appg g01 g20

study objectives

After studying this appendix, you should be able to:

1 Identify the characteristics of the partnership form ofbusiness organization.

2 Explain the accounting entries for the formation of apartnership.

3 Identify the bases for dividing net income or net loss.

appendix

Accounting for

Partnerships

G

G-1

Partnership Form of Organization

The Uniform Partnership Act provides the basic rules for the formation and op-eration of partnerships in most states in the United States. This act defines apartnership as an association of two or more persons to carry on as co-ownersof a business for profit. Partnerships are common in retail establishments andin small manufacturing companies. Also, accountants, lawyers, and doctors findit desirable to form partnerships with other professionals in their field. Profes-sional partnerships vary in size from a medical partnership of 3 to 5 doctors, to150 to 200 partners in a large law firm, to more than 2,000 partners in aninternational accounting firm.

CHARACTERISTICS OF PARTNERSHIPS

Partnerships are fairly easy to form. They can be formed simply by a verbalagreement or, more formally, by putting in writing the rights and obligationsof the partners. Partners who have not put their agreement in writing sometimeshave found that the characteristics of partnerships can lead to later difficul-ties. The principal characteristics of the partnership form of business organi-zation are shown in Illustration G-1 (page G-2) and explained in the followingsections.

Association of Individuals

The voluntary association of two or more individuals in a partnership may bebased on as simple an act as a handshake. However, it is preferable to statethe agreement in writing. Under the Uniform Partnership Act, a partnership isa legal entity for certain purposes. For instance, property (land, buildings,equipment) can be owned in the name of the partnership, and the firm can sueor be sued. A partnership also is an accounting entity for financial report-ing purposes. Thus, the purely personal assets, liabilities, and transactions ofthe partners are excluded from the accounting records of the partnership.

The net income of a partnership is not taxed as a separate entity. But, a part-nership must file an information tax return showing partnership net incomeand each partner’s share of that net income. Each partner’s share is taxable at

Identify the characteristics

of the partnership form of

business organization.

1study objective

4 Describe the form and content of partnership financialstatements.

5 Explain the effects of the entries to record the liquidationof a partnership.

personal tax rates, regardless of the amount of net income withdrawn from thebusiness during the year.

Mutual Agency

Mutual agency means that each partner acts on behalf of the partnership whenengaging in partnership business. The act of any partner is binding on all otherpartners. This is true even when partners act beyond the scope of their authority,so long as the act appears to be appropriate for the partnership. For example, apartner of a grocery store who purchases a delivery truck creates a binding con-tract in the name of the partnership, even if the partnership agreement deniesthis authority. On the other hand, if a partner in a law firm purchased a snow-mobile for the partnership, such an act would not be binding on the partner-ship. The purchase is clearly outside the scope of partnership business.

Limited Life

A partnership does not have unlimited life. It may be ended voluntarily at any timethrough the acceptance of a new partner or the withdrawal of a partner. A part-nership may be ended involuntarily by the death or incapacity of a partner. Thusthe life of a partnership is indefinite. Partnership dissolution occurs whenevera partner withdraws or a new partner is admitted. Dissolution of a partnershipdoes not necessarily mean that the business ends. If the continuing partners agree,operations can continue without interruption by forming a new partnership.

Unlimited Liability

Each partner is personally and individually liable for all partnership liabilities.Creditors’ claims attach first to partnership assets. If these are insufficient, theclaims then attach to the personal resources of any partner, irrespective of thatpartner’s equity in the partnership. Because each partner is responsible for all thedebts of the partnership, each partner is said to have unlimited liability.

Co-Ownership of Property

Partnership assets are owned jointly by the partners. If the partnership is dis-solved, the assets do not legally revert to the original contributor. Each partner

G-2 appendix G Accounting for Partnerships

Limited LifeUnlimited Liability

Mutual Agency

Association of Individuals

Co-Ownership of Property

PartnershipForm of Business

Organization

TOR Ltd.

Illustration G-1

Partnership characteristics

Helpful Hint Because of mutualagency, an individual should beextremely cautious in selectingpartners.

Partnership Form of Organization G-3

has a claim on total assets equal to the balance in his or her respective capitalaccount. This claim does not attach to specific assets that an individual partnercontributed to the firm. Similarly, if a partner invests a building in the partner-ship valued at $100,000 and the building is later sold at a gain of $20,000, thatpartner does not personally receive the entire gain.

Partnership net income (or net loss) is also co-owned. If the partnershipcontract does not specify to the contrary, all net income or net loss is sharedequally by the partners. As you will see later, though, partners may agree tounequal sharing of net income or net loss.

ORGANIZATIONS WITH PARTNERSHIP

CHARACTERISTICS

With surprising speed, states are creating special forms of business organiza-tions that have partnership characteristics. These new organizations are beingadopted by many small companies. These special forms are: limited partner-ships, limited liability partnerships, limited liability companies, and “S” corpo-rations.

Limited Partnerships

In a limited partnership, one or more partners have unlimited liability andone or more partners have limited liability for the debts of the firm. Those withunlimited liability are called general partners. Those with limited liability arecalled limited partners. Limited partners are responsible for the debts of thepartnership up to the limit of their investment in the firm. This organization isidentified in its name with the words “Limited Partnership,” or “Ltd.,” or “LP.”For the privilege of limited liability, the limited partner usually accepts less com-pensation than a general partner and exercises less influence in the affairs of thefirm.

Limited Liability Partnership

Most states allow professionals such as lawyers, doctors, and accountants toform a limited liability partnership or “LLP.” The LLP is designed to protectinnocent partners from malpractice or negligence claims resulting from the actsof another partner. LLPs generally carry large insurance policies in case the part-nership is guilty of malpractice.

Limited Liability Companies

A new, hybrid form of business organization with certain features like a corpo-ration and others like a limited partnership is the limited liability company, or“LLC” (or “LC”). An LLC usually has a limited life. The owners, called members,have limited liability like owners of a corporation. Whereas limited partners donot actively participate in the management of a limited partnership (LP), themembers of a limited liability company (LLC) can assume an active manage-ment role. For income tax purposes, the IRS usually classifies an LLC as apartnership.

“S” Corporations

An “S” corporation is a corporation that is taxed in the same way that a part-nership is taxed. To qualify as an “S” corporation, the company must have 75or fewer stockholders, all of whom must be citizens or residents of the UnitedStates. The advantage of an “S” corporation (also called a Sub-Chapter “S” cor-poration) is that, like a partnership and unlike a corporation, it does not payincome taxes.

ADVANTAGES AND DISADVANTAGES

OF PARTNERSHIPS

Why do people choose partnerships? One major advantage of a partnership isthat the skills and resources of two or more individuals can be combined.For example, a large public accounting firm such as Ernst & Young must haveexpertise in auditing, taxation, and management consulting. In addition, a part-nership is easily formed and is relatively free from governmental regula-tions and restrictions. A partnership does not have to contend with the “redtape” that a corporation must face. Also, decisions can be made quickly onsubstantive matters affecting the firm; there is no board of directors that mustbe consulted.

On the other hand, partnerships also have some major disadvantages: mutual agency, limited life, and unlimited liability. Unlimited liability is par-ticularly troublesome. Many individuals fear they may lose not only their initialinvestment but also their personal assets, if those assets are needed to pay part-nership creditors. As a result, partnerships often find it difficult to obtain largeamounts of investment capital. That is one reason why the largest businessenterprises in the United States are corporations, not partnerships.

The advantages and disadvantages of the partnership form of business or-ganization are summarized in Illustration G-2.


Illustration G-2

Advantages anddisadvantages of apartnership

Advantages Disadvantages

Combining skills and resources of two or more individuals Mutual agencyEase of formation Limited lifeFreedom from governmental regulations and restrictions Unlimited liabilityEase of decision making

THE PARTNERSHIP AGREEMENT

Ideally, the agreement of two or more individuals to form a partnership shouldbe expressed in writing. This written contract is often called the partnershipagreement or articles of co-partnership. The partnership agreement containssuch basic information as the name and principal location of the firm, the pur-pose of the business, and date of inception. In addition, relationships among thepartners should be specified, such as:

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 in the event of a partner’s death.

We cannot overemphasize the importance of a written contract. The agree-ment should be drawn with care and should attempt to anticipate all possiblesituations, contingencies, and disagreements. The help of a lawyer is highlydesirable in preparing the agreement.

Basic Partnership Accounting

We now turn to the basic accounting for partnerships. The major accounting issues relate to forming the partnership, dividing income or loss, and preparingfinancial statements.

Basic Partnership Accounting G-5

FORMING A PARTNERSHIP

Each partner’s initial investment in a partnership is entered in the partnershiprecords. These investments should be recorded at the fair market value of theassets at the date of their transfer to the partnership. The values assignedmust be agreed to by all of the partners.

To illustrate, assume that A. Rolfe and T. Shea combine their proprietorshipsto start a partnership named U.S. Software. The firm will specialize in develop-ing financial modeling software packages. Rolfe and Shea have the following as-sets prior to the formation of the partnership.

Book Value Market Value

A. Rolfe T. Shea A. Rolfe T. Shea

Cash $ 8,000 $ 9,000 $ 8,000 $ 9,000Office equipment 5,000 4,000Accumulated depreciation (2,000)Accounts receivable 4,000 4,000Allowance for doubtful accounts (700) (1,000)

$11,000 $12,300 $12,000 $12,000

The entries to record the investments are:

Note that neither the original cost of the office equipment ($5,000) nor itsbook value ($5,000 � $2,000) is recorded by the partnership. The equipment isrecorded at its fair market value, $4,000. Because the equipment has not beenused by the partnership, there is no accumulated depreciation.

In contrast, the gross claims on customers ($4,000) are carried forward tothe partnership. The allowance for doubtful accounts is adjusted to $1,000 toarrive at a cash (net) realizable value of $3,000. A partnership may start with anallowance for doubtful accounts because it will continue to collect existingaccounts receivable, some of which are expected to be uncollectible. In addition,this procedure maintains the control and subsidiary relationship betweenAccounts Receivable and the accounts receivable subsidiary ledger.

After the partnership has been formed, the accounting for transactions issimilar to any other type of business organization. For example, all transactionswith outside parties, such as the purchase or sale of merchandise inventory andthe payment or receipt of cash, should be recorded the same for a partnershipas for a corporation.

Investment of A. Rolfe

Cash 8,000Office Equipment 4,000

A. Rolfe, Capital 12,000(To record investment of Rolfe)

Investment of T. Shea

Cash 9,000Accounts Receivable 4,000

Allowance for Doubtful Accounts 1,000T. Shea, Capital 12,000

(To record investment of Shea)

Illustration G-3 Bookand market values ofassets invested

Cash Flows�8,000

A OEL= +

�8,000�4,000

�12,000

Cash Flows�9,000

A OEL= +

�9,000�4,000�1,000

�12,000

Explain the accounting

entries for the formation

of a partnership.

2study objective

The steps in the accounting cycle described in Chapter 4 also apply to a part-nership. For example, the partnership prepares a trial balance and journalizesand posts adjusting entries. A work sheet may be used. There are minor differ-ences in journalizing and posting closing entries and in preparing financial state-ments, as explained in the following sections.

DIVIDING NET INCOME OR NET LOSS

Partnership net income or net loss is shared equally unless the partner-ship contract indicates otherwise. The same basis of division usually appliesto both net income and net loss. It is customary to refer to this basis as the in-come ratio, the income and loss ratio, or the profit and loss (P&L) ratio.Because of its wide acceptance, we will use the term income ratio to identifythe basis for dividing net income and net loss. A partner’s share of net incomeor net loss is recognized in the capital accounts through closing entries.

Closing Entries

Four entries are required in preparing closing entries for a partnership. The en-tries are:

1. Debit each revenue account for its balance, and credit Income Summary fortotal revenues.

2. Debit Income Summary for total expenses, and credit each expense accountfor its balance.

3. Debit Income Summary for its balance, and credit each partner’s Capital ac-count for his or her share of net income. Or, credit Income Summary, anddebit each partner’s Capital account for his or her share of net loss.

4. Debit each partner’s Capital account for the balance in that partner’s draw-ing account, and credit each partner’s drawing account for the same amount.

The first two entries are the same as in a corporation. The last two entries aredifferent because (1) there are two or more owners’ capital and drawing accounts, and (2) it is necessary to divide net income (or net loss) among thepartners.

To illustrate the last two closing entries, assume that AB Company has netincome of $32,000 for 2010. The partners, L. Arbor and D. Barnett, share net in-come and net loss equally. Drawings for the year were Arbor $8,000 and Barnett$6,000. The last two closing entries are:


Dec. 31 Income Summary 32,000L. Arbor, Capital ($32,000 � 50%) 16,000D. Barnett, Capital ($32,000 � 50%) 16,000

(To transfer net income to partners’ capital accounts)

31 L. Arbor, Capital 8,000D. Barnett, Capital 6,000

L. Arbor, Drawing 8,000D. Barnett, Drawing 6,000

(To close drawing accounts to capitalaccounts)

Assume that the beginning capital balance is $47,000 for Arbor and $36,000 forBarnett. The capital and drawing accounts will show the following after postingthe closing entries.


The partners’ capital accounts are permanent accounts; their drawing ac-counts are temporary accounts. Normally, the capital accounts will have creditbalances and the drawing accounts will have debit balances. Drawing accountsare debited when partners withdraw cash or other assets from the partnershipfor personal use.

Income Ratios

As noted earlier, the partnership agreement should specify the basis for sharingnet income or net loss. The following are typical income ratios.

1. A fixed ratio, expressed as a proportion (6 :4), a percentage (70% and 30%),or a fraction (2�3 and 1�3).

2. A ratio based either on capital balances at the beginning of the year or onaverage capital balances during the year.

3. Salaries to partners and the 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, and the remainder on afixed ratio.

The objective is to settle on a basis that will equitably reflect the partners’ cap-ital investment and service to the partnership.

A fixed ratio is easy to apply, and it may be an equitable basis in some cir-cumstances. Assume, for example, that Hughes and Lane are partners. Eachcontributes the same amount of capital, but Hughes expects to work full-timein the partnership and Lane expects to work only half-time. Accordingly, thepartners agree to a fixed ratio of 2�3 to Hughes and 1�3 to Lane.

A ratio based on capital balances may be appropriate when the funds in-vested in the partnership are considered the critical factor. Capital ratios mayalso be equitable when a manager is hired to run the business and the partnersdo not plan to take an active role in daily operations.

The three remaining ratios (items 3, 4, and 5) give specific recognition todifferences among partners. These ratios provide salary allowances for timeworked and interest allowances for capital invested. Then, any remaining net income or net loss is allocated on a fixed ratio. Some caution needs to beexercised in working with these types of income ratios. These ratios pertain exclusively to the computations that are required in dividing net income ornet loss among the partners.

Salaries to partners and interest on partners’ capital are not expensesof the partnership. Therefore, these items do not enter into the matchingof expenses with revenues and the determination of net income or net loss.For a partnership, as for other entities, salaries expense pertains to the cost ofservices performed by employees. Likewise, interest expense relates to the costof borrowing from creditors. But partners, as owners, are not considered either

L. Arbor, Capital

12/31 Clos. 8,000 1/1 Bal. 47,00012/31 Clos. 16,000

12/31 Bal. 55,000

L. Arbor, Drawing

12/31 Bal. 8,000 12/31 Clos. 8,000

D. Barnett, Capital

12/31 Clos. 6,000 1/1 Bal. 36,00012/31 Clos. 16,000

12/31 Bal. 46,000

D. Barnett, Drawing

12/31 Bal. 6,000 12/31 Clos. 6,000

Illustration G-4

Partners’ capital anddrawing accounts afterclosing

Identify the bases for

dividing net income or

net loss.

3study objective

employees or creditors. Therefore, when the income ratio includes a salary allowance for partners, some partnership agreements permit the partner tomake monthly withdrawals of cash based on their “salary.” Such withdrawalsare debited to the partner’s drawing account.

Salaries, Interest, and Remainder on a Fixed Ratio

Under income ratio (5) in the list above, the provisions for salaries and interestmust be applied before the remainder is allocated on the specified fixed ratio.This is true even if the provisions exceed net income. It is also true evenif the partnership has suffered a net loss for the year. Detailed informationconcerning the division of net income or net loss should be shown below netincome on the income statement.

To illustrate this income ratio, assume that 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 allowancesof 10% on capital balances at the beginning of the year, and (3) the remainderequally. Capital balances on January 1 were King $28,000, and Lee $24,000. In2010, partnership net income is $22,000. The division of net income is as follows.


KINGSLEE COMPANY

Income Statement (partial)For the Year Ended December 31, 2010

Sales $200,000

Net income $ 22,000

Division of Net Income

Sara RayKing Lee Total

Salary allowance $ 8,400 $ 6,000 $ 14,400Interest allowance on partners’ capital

Sara King ($28,000 � 10%) 2,800Ray Lee ($24,000 � 10%) 2,400

Total interest allowance 5,200

Total salaries and interest 11,200 8,400 19,600Remaining income, $2,400

($22,000 � $19,600)Sara King ($2,400 � 50%) 1,200Ray Lee ($2,400 � 50%) 1,200

Total remainder 2,400

Total division of net income $12,400 $9,600 $22,000

Illustration G-5 Incomestatement with division ofnet income

The entry to record the division of net income is:

Dec. 31 Income Summary 22,000Sara King, Capital 12,400Ray Lee, Capital 9,600

(To close net income to partners’ capital)Cash Flowsno effect

A OEL= +

�22,000�12,400

�9,600

Now let’s look at a situation in which the salary and interest allowances exceed net income. Assume that Kingslee Company’s net income is only $18,000.


In this case, the salary and interest allowances will create a deficiency of $1,600($19,600 � $18,000). The computations of the allowances are the same as thosein the preceding example. Beginning with total salaries and interest, we com-plete the division of net income as follows.


Total salaries and interest $ 11,200 $ 8,400 $ 19,600Remaining deficiency ($1,600)

($18,000 � $19,600)Sara King ($1,600 � 50%) (800)Ray Lee ($1,600 � 50%) (800)

Total remainder (1,600)

Total division $10,400 $7,600 $18,000

PARTNERSHIP

FINANCIAL STATEMENTS

The financial statements of a partnership are similar to those of a corporation.The income statement for a partnership is identical to the income statement fora corporation except for the additional section that reports the division of netincome, as shown earlier.

The owners’ equity statement for a partnership is called the partners’ capital statement. Its function is to explain the changes in each partner’s cap-ital account and in total partnership capital during the year. The partners’ cap-ital statement for Kingslee Company is shown below. It is based on the divisionof $22,000 of net income in Illustration G-5. The statement includes assumeddata for the additional investment and drawings.

KINGSLEE COMPANY

Partners’ Capital StatementFor the Year Ended December 31, 2010


Capital, January 1 $ 28,000 $ 24,000 $ 52,000Add: Additional investment 2,000 2,000

Net income 12,400 9,600 22,000

42,400 33,600 76,000Less: Drawings 7,000 5,000 12,000

Capital, December 31 $35,400 $28,600 $64,000

The partners’ capital statement is prepared from the income statement and thepartners’ capital and drawing accounts.

The balance sheet for a partnership is the same as for a corporation exceptfor the owner’s equity section. In a partnership, the capital balances of each part-ner are shown in the balance sheet. The owners’ equity section for Kingslee Com-pany is shown in Illustration G-8 (page G-10).

Illustration G-6 Divisionof net income—incomedeficiency

Illustration G-7

Partners’ capital statement

Helpful Hint Partners’ capitalmay change due to (1) additionalinvestment, (2) drawings, and (3) net income or net loss.

Describe the form and

content of partnership

financial statements.

4study objective

Admission and Withdrawal

of Partners

We have seen how the basic accounting for a partnership works. Another issuerelates to the accounting for the addition or withdrawal of a partner. From aneconomic standpoint, the admission or withdrawal of a partner is often of mi-nor significance in the continuity of the business. For example, in large publicaccounting or law firms, partners are added or dropped without any change inoperating policies. Because the accounting for the admission or withdrawal ofa partner is complex, it is discussed in more advanced accounting courses.

Liquidation of a Partnership

The liquidation of a partnership terminates the business. It involves selling theassets of the firm, paying liabilities, and distributing any remaining assets to thepartners. Liquidation may result from the sale of the business by mutual agree-ment of the partners, from the death of a partner, or from bankruptcy. In con-trast to partnership dissolution, partnership liquidation ends both the legaland economic life of the entity.

From an accounting standpoint, liquidation should be preceded by complet-ing the accounting cycle for the final operating period. This includes preparingadjusting entries and financial statements. It also involves preparing closing en-tries and a post-closing trial balance. Thus, only balance sheet accounts shouldbe open as the liquidation process begins.

In liquidation, the sale of noncash assets for cash is called realization. Anydifference between book value and the cash proceeds is called the gain or losson realization. To liquidate a partnership, 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 basis of their capital balances.

Each of the steps must be performed in sequence. Creditors must be paidbefore partners receive any cash distributions. Each step also must be recordedby an accounting entry.

When a partnership is liquidated, all partners may have credit balances intheir capital accounts. This situation is called no capital deficiency. Or, at leastone partner’s capital account may have a debit balance. This situation is termeda capital deficiency. To illustrate each of these conditions, assume that the AceCompany is liquidated when its ledger shows the assets, liabilities, and owners’equity accounts listed in Illustration G-9.


KINGSLEE COMPANY

Balance Sheet (partial)December 31, 2010

Total liabilities (assumed amount) $115,000Owners’ equity

Sara King, Capital $35,400Ray Lee, Capital 28,600

Total owners’ equity 64,000

Total liabilities and owners’ equity $179,000

Illustration G-8

Owners’ equity section of apartnership balance sheet

Explain the effects of the

entries to record the

liquidation of a partnership.

5study objective

Liquidation of a Partnership G-11

NO CAPITAL DEFICIENCY

The partners of Ace Company agree to liquidate the partnership on the follow-ing terms: (1) The noncash assets of the partnership will be sold to JacksonEnterprises for $75,000 cash. And (2) the partnership will pay its partnershipliabilities. The income ratios of the partners are 3 :2 :1, respectively. The stepsin the liquidation process are as follows.

1. The noncash assets (accounts receivable, inventory, and equipment) are soldfor $75,000. The book value of these assets is $60,000 ($15,000 � $18,000 �$35,000 � $8,000). Thus a gain of $15,000 is realized on the sale. The entry is:

Assets Liabilities and Owners’ Equity

Cash $ 5,000 Notes payable $15,000Accounts receivable 15,000 Accounts payable 16,000Inventory 18,000 R. Arnet, Capital 15,000Equipment 35,000 P. Carey, Capital 17,800Accum. depr.—equipment (8,000) W. Eaton, Capital 1,200

$65,000 $65,000

2. The gain on realization of $15,000 is allocated to the partners on their in-come ratios, which are 3 :2 :1. The entry is:

3. Partnership liabilities consist of Notes Payable $15,000 and Accounts Payable$16,000. Creditors are paid in full by a cash payment of $31,000. The entry is:

4. The remaining cash is distributed to the partners on the basis of their capitalbalances. After the entries in the first three steps are posted, all partnershipaccounts, including Gain on Realization, will have zero balances except for fouraccounts: Cash $49,000; R. Arnet, Capital $22,500; P. Carey, Capital $22,800;and W. Eaton, Capital $3,700, as shown in Illustration G-10 (page G-12).

(1)

Cash 75,000Accumulated Depreciation—Equipment 8,000

Accounts Receivable 15,000Inventory 18,000Equipment 35,000Gain on Realization 15,000

(To record realization of noncash assets)

(2)

Gain on Realization 15,000R. Arnet, Capital ($15,000 � 3�6) 7,500P. Carey, Capital ($15,000 � 2�6) 5,000W. Eaton, Capital ($15,000 � 1�6) 2,500

(To allocate gain to partners’ capital accounts)

(3)

Notes Payable 15,000Accounts Payable 16,000

Cash 31,000(To record payment of partnership liabilities)

Illustration G-9 Accountbalances prior to liquidation

Cash Flows�75,000

A OEL= +

�75,000�8,000

�15,000�18,000�35,000

�15,000

Cash Flows�31,000

A OEL= +

�15,000�16,000

�31,000

Cash Flowsno effect

A OEL= +

�15,000�7,500�5,000�2,500

The entry to record the distribution of cash is as follows.


After this entry is posted, all partnership accounts will have zero balances.A word of caution: Cash should not be distributed 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 nota proper basis for making the final distribution of cash to the partners.

Schedule of Cash Payments

Some accountants prepare a cash payments schedule to determine the distribu-tion of cash to the partners in the liquidation of a partnership. The schedule ofcash payments is organized around the basic accounting equation. The sched-ule for the Ace Company is shown in Illustration G-11. The numbers in paren-theses refer to the four required steps in the liquidation of a partnership. Theyalso identify the accounting entries that must be made. The cash payments sched-ule is especially useful when the liquidation process extends over a period of time.

Cash

Bal. 5,000 (3) 31,000(1) 75,000

Bal. 49,000

R. Arnet, Capital

Bal. 15,000(2) 7,500

Bal. 22,500

P. Carey, Capital

Bal. 17,800(2) 5,000

Bal. 22,800

W. Eaton, Capital

Bal. 1,200(2) 2,500

Bal. 3,700

Illustration G-10 Ledgerbalances before distributionof cash

(4)

R. Arnet, Capital 22,500P. Carey, Capital 22,800W. Eaton, Capital 3,700

Cash 49,000(To record distribution of cash to partners)

Helpful Hint Zero balances afterposting is a quick proof of theaccuracy of the cash distributionentry.

Cash Flows�49,000

A OEL= +

�49,000 �22,500�22,800

�3,700

ACE COMPANY

Schedule of Cash Payments

Noncash R. Arnet P. Carey W. EatonItem Cash � Assets � Liabilities � Capital � Capital � Capital

Balances before liquidation 5,000 � 60,000 � 31,000 � 15,000 � 17,800 � 1,200Sales of noncash assets and

allocation of gain (1)&(2) 75,000 � (60,000) � 7,500 � 5,000 � 2,500

New balances 80,000 � –0– � 31,000 � 22,500 � 22,800 � 3,700Pay liabilities (3) (31,000) � (31,000)

New balances 49,000 � –0– � –0– � 22,500 � 22,800 � 3,700Cash distribution to

partners (4) (49,000) � (22,500) � (22,800) � (3,700)

Final balances –0– –0– –0– –0– –0– –0–

Illustration G-11

Schedule of cashpayments, no capitaldeficiency

CAPITAL DEFICIENCY

A capital deficiency may be caused by recurring net losses, excessive drawings,or losses from realization suffered during liquidation. To illustrate, assume thatAce Company is on the brink of bankruptcy. The partners decide to liquidate by

Liquidation of a Partnership G-13

having a “going-out-of-business” sale. Merchandise is sold at substantial dis-counts, and the equipment is sold at auction. Cash proceeds from these sales andcollections from customers total only $42,000. Thus, the loss from liquidation is$18,000 ($60,000 � $42,000). The steps in the liquidation process are as follows.

1. The entry for the realization of noncash assets is:

2. The loss on realization is allocated to the partners on the basis of their in-come ratios. The entry is:

3. Partnership liabilities are paid. This entry is the same as in the previousexample.

4. After posting the three entries, two accounts will have debit balances—Cash$16,000, and W. Eaton, Capital $1,800. Two accounts will have creditbalances—R. Arnet, Capital $6,000, and P. Carey, Capital $11,800. All fouraccounts are shown below.

(1)

Cash 42,000Accumulated Depreciation—Equipment 8,000Loss on Realization 18,000

Accounts Receivable 15,000Inventory 18,000Equipment 35,000

(To record realization of noncash assets)

(2)

R. Arnet, Capital ($18,000 � 3�6) 9,000P. Carey, Capital ($18,000 � 2�6) 6,000W. Eaton, Capital ($18,000 � 1�6) 3,000

Loss on Realization 18,000(To allocate loss on realization to partners)

(3)

Notes Payable 15,000Accounts Payable 16,000

Cash 31,000(To record payment of partnership liabilities)

Cash

Bal. 5,000 (3) 31,000(1) 42,000

Bal. 16,000

R. Arnet, Capital

(2) 9,000 Bal. 15,000

Bal. 6,000

P. Carey, Capital

(2) 6,000 Bal. 17,800

Bal. 11,800

W. Eaton, Capital

(2) 3,000 Bal. 1,200

Bal. 1,800

Eaton has a capital deficiency of $1,800, and thus owes the partnership $1,800.Arnet and Carey have a legally enforceable claim for that amount against Eaton’spersonal assets. The distribution of cash is still made on the basis of capital bal-ances. But the amount will vary depending on how Eaton’s deficiency is settled.Two alternatives are presented below.

Payment of 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 thepartnership. The entry is:

Illustration G-12 Ledgerbalances before distributionof cash

Cash Flows�42,000

A OEL= +

�42,000�8,000

�18,000�15,000�18,000�35,000

Cash Flows�31,000

A OEL= +

�15,000�16,000

�31,000

Cash Flowsno effect

A OEL= +

�9,000�6,000�3,000

�18,000

After posting this entry, account balances are as follows.


The cash balance of $17,800 is now equal to the credit balances in the capitalaccounts (Arnet $6,000 � Carey $11,800). Cash now is distributed on the basisof these balances. The entry is:

After this entry is posted, all accounts will have zero balances.

Nonpayment of Deficiency

If a partner with a capital deficiency is unable to pay the amount owed to thepartnership, the partners with credit balances must absorb the loss. The loss isallocated on the basis of the income ratios that exist between the partners withcredit balances.

For example, the income ratios of Arnet and Carey are 3 :2, or 3�5 and 2�5,respectively. Thus, the following entry would be made to remove Eaton’s capitaldeficiency.

(a)

Cash 1,800W. Eaton, Capital 1,800

(To record payment of capital deficiency by Eaton)

Cash

Bal. 5,000 (3) 31,000(1) 42,000(a) 1,800

Bal. 17,800

R. Arnet, Capital

(2) 9,000 Bal. 15,000

Bal. 6,000

P. Carey, Capital

(2) 6,000 Bal. 17,800

Bal. 11,800

W. Eaton, Capital

(2) 3,000 Bal. 1,200(a) 1,800

Bal. –0–

Illustration G-13 Ledgerbalances after payingcapital deficiency

R. Arnet, Capital 6,000P. Carey, Capital 11,800

Cash 17,800(To record distribution of cash to the partners)

Cash Flows�1,800

A OEL= +

�1,800�1,800

A SEL= +

�1,080�720

�1,800

Cash Flows�17,800

A OEL= +

�6,000�11,800

�17,800

(a)

R. Arnet, Capital ($1,800 � 3�5) 1,080P. Carey, Capital ($1,800 � 2�5) 720

W. Eaton, Capital 1,800(To record write-off of capital deficiency)

Cash

Bal. 5,000 (3) 31,000(1) 42,000

Bal. 16,000

R. Arnet, Capital

(2) 9,000 Bal. 15,000(a) 1,080

Bal. 4,920

P. Carey, Capital

(2) 6,000 Bal. 17,800(a) 720

Bal. 11,080

W. Eaton, Capital

(2) 3,000 Bal. 1,200(a) 1,800

Bal. –0–

Illustration G-14 Ledgerbalances after nonpaymentof capital deficiency

After posting this entry, the cash and capital accounts will have the followingbalances.

Glossary G-15

The cash balance of $16,000 now equals the sum of the credit balances in thecapital accounts (Arnet $4,920 � Carey $11,080). The entry to record the distri-bution of cash is:

After this entry is posted, all accounts will have zero balances.

R. Arnet, Capital 4,920P. Carey, Capital 11,080

Cash 16,000(To record distribution of cash to the partners)

Summary of Study Objectives

1 Identify the characteristics of the partnership form

of business organization. The principal characteristicsof a partnership are: (a) association of individuals,(b) mutual agency, (c) limited life, (d) unlimited lia-bility, and (e) co-ownership of property.

2 Explain the accounting entries for the formation of a

partnership. When a partnership is formed, each part-ner’s initial investment should be recorded at the fairmarket value of the assets at the date of their trans-fer to the partnership.

3 Identify the bases for dividing net income or net loss.

Net income or net loss is divided on the basis of theincome ratio, which may be (a) a fixed ratio, (b) a ra-tio based on beginning or average capital balances,(c) salaries to partners and the remainder on a fixedratio, (d) interest on partners’ capital and the remain-der on a fixed ratio, and (e) salaries to partners,

interest on partners’ capital, and the remainder on afixed ratio.

4 Describe the form and content of partnership financial

statements. The financial statements of a partnershipare similar to those of a corporation. The principaldifferences are: (a) the division of net income is shownon the income statement, (b) the owners’ equity state-ment is called a partners’ capital statement, and (c) eachpartner’s capital is reported on the balance sheet.

5 Explain the effects of the entries to record the liquida-

tion of a partnership. When a partnership is liquidated,it is necessary to record the (a) sale of noncash assets,(b) allocation of the gain or loss on realization, (c) pay-ment of partnership liabilities, and (d) distributionof cash to the partners on the basis of their capitalbalances.

Glossary

Capital deficiency (p. G-10) A debit balance in a part-ner’s capital account after allocation of gain or loss.

General partner (p. G-3) A partner who has unlimitedliability for the debts of the firm.

Income ratio (p. G-6) The basis for dividing net incomeand net loss in a partnership.

Limited liability company (p. G-3) A form of businessorganization, usually classified as a partnership and usu-ally with limited life, in which partners, who are calledmembers, have limited liability.

Limited liability partnership (p. G-3) A partnership ofprofessionals in which partners are given limited liabil-ity and the public is protected from malpractice by in-surance carried by the partnership.

Limited partner (p. G-3) A partner who has limited li-ability for the debts of the firm.

Limited partnership (p. G-3) A partnership in whichone or more general partners have unlimited liability andone or more partners have limited liability for the obli-gations of the firm.

No capital deficiency (p. G-10) All partners have creditbalances after allocation of gain or loss.

Partners’ capital statement (p. G-9) The owners’ equity statement for a partnership which shows thechanges in each partner’s capital balance and in totalpartnership capital during the year.

Partnership (p. G-1) An association of two or more per-sons to carry on as co-owners of a business for profit.

Partnership agreement (p. G-4) A written contract ex-pressing the voluntary agreement of two or more indi-viduals in a partnership.

Partnership dissolution (p. G-2) A change in partnersdue to withdrawal or admission, which does not neces-sarily terminate the business.

Partnership liquidation (p. G-10) An event that endsboth the legal and economic life of a partnership.

“S” corporation (p. G-3) Corporation, with 75 or fewerstockholders, that is taxed like a partnership.

Schedule of cash payments (p. G-12) A scheduleshowing the distribution of cash to the partners in a part-nership liquidation.

Cash Flows�16,000

A OEL= +

�4,920�11,080

�16,000


Questions

1. The characteristics of a partnership include the fol-lowing: (a) association of individuals, (b) limited life,and (c) co-ownership of property. Explain each ofthese terms.

2. Vera Cruz is confused about the partnership charac-teristics of (a) mutual agency and (b) unlimited lia-bility. Explain these two characteristics for Vera.

3. Swen Varberg and Egor Karlstad are considering abusiness venture. They ask you to explain the advan-tages and disadvantages of the partnership form oforganization.

4. Ginny Brown and Dorothy Fleming form a partner-ship. Brown contributes land with a book value of$50,000 and a fair market value of $75,000. Brownalso contributes equipment with a book value of$52,000 and a fair market value of $57,000. The part-nership assumes a $20,000 mortgage on the land.What should be the balance in Brown’s capital ac-count upon formation of the partnership?

5. Roy Orbison, S. Innis, and David Bowie have a part-nership called Depeche Mode. A dispute has arisenamong the partners. Orbison has invested twice asmuch in assets as the other two partners, and he be-lieves net income and net losses should be shared inaccordance with the capital ratios. The partnershipagreement does not specify the division of profits andlosses. How will net income and net loss be divided?

6. Leon Redbone and Elvis Costello are discussing howincome and losses should be divided in a partnershipthey plan to form. What factors should be consideredin determining the division of net income or net loss?

7. Doreen Shaffer and Quincy Jones have partnershipcapital balances of $40,000 and $80,000, respectively.The partnership agreement indicates that net incomeor net loss should be shared equally. If net incomefor the partnership is $24,000, how should the netincome be divided?

8. Robben Ford and Greg Allman share net income andnet loss equally. (a) Which account(s) is (are) debitedand credited to record the division of net income be-tween the partners? (b) If Robben Ford withdraws$30,000 in cash for personal use in lieu of salary,which account is debited and which is credited?

9. Partners Reba McEntire and B. Zander are providedsalary allowances of $30,000 and $25,000, respec-tively. They divide the remainder of the partnershipincome in a ratio of 60: 40. If partnership net incomeis $50,000, how much is allocated to McEntire andZander?

10. Are the financial statements of a partnership similarto those of a corporation? Discuss.

11. Phil Collins and Herb Alpert are discussing the liqui-dation of a partnership. Phil maintains that all cashshould be distributed to partners on the basis of theirincome ratios. Is he correct? Explain.

12. In continuing their discussion, Herb says that evenin the case of a capital deficiency, all cash should stillbe distributed on the basis of capital balances. IsHerb correct? Explain.

13. Erin, Cole, and Morgan have income ratios of 5 :3 :2and capital balances of $34,000, $31,000, and$28,000, respectively. Noncash assets are sold at again. After creditors are paid, $119,000 of cash isavailable for distribution to the partners. How muchcash should be paid to Cole?

14. Before the final distribution of cash, account bal-ances are: Cash $25,000; B. Springsteen, Capital$19,000 (Cr.); L. Hamilton, Capital $12,000 (Cr.); andT. Zaret, Capital $6,000 (Dr.). Zaret is unable to payany of the capital deficiency. If the income-sharingratios are 5 : 3 :2, respectively, how much cash shouldbe paid to L. Hamilton?

Brief Exercises

BEG-1 Britney Spears and Pablo Cruise decide to organize the ALL-Star partnership.Britney Spears invests $15,000 cash, and Cruise contributes $10,000 cash and equipmenthaving a book value of $3,500. Prepare the entry to record Cruise’s investment in the part-nership, assuming the equipment has a fair market value of $7,000.

BEG-2 H. Tylo and R. Moss decide to merge their proprietorships into a partnershipcalled Tylomoss Company. The balance sheet of Moss Co. shows:

Accounts receivable $16,000Less: Allowance for doubtful accounts 1,200 $14,800

Equipment 20,000Less: Accumulated depreciation 8,000 12,000

The partners agree that the net realizable value of the receivables is $12,500 and that thefair market value of the equipment is $10,000. Indicate how the four accounts shouldappear in the opening balance sheet of the partnership.

Journalize entries in forminga partnership.

(SO 2)

Prepare portion of openingbalance sheet for partnership.

(SO 2)

Exercises G-17

BEG-3 Led Zeppelin Co. reports net income of $70,000. The income ratios are Led 60%and Zeppelin 40%. Indicate the division of net income to each partner, and prepare theentry to distribute the net income.

BEG-4 MET Co. reports net income of $65,000. Partner salary allowances are Moses$20,000, Evelyn $5,000, and Tom $5,000. Indicate the division of net income to each part-ner, assuming the income ratio is 50 :30 :20, respectively.

BEG-5 Bill&Til Co. reports net income of $24,000. Interest allowances are Bill $6,000and Til $5,000; salary allowances are Bill $15,000 and Til $10,000; the remainder is sharedequally. Show the distribution of income on the income statement.

BEG-6 After liquidating noncash assets and paying creditors, account balances in theMissouri Co. are Cash $21,000, A Capital (Cr.) $9,000, R Capital (Cr.) $7,000, and B Cap-ital (Cr.) $5,000. The partners share income equally. Journalize the final distribution ofcash to the partners.

Exercises

EG-1 Frank Voris has owned and operated a proprietorship for several years. On January 1, he decides to terminate this business and become a partner in the firm ofPayne and Voris. Voris’s investment in the partnership consists of $15,000 in cash, andthe following assets of the proprietorship: accounts receivable $14,000 less allowance fordoubtful accounts of $2,000, and equipment $20,000 less accumulated depreciation of$4,000. It is agreed that the allowance for doubtful accounts should be $3,000 for thepartnership. The fair market value of the equipment is $17,500.

InstructionsJournalize Voris’s admission to the firm of Payne and Voris.

EG-2 B. Manilow and O. Newton have capital balances on January 1 of $50,000 and$40,000, respectively. The partnership income-sharing agreement provides for (1) annualsalaries of $20,000 for Manilow and $12,000 for Newton, (2) interest at 10% on begin-ning capital balances, and (3) remaining income or loss to be shared 70% by Manilowand 30% by Newton.

Instructions(a) Prepare a schedule showing the distribution of net income, assuming net income is

(1) $55,000 and (2) $30,000.(b) Journalize the allocation of net income in each of the situations above.

EG-3 In Fleetwood Mac Co., beginning capital balances on January 1, 2010, are KenTucki $20,000 and Chris Cross $18,000. During the year, drawings were Tucki $8,000 andCross $3,000. Net income was $32,000, and the partners share income equally.

Instructions(a) Prepare the partners’ capital statement for the year.(b) Prepare the owners’ equity section of the balance sheet at December 31, 2010.

EG-4 The Pips Company at December 31 has cash $20,000, noncash assets $100,000,liabilities $55,000, and the following capital balances: Agnes $45,000 and Mildred $20,000.The firm is liquidated, and $120,000 in cash is received for the noncash assets. Agnesand Mildred income ratios are 55% and 45%, respectively.

InstructionsPrepare a cash distribution schedule.

EG-5 Data for The Pips partnership are presented in EG-4.

InstructionsPrepare the entries to record:(a) The sale of noncash assets.(b) The allocation of the gain or loss on liquidation to the partners.(c) Payment of creditors.(d) Distribution of cash to the partners.

Journalize the division of netincome using fixed incomeratios.

(SO 3)Compute division of netincome with a salaryallowance and fixed ratios.

(SO 3)Show division of net incomewhen allowances exceed netincome.

(SO 3)Journalize final cashdistribution in liquidation.

(SO 5)

Journalize entry forformation of a partnership.

(SO 2)

Prepare schedule showingdistribution of net incomeand closing entry.

(SO 3)

Prepare partners’ capitalstatement and partialbalance sheet.

(SO 4)

Prepare cash distributionschedule.

(SO 5)

Journalize transactions in a liquidation.

(SO 5)

EG-6 Prior to the distribution of cash to the partners, the accounts in the MEL Com-pany are: Cash $30,000, Maureen Capital (Cr.) $18,000, Ellen Capital (Cr.) $14,000, andLou Capital (Dr.) $2000. The income ratios are 5 :3 :2, respectively.

Instructions(a) Prepare the entry to record (1) Lou’s payment of $2,000 in cash to the partnership

and (2) the distribution of cash to the partners with credit balances.(b) Prepare the entry to record (1) the absorption of Lou’s capital deficiency by the other

partners and (2) the distribution of cash to the partners with credit balances.


Journalize transactions witha capital deficiency.

(SO 5)

Problems

PG-1 The post-closing trial balances of two proprietorships on January 1, 2010, arepresented below.

Mel and Gibson decide to form a partnership, Mel Gibson Company, with the followingagreed upon valuations for noncash assets.

Mel Company Gibson Company

Dr. Cr. Dr. Cr.

Cash $ 14,000 $13,000Accounts receivable 17,500 26,000Allowance for doubtful accounts $ 3,000 $ 4,400Merchandise inventory 26,500 18,400Equipment 45,000 28,000Accumulated depreciation—equipment 24,000 12,000Notes payable 20,000 15,000Accounts payable 20,000 31,000Mel, Capital 36,000Gibson, Capital 23,000

$103,000 $103,000 $85,400 $85,400

Mel Company Gibson Company

Accounts receivable $17,500 $26,000Allowance for doubtful accounts 4,500 4,000Merchandise inventory 30,000 20,000Equipment 25,000 18,000

All cash will be transferred to the partnership, and the partnership will assume all theliabilities of the two proprietorships. Further, it is agreed that Mel will invest $3,000 incash, and Gibson will invest $18,000 in cash.

Instructions(a) Prepare separate journal entries to record the transfer of each proprietorship’s assets

and liabilities to the partnership.(b) Journalize the additional cash investment by each partner.(c) Prepare a balance sheet for the partnership on January 1, 2010.

PG-2 At the end of its first year of operations on December 31, 2010, MTC Company’saccounts show the following.

Partner Drawings Capital

Teena Marie $23,000 $48,000Robin Tower 14,000 30,000George Clinton 10,000 25,000

The capital balance represents each partner’s initial capital investment. Therefore, netincome or net loss for 2010 has not been closed to the partners’ capital accounts.

Prepare entries for formationof a partnership and abalance sheet.

(SO 2, 4)

(a) Mel, Capital $42,000Gibson, Capital $27,000

(c) Total assets $176,000

Journalize divisions of netincome and prepare apartners’ capital statement.

(SO 3, 4)

Problems G-19

Instructions(a) Journalize the entry to record the division of net income for the year 2010 under

each of the following independent assumptions.(1) Net income is $28,000. Income is shared 6:3:1.(2) Net income is $34,000. Marie and Tower are given salary allowances of $18,000

and $10,000, respectively. The remainder is shared equally.(3) Net income is $22,000. Each partner is allowed interest of 10% on beginning

capital balances. Marie is given a $15,000 salary allowance. The remainder isshared equally.

(b) Prepare a schedule showing the division of net income under assumption (3) above.(c) Prepare a partners’ capital statement for the year under assumption (3) above.

PG-3 The partners in Wilkowski Company decide to liquidate the firm when the bal-ance sheet shows the following.

The partners share income and loss 5 :3 :2. During the process of liquidation, the follow-ing transactions were completed in the following sequence.

1. A total of $53,000 was received from converting noncash assets into cash.2. Gain or loss on realization was allocated to partners.3. Liabilities were paid in full.4. Mick Jagger paid his capital deficiency.5. Cash was paid to the partners with credit balances.

Instructions(a) Prepare the entries to record the transactions.(b) Post to the cash and capital accounts.(c) Assume that Jagger is unable to pay the capital deficiency.

(1) Prepare the entry to allocate Jagger’s debit balance to Wilkowski and Harkins.(2) Prepare the entry to record the final distribution of cash.

WILKOWSKI COMPANYBalance SheetMay 31, 2010

Assets Liabilities and Owners’ Equity

Cash $ 27,500 Notes payable $ 13,500Accounts receivable 25,000 Accounts payable 27,000Allowance for doubtful accounts (1,000) Wages payable 3,800Merchandise inventory 34,500 S. Wilkowski, Capital 36,000Equipment 21,000 J. Harkins, Capital 20,000Accumulated depreciation—equipment (5,500) Mick Jagger, Capital 1,200

Total $101,500 Total $101,500

(a) (1) Marie $16,800 (2) Marie $20,000 (3) Marie $18,700

(c) Marie $43,700

Prepare entries with a capitaldeficiency in liquidation of apartnership.

(SO 5)