Chapter 9: 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. Most accounting firms, legal firms, and
many medical practices are partnerships.

II. Advantages:

A. Partners abilities: A partnership can take advantage of the abilities of many

different individuals. For example, some partners might have special product or
service development skills, while other partners might have marketing skills,
while others might possess sufficient cash resources to allow the business to
operate effectively.

B. Ease of formation: A partnership can be formed simply by two or more people or

organizations agreeing to engage in some activity. There is no need to register
with a state (as required of corporations) or to file with the Securities and
Exchange Commission. There is no legal requirement for a written contract,
although it is strongly recommended that a partnership agreement be prepared. A
partnership agreement should be prepared in order to clarify the roles and
responsibilities of the various partners and to specify how partnership income is to
be allocated among the partners.

C. No partnership income taxes: Unlike corporations, which are separate taxable

entities, partnerships do not pay income taxes. All income of the partnership is
allocated to the partners and they are taxed on their share. Thus, the partnership is
not taxed, but the partners are. The fact that corporations are taxed as separate
entities and then the owners are taxed when they receive cash dividends usually
makes the tax effect on corporation income greater than on partnership income.

III. Disadvantages:

A. Unlimited legal liability: Partnership law allows each partner to legally represent
the partnership in business transactions (mutual agency). In addition, partnership
law specifies that any partner can be held personally responsible for all debts of
the partnership (unlimited liability). As a result, the major disadvantage of a
partnership is that a partner could be held financially responsible for any other
partners action on behalf of the partnership. Thus, even though a partner
invested only $10,000 in a partnership, that partner could be legally responsible
(at risk) for significantly more than the $10,000 if the partnership experiences
severe financial difficulties. In contrast, if an individual invests $10,000 in a
corporation, that individual is at risk for only $10,000, no matter how much
financial difficulty the corporation experiences.
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B. Obtaining resources: Due to the unlimited legal liability of partners, partnerships

often find it much more difficult than corporations to raise large dollar amounts
from investors.

IV. Owners Investments: Owners investments are important sources of partnership

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

Date Accounts Debits Credits

Cash 50,000
Chen, Capital 10,000
Khan, Capital 40,000

In the above example, each partner received credit for the dollar amount of cash he
invested. Although it was necessary to increase cash by the $50,000 received by the
partnership, the partners could have agreed to give a different amount of credit to
each partner. For example, if the partners agreed to give equal credit to each partner,
the effects would be as follows.

Date Accounts Debits Credits

Cash 50,000
Chen, Capital 25,000
Khan, Capital 25,000

It is important to note that 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.

It is also important to note in the above examples that the accounting terminology for
partnerships differs from that of corporations. Owners investments in partnerships
are recorded in capital accounts, which are parts of a general classification called
owners equity. Owners investments in corporations are recorded in contributed
capital accounts, which are parts of a general classification called stockholders
equity.
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V. Withdrawals: Partners receive assets from a partnership by withdrawing them.

Unlike corporations in which such distributions of assets to owners are usually
recorded as dividends, asset withdrawals by partners are recorded in partner
withdrawal accounts. For example, if Chen withdrew $500 and Khan withdrew $400
from their partnership, the effects would be as follows.

Date Accounts Debits Credits

Chen, Drawing 500
Khan, Drawing 400
Cash 900

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. For example, if
Chens drawing account were closed to his capital account, the effects would be as
follows.

Date Accounts Debits Credits

Chen, Capital 500
Chen, Drawing 500

VI. 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 retained earnings,
partnership income summary is closed to individual partners accounts. This process
of income allocation depends upon the requirements detailed in the partnership
agreement. In the absence of a partnership agreement, partners share income equally.
The allocation of partnership income often takes into consideration such things as
investments, partner efforts, and special talents. For example, assume that the
partnership agreement of Chen and Khan specifies that (1) each partner is to receive
interest of 1% per month on his capital balance at the beginning of the month, (2)
Chen is to receive a monthly salary of $6,000 and Khan is to receive $4,000, and (3)
any remaining income is to be split equally between the partners. Assume that on
April 1, 2006, Chens capital balance was $12,000 and Khans was $45,000. Assume
also that the partnerships income for April was $18,000. Based on this data, the
partnerships income would be distributed as shown below.

Item Chen Khan Totals

Interest
$12,000 x .01 $120 $0 $120
$45,000 x .01 $0 $450 $450
Salary $6,000 $4,000 $10,000
Remaining income: $18,000 - $10,570 $3,715 $3,715 $7,430
Totals $9,835 $8,165 $18,000
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The above income allocation affects the partnership as follows.

Date Accounts Debits Credits

Income Summary 18,000
Chen, Capital 9,835
Khan, Capital 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 Chen Khan Totals

Interest
$12,000 x .01 $120 $0 $120
$45,000 x .01 $0 $450 $450
Salary $6,000 $4,000 $10,000
Remaining income: $9,000 - $10,570 ($785) ($785) ($1,570)
Totals $5,335 $3,665 $9,000

The above income allocation affects the partnership as follows.

Date Accounts Debits Credits

Income Summary 9,000
Chen, Capital 5,335
Khan, Capital 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 Chen Khan Totals

Interest
$12,000 x .01 $120 $0 $120
$45,000 x .01 $0 $450 $450
Salary $6,000 $4,000 $10,000
Remaining income: - $1,000 - $10,570 ($5,785) ($5,785) ($11,570)
Totals $335 ($1,335) ($1,000)

The above income allocation affects the partnership as follows.

Date Accounts Debits Credits

Khan, Capital 1,335
Income Summary 1,000
Chen, Capital 335
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VII. Dissolution: Technically, a partnership is dissolved whenever there is a change in

partners. For example, the admission of another partner dissolves the old
partnership and creates a new one. Similarly, when a partner leaves a partnership,
the partnership is dissolved. Both these methods of dissolution are examined
below.

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 or (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. In its
simplest terms, the old partners capital interest is replaced by an equal
dollar amount of capital interest of the new partner. For example, assume
that Khan sells his $65,000 capital interest to Powell for $78,000. In this
case, Khan receives $78,000 cash and Powell 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

Khan, Capital 65,000
Powell, Capital 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 Powell pays $30,000 to the Chen and Khan
partnership for a 15% interest in the firm. Assume that immediately prior
to the admission of Powell, the partners capital interests were as follows.

Partner Partners Capital %

Chen $35,000 35%
Khan $65,000 65%
Totals $100,000 100%

Powells $30,000 payment increases the partnerships net assets to

$130,000. Powells 15% capital interest would be $19,500 ($130,000 x .
15). Since Powell 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 Chen and Khan would each increase by $5,250
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($10,500 / 2), since they share income equally. The effects on the
partnership would be as follows.

Date Accounts Debits Credits

Cash 30,000
Chen, Capital 5,250
Khan, Capital 5,250
Powell, Capital 19,500

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

follows.

Partner Partners Capital %

Chen $40,250 31%
Khan $70,250 54%
Powell $19,500 15%
Totals $130,000 100%

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 Chen decides to withdraw from the partnership. Immediately

prior to his withdrawal, the partners capital interests were as follows.

Partner Partners Capital Income Sharing %

Chen $60,000 40%
Khan $100,000 40%
Powell $50,000 20%
Totals $210,000 100%

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, Chen would receive $96,000 when he
withdraws. The $96,000 was calculated as follows.

Item Amount
Chen capital balance $60,000
Chen share of excess partnership value: ($300,000 - $210,000) x .40 $36,000
Total $96,000

The payment of $96,000 cash to Chen upon his withdrawal results in him
receiving $36,000 more than his capital interest in the partnership. A simple
way to account for this difference is to reduce the other partners capital
interests by a total of $36,000, according to their income sharing percentages.
Since Khans income sharing percentage was 40%, and Powells was 20%,
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Khans capital balance would be reduced by $24,000 {$36,000 x [.40 / (.40 + .

20)]} and Powells capital balance would be reduced by $12,000 {$36,000 x
[.20 /(.40 + .20)]}. Chens withdrawal would affect the partnership as follows.

Date Accounts Debits Credits

Chen, Capital 60,000
Khan, Capital 24,000
Powell, Capital 12,000
Cash 96,000