Chapter 14: 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.

II.

Advantages:
A. Partners abilities:

B. Ease of formation:

C. No partnership income taxes:

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III.

Disadvantages:
A. Unlimited legal liability:

B. Obtaining resources:

IV.

Owners Investments:
Unlike corporation owners investments that are recorded in stockholders
equity accounts, owners investments in partnerships are recorded in capital
accounts.
Assume that Lowell and Nashua form a partnership to provide internet art
services. Lowell is an internet expert and Nashua has a significant amount of
cash available from his previous business experience. To start the partnership,
Lowell invests $10,000 and Nashua invests $40,000. The effects of their
investments could be as follows.

Date

Accounts

Debits

Credits

Date

Accounts

Debits
50,000

Credits

Cash
Lowell, Capital
Nashua, Capital

10,000
40,000

If the partners agreed to give equal credit to each partner, the effects would be
as follows.
Date

Accounts

Debits

Credits

Date

Accounts

Debits
50,000

Credits

Cash
Lowell, Capital
Nashua, Capital

25,000
25,000

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.
The accounting terminology for partnerships differs from that of corporations.

V.

Withdrawals:
Partners receive assets from a partnership by withdrawing them.
Asset withdrawals by partners are recorded in partner withdrawal accounts.

If Lowell withdrew $500 and Nashua withdrew $400 from their partnership,
the effects would be as follows.

Date

Accounts
Lowell, Drawing
Nashua, Drawing
Cash

Debits
500
400

Credits

Each partners drawing account is a contra owners equity account (similar to

the dividends account in a corporation). At the end of each accounting period,
each partners drawing account is closed to the partners capital account.

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If Lowells drawing account were closed to his capital account, the effects
would be as follows.
Date

Date
Lowell, Capital
Lowell, Drawing

VI.

Accounts

Debits

Credits

Accounts

Debits
500

Credits

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
,
partnership income summary is closed
. This
process of income allocation depends upon

Assume that the partnership agreement of Lowell and Nashua specifies that
(1) each partner is to receive interest of 1% per month on his capital balance at
the beginning of the month, (2) Lowell is to receive a monthly salary of
$6,000 and Nashua is to receive $4,000, and (3) any remaining income is to be
split equally between the partners. Assume that on April 1, 2007, Lowells
capital balance was $12,000 and Nashuas was $45,000. Assume also that the

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partnerships income for April was $18,000. Based on this data, the
partnerships income would be distributed as shown below.
Item

Lowell

Nashua

Totals

Item
Interest
$12,000 x .01
$45,000 x .01
Salary
Remaining income: $18,000 - $10,570
Totals

Lowell

Nashua

Totals

Totals

$120
$0
$6,000
$3,715
$9,835

$0
$450
$4,000
$3,715
$8,165

$120
$450
$10,000
$7,430
$18,000

The above income allocation affects the partnership as follows.

Date

Accounts

Debits

Credits

Date

Accounts

Debits
18,000

Credits

Income Summary
Lowell, Capital
Nashua, Capital

9,835
8,165

Assume that instead of $18,000, the partnerships income for April was
$9,000. Based on this data, the partnerships income would be distributed as
shown below.
Item

Lowell

Interest
$12,000 x .01
$45,000 x .01
Salary

$120
$0
$6,000

Nashua
$0
$450
$4,000

Totals
$120
$450
$10,000

Totals

Item

Lowell

Interest
$12,000 x .01
$45,000 x .01
Salary
Remaining income: $9,000 - $10,570
Totals

$120
$0
$6,000
($785)
$5,335

Nashua
$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

Credits

Date

Accounts

Debits
9,000

Income Summary
Lowell, Capital
Nashua, Capital

Credits
5,335
3,665

Assume that instead of $18,000, the partnerships income for April was a
$1,000 loss. Based on this data, the partnerships income would be distributed
as shown below.
Item
Interest
$12,000 x .01
$45,000 x .01
Salary

Lowell
$120
$0
$6,000

Nashua
$0
$450
$4,000

Totals
$120
$450
$10,000

Totals

Item

Lowell

Nashua

Totals

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Interest
$12,000 x .01
$45,000 x .01
Salary
Remaining income: - $1,000 - $10,570
Totals

$120
$0
$6,000
($5,785)
$335

$0
$450
$4,000
($5,785)
($1,335)

$120
$450
$10,000
($11,570)
($1,000)

The above income allocation affects the partnership as follows.

Date

Accounts

Debits

Credits

Date

Accounts

Debits
1,335

Credits

Nashua, Capital
Income Summary
Lowell, Capital

VII. Dissolution: Technically, a partnership is dissolved whenever there is

a change in partners.
A. Admission of a new partner: A new partner can be admitted to a
partnership in two ways:
(1) the purchase of an existing partners interest directly from the
partner

1,000
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(2) the investing of resources directly in the partnership

1. Purchase of existing partners interest: When a new partner

purchases an interest in a partnership by buying it directly from a
current partner,
the current partners capital interest is eliminated from the
partnerships accounting records and the new partners interest is
recorded.

For example, assume that Nashua sells his $65,000 capital interest to
Orono for $78,000. In this case, Nashua receives $78,000 cash and Orono
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

Credits

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Date

Accounts

Debits
65,000

Nashua, Capital
Orono, 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 partners capital interest is recorded.
In its simplest terms, the new partners capital interest is recorded at that
dollar amount equal to the new partners percentage interest in the
partnership.
For example, assume that Orono pays $30,000 to the Lowell and Nashua
partnership for a 15% interest in the firm. Assume that immediately prior
to the admission of Orono, the partners capital interests were as follows.
Partner
Lowell
Nashua
Totals

Partners Capital
$35,000
$65,000
$100,000

%
35%
65%
100%

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Oronos $30,000 payment increases the partnerships net assets to
$130,000.
Oronos 15% capital interest would be $19,500 ($130,000 x .15).
Since Orono 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 Lowell and Nashua would each
increase by $5,250 ($10,500 / 2), since they share income equally.
The effects on the partnership would be as follows.
Date

Accounts

Debits

Credits

Date

Accounts

Debits
30,000

Credits

Cash
Lowell, Capital
Nashua, Capital
Orono, Capital

5,250
5,250
19,500

After the admission of Orono, the partners capital interests would be as

follows.
Partner
Lowell
Nashua
Orono
Totals

Partners Capital
$40,250
$70,250
$19,500
$130,000

%
31%
54%
15%
100%

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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 Lowell decides to withdraw from the partnership. Immediately

prior to his withdrawal, the partners capital interests were as follows.
Partner
Lowell
Nashua
Orono
Totals

Partners Capital
$60,000
$100,000
$50,000
$210,000

Income Sharing %
40%
40%
20%
100%

If the partnership agreement requires an appraisal of the partnerships value

before a partner withdraws and such an appraisal indicates that the
partnerships value is $300,000, Lowell would receive
$96,000 when he withdraws. The $96,000 was calculated as follows.
Item

Amount

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Item
Lowell capital balance
Lowell share of excess partnership value: ($300,000 - $210,000) x .40
Total

Amount
$60,000
$36,000
$96,000

Lowells withdrawal would affect the partnership as follows.

Date

Accounts

Debits

Credits

Date

Accounts

Debits
60,000
24,000
12,000

Credits

Lowell, Capital
Nashua, Capital
Orono, Capital
Cash

96,000