries in the first three
steps, all partnership accounts, including Gain on

Realization, will have zero balances except for
four accounts:
Chapter
12-36
Cash, $49,000;
R. Arnet, Capital $22,500;
P. Carey, Capital $22,800; and
W. Eaton, Capital $3,700, as shown below.
LIQUIDATION OF A
PARTNERSHIP
Chapter
12-37
LIQUIDATION OF A
PARTNERSHIP
Chapter
12-38
LIQUIDATION OF A
PARTNERSHIP
word of caution: Partnerships should not
distribute remaining cash to partners on the
basis of their income-sharing ratios.
On this basis, Arnet would receive three-
sixths, or $24,500, which would produce an

erroneous debit balance of $2,000.
The income ratio is the proper basis for
allocating net income or loss. It is not a proper

basis for making the fi nal distribution of cash
Chapter
12-39
to the partners.
LIQUIDATION OF A
PARTNERSHIP
Schedule of Cash Payments
The schedule of cash payments shows the

distribution of cash to the partners in a
partnership liquidation.
A cash payments schedule is sometimes prepared

to determine the distribution of cash to the
partners in the liquidation of a partnership
The schedule of cash payments is organized

around the basic accounting equation.
Chapter
12-40
LIQUIDATION OF A PARTNERSHIP
Chapter
12-41
Capital Deficiency
A capital deficiency may result from recurring

net losses, excessive drawings, or losses from
realization suffered during liquidation.
If such a partnership business is on the brink
of bankruptcy, the partners decide to liquidate

by having a going-out-of-business sale.
They sell merchandise at substantial discounts,

and sell the equipment at auction
Chapter
12-42
Capital Deficiency
Illustration: Assume that cash proceeds for Ace

Company from sale of equipment and merchandise
and collections from customers totals $42,000.
1. Prepare the entry for the realization of noncash
assets.
Cash
42,000
Accumulated depreciation
8,000
Loss on realization
18,000
Accounts receivable
15,000
Inventory
18,000
Chapter
12-43
Equipment
35,000
Capital Deficiency
Illustration: (2) Ace allocates the loss on
realization to the partners on the basis of their
income ratios. The entry is:
R. Arnet, Capital ($18,000 x 3/6)9,000
P. Carey, Capital ($18,000 x 2/6)6,000
W. Eaton, Capital ($18,000 x 1/6)3,000
Chapter
12-44
Loss on realization
(To allocate loss on realization
to partners)
18,000
Capital Deficiency
Illustration: (3) Prepare the entry to record
the payment in full to the creditors.
Notes payable
Accounts payable
Cash
15,000
16,000
(To record payment of partnership

liabilities)
Chapter
12-45
31,000
Capital Deficiency
Illustration: (4) After posting the three entries,
two accounts will have debit balancesCash, $16,000
and W. Eaton, Capital $1,800. Two accounts will have
credit balances R. Arnet, Capital $6,000, and P.
Carey, Capital $11,800. All four accounts are shown:
Chapter
12-46
Capital Deficiency
Eaton has a capital deficiency of $1,800, and

so owes the partnership $1,800.
Arnet and Carey have a legally enforceable
claim for that amount against Eatons personal

assets.
Note that the distribution of cash is still
made on the basis of capital balances. But the

amount will vary depending on how Eaton
settles the deficiency.
Chapter
12-47
Capital Deficiency
If the partner with the capital deficiency pays

the amount owed the partnership, the
deficiency is eliminated.
To illustrate, assume that Eaton pays $1,800

to the partnership. The entry is:
Chapter
12-48
Capital Deficiency
After posting this entry, account balances

are as follows.
Chapter
12-49
Capital Deficiency
Payment of Deficiency
R. Arnet
P. Carey
W. Eaton
Capital
Capital
Capital
Cash
Balances before liquidation
Farley payment
Balance
$ 16,000
(6,000) $ (11,800) $
1,800
$ 17,800
1,800
(1,800)
(6,000) $ (11,800) $
The cash balance of $17,800 is now equal to the credit

balances in the capital accounts (Arnet $6,000 1 Carey
$11,800). Ace now distributes cash on the basis of these
balances. The entry is:
Chapter
12-50
Capital Deficiency
If a partner with a capital deficiency is unable to
pay the amount owed to the partnership, the

partners with credit balances must absorb the loss.
The partnership allocates the loss on the basis of
the income ratios that exist between the partners

with credit balances.
The income ratios of Arnet and Carey are 3: 2, or

3/5 and 2/5, respectively. Thus, Ace would make
the following entry to remove Eatons capital
deficiency.
Chapter
12-51
Capital Deficiency
E12-10 (b)
Nonpayment
of Deficiency
R. Arnet
P. Carey
W. Eaton
Capital
Capital
Capital
Cash
Balances before liquidation
$ 16,000
Allocation of deficiency
Balance
(b)
(6,000) $ (11,800) $
1,080
$ 16,000
R. Arnet, Capital
P. Carey, Capital
Eaton, Capital
720
(1,800)
(4,920) $ (11,080) $
1,080
720
(To record write-off of capital

deficiency)
Chapter
12-52
1,800
1,800
Capital Deficiency
After posting this entry, the cash and capital
accounts will have the following balances.
Chapter
12-53
Capital Deficiency
The cash balance ($16,000) now equals the sum

of the credit balances in the capital accounts
(Arnet $4,920 1 Carey $11,080). Ace records
the distribution of cash as:
(b)
R. Arnet, Capital
P. Carey, Capital
Cash
4,920
11,080
16,000
(To record distribution of cash to the

partners)
Chapter
12-54

1 Partnership

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Chapter

Act of any partner is binding

Dissolution occurs whenever

Each partner is personally

ADVANTAGES AND DISADVANTAGES

3. Basis for sharing net income or net loss.

6. Procedures for the withdrawal or

DIVIDING NET INCOME OR

Partners equally share net income or net loss

Close each partners Drawing account to his

DIVIDING NET INCOME OR

Illustration: Assume that AB Company has net

DIVIDING NET INCOME OR

DIVIDING NET INCOME OR

Assume that the beginning capital balance is $47,000

DIVIDING NET INCOME OR

Partnership agreement should specify the basis for

DIVIDING NET INCOME OR

May be an equitable basis in some circumstances

Assume, for example, that Hughes and Lane are

DIVIDING NET INCOME OR

Ratio based on capital balances:

DIVIDING NET INCOME OR

The partnership must apply salaries and

The partnerships income statement should show,

DIVIDING NET INCOME OR

Illustration: Sara King and Ray Lee are co-partners in

DIVIDING NET INCOME OR

DIVIDING NET INCOME OR

DIVIDING NET INCOME OR

As in a proprietorship, partners capital

The balance sheet for a partnership is the

gain or loss on realization.

2. Allocate gain/loss on realization to the partners

based on their income ratios.

3. Pay partnership liabilities in cash.

4. Distribute remaining cash to partners on the

basis of their capital balances.

This situation is called no capital deficiency.

Assume that the partners of Ace Company

1. The partnership will sell its noncash assets to

Partnership liabilities consist of Notes Payable

$15,000 and Accounts Payable $16,000. Ace pays

After posting the entries in the first three

steps, all partnership accounts, including Gain on

On this basis, Arnet would receive three-

sixths, or $24,500, which would produce an

The income ratio is the proper basis for

allocating net income or loss. It is not a proper

The schedule of cash payments shows the

A cash payments schedule is sometimes prepared

The schedule of cash payments is organized

A capital deficiency may result from recurring

If such a partnership business is on the brink

of bankruptcy, the partners decide to liquidate

They sell merchandise at substantial discounts,

Illustration: Assume that cash proceeds for Ace

(To record payment of partnership

Eaton has a capital deficiency of $1,800, and

Arnet and Carey have a legally enforceable

claim for that amount against Eatons personal

Note that the distribution of cash is still

made on the basis of capital balances. But the