CHAPTER 1 PARTNERSHIP ACCOUNTING

1.1 PARTNERSHIPS: ORGANIZATION AND OPERATION

A partnership may be defined as an association of two or more persons

to carry on, as co-owners, a business for profit.
1.1.1 Types of partnerships

There are three types of partnerships. The distinctive features of each are
described below while their characteristics are discussed in detail in
another section.

1. General partnership
Is a firm in which all the partners are responsible for liabilities of
the firm and all have authority to act for the firm.
2. Limited partnership
Is a firm owned by two types of partners, general partners and
limited partners. The former are responsible for liabilities of the
firm while the later are not.
3. Limited liability partnerships (LLPs)
Have features of both general partnerships and professional
corporations. Individual partners of LLPs are personally
responsible for their own actions and for the actions of the
partnership employees under their supervision; however, they are
not responsible for the action of other partners.

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2.1.2 Characteristics and principles of partnerships
The basic characteristics of each type of partnership are discussed
hereunder:
General partnership
 Ease of formation
o A general partnership may be created by an oral or written
contract between two or more persons, or may be implied by
their conduct
o This advantage of convenience and minimum cost may be
offset by certain difficulties inherent in such an informal
organizational structure
 Limited life
o A partnership may be ended by the death, retirement,
bankruptcy or incapacity of a partner
o The admission of a new partner also legally ends the former
partnership and establishes a new one.
 Unlimited liability
o All the partners are responsible for liabilities of the firm and
all have authority to act for the firm.
o Creditors having difficulty in collecting from the partnership
would likely turn to those partners who have other financial
resources
 Co-ownership of partnership assets and earnings
o Individuals retain no claim to specific assets they invest in a
partnership but acquire an ownership equity in all assets of
the partnership
o Every member also has an ownership equity in partnership
earnings

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Limited partnership
Among the features of limited partnerships are the following:
 There must be at least one general partner
 Limited partners have no obligation for unpaid liabilities of the
limited partnership; only general partners have such liability
 Limited partners have no participation in the management of
the limited partnership
 Limited partners may invest only cash or other assets in a
limited partnership; they may not provide service as their
investment
 The surname of a limited partner may not appear in the name
of the partnership
 The formation of a limited partnership is evidenced by a
certificate filed with county recorder of the principal place of
business of the limited partnership
 The certificate includes many of the items present in the typical
partnership contract, in addition it must include:
o The name and residence of each general partner and
limited partner
o The amount of cash and other asset invested by each
limited partner
o Provision for return of a limited partner’s investment
o Any priority of one or more limited partners over other
limited partners
o Any right of limited partners to vote for election or
removal of general partners, termination of the
partnership, amendment of the certificate, or disposal of
all partnership assets
 Membership in a limited partnership is offered to limited
partners in units and a registration statement of offered units

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 and periodic reports must be filed with the Securities and
Exchange Commission (SEC)
Limited Liability Partnership (LLP)
The basic characteristics of an LLP are as follows:
 Ease of formation
o A limited liability partnership may be created by an oral
or written contract between two or more persons, or may
be implied by their conduct
o This advantage of convenience and minimum cost may be
offset by certain difficulties inherent in such an informal
organizational structure
o LLPs that are accounting or law firms generally must
register with the state licensing authority
 Limited life
o An LLP may be ended by death, retirement, bankruptcy,
or incapacity of a partner
o The admission of a new partner also legally dissolves the
former partnership and establishes a new one.
 Mutual agency
o Each partner has the authority to act for the limited LLP
and to enter into contracts on its behalf but within the
normal scope of business unless specifically authorized to
enter into certain transactions.
 Co-ownership of partnership assets and earnings
o Individuals retain no claim to specific assets they invest in a
partnership but acquire an ownership equity in all assets of
the partnership
o Every member also has an interest in partnership earnings

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The partnership contract
Although general partnerships and LLPs may exist on the basis of an oral
agreement or may be implied by the actions of its members, good
business practice demands the partnership contract be clearly stated in
writing. The most important points in partnership contract are the
following:
 The date of formation of the partnership, the duration of the
contract, the names of the partners, and the name and business
activities of the partnership.
 The assets to be invested by each partner, the procedure for
valuing non-cash investments, and penalties for failure to invest
and maintain the agreed amount of capital.
 The authority of each partner and the rights and duties of each.
 The accounting period to be used, the nature of accounting
records, financial statements, and audit by independent public
accountants.
 The plan for sharing net income or loss, including the frequency of
income measurement and the distribution of income or loss among
the partners.
 The salaries and drawings allowed to partners and the penalties, if
any, for excessive withdrawals.
 Insurance on the lives of partners, with partnership or surviving
partners named as beneficiaries.
 Provisions for arbitration of disputes and liquidation of the
partnership
Revision of the partnership contract generally requires the
approval of all partners.

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2.1.3 Choosing Between Partnership and Corporation
One of the most important considerations in such a decision is the
income tax status of the enterprise and its owners. A partnership
pays no income tax but is required to file an information return
showing its revenue and expenses, the amount of net income and
its division among partners. The partners report their respective
share of the net income.
A corporation is a separate legal entity subject to corporate income
tax. The net income, when and if distributed to stockholders as
dividends, also is taxable income to stockholders. A partnership
may incorporate as a subchapter S corporation to retain the
advantages of limited liability but at the same time elect to be
taxed as a partnership.
The other factors that tip the scale towards incorporation are:
 The opportunity for obtaining larger amount of capital
 The limited liability of all stockholders for unpaid debts of
the corporation
2.1.4 Partnership Provisions in Ethiopia
Commercial Code
The 1960 Commercial Code of Ethiopia prescribes legal provisions
for organization and operation of partnerships in Ethiopia in
Articles 280 to 303.
Accordingly, the code recognizes general and limited partnerships
with essentially the same characteristics and principles discussed
above except that a memorandum of association shall be drawn up
by the partners, notice of same published, and entered in the
commercial register.
A partnership may acquire rights and liabilities and sue or be sued
under its firm name according Article 286.

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Hence, “a general partnership consists of partners who are
personally, jointly, severally and fully liable as between themselves
and to the partnership for the partnership firm’s undertakings. –“
Article 280 sub article 1. Sub article 2 of the same article states
that each a partner of a commercial partnership shall have the
status of a trader.
Memorandum of association
According to article 284 of the commercial code of Ethiopia the
memorandum of association drawn up by the partners shall
contain:
 The name, address and nationality of each partner
 The firm name
 The head office and branches, if any
 The business purpose of the firm
 The contribution of each partner, their value and the method
of valuation
 The services required from persons contributing skill
 The share of each partner in the profits and in the losses
and the agreed procedure for allocation
 The managers and agents of the firm
 The period of time for which the partnership has been
established
 A limited partnership as per Article 296 consists of two types
of partners; general partners in full liable personally, jointly
and severally and limited partners who are only liable to the
extent of their contributions.

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Income Tax Proclamation
Income tax proclamation No.286/2002 includes registered
partnerships under ‘bodies’ along with companies and public
enterprises. The income tax rate set for bodies is 30% while a
progressive rate applies to other taxpayers. On the other hand,
Income tax regulation No. 78/2002 lists sum paid as salary, wages
or other personal emoluments to partners among non deductible
expenses.
Even if the commercial code states that each partner in a
commercial partnership shall have the status of a trader, the
income tax proclamation does not have any provision to this effect
except categorizing the partnership with bodies viz. companies and
public enterprises. The taxpayer, therefore, is the partnership not
the partners.
On the other hand, profit share paid by a resident registered
partnership is listed as taxable source of income under Article 6 (i)
of the proclamation.
From the foregoing discussion, it could be concluded that the tax
law treats partnerships in the same way as companies except that
partners’ salary is not a tax deductible expenditure. Therefore,
there is no mach tax consideration to make in deciding between
partnership and incorporation for Ethiopian business people.

2.1.5 Partnership versus Partners

In accounting literature, the legal aspects of partnerships generally
have received more emphasis than the managerial and financial
issues. It has been common practice to distinguish a partnership
from a corporation by saying that a partnership is an “association
of persons” and a corporation is a separate entity.

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Such distinction stresses the legal form rather than the economic
substance of the business organization. In terms of managerial
policy and business objectives, partnerships are as truly business
and accounting entities as are corporations. Partnerships are
guided by long range plans not likely to be affected by admission or
withdrawal of a single member. In these firms accounting policies
should reflect the fact that the partnership is an entity apart from
its owners.
Treating the partnership as a business and accounting entity often
will aid in developing financial statements that provide the most
meaningful picture financial position and results of operation.
Among the accounting policies to be stressed is continuity in asset
valuation, despite changes in the income sharing ratio and
changes in personnel.
Another helpful step may be recognition as expenses of the value of
personal services rendered by partners who also hold managerial
position. In theoretical discussions, considerable support is found
for treating every business enterprise as an accounting entity,
apart from its owners, regardless of the form of organization. A
managing partner under this view is both an employee and an
owner, and the value of the personal services rendered by a
partner is an expense of the partnership.
The inclusion of partners’ salaries among expenses has been
opposed by some accountants on grounds that partners’ salaries
may be set at unrealistic levels and that a partnership is an
association of individuals who are owners and not employees of the
partnership.
A partnership has the characteristics of a separate entity in that it
may hold title to property, may enter into contracts, and sue or be
sued as an entity. In practice, most accountants treat partnerships

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 as separate entities with continuity of accounting policies and
asset valuations not interrupted by changes in partnership
personnel.
1.2 Accounting for Partnership Formation and Operation

1.2.1 Partners’ Accounts

Accounting for partnership differs from accounting for a sole
proprietorship or a corporation with respect to the sharing of net income
and loss and maintenance of the partners’ ledger accounts. Although it
might be possible to maintain partnership accounts with only one ledger
for each partner, the usual practice is to maintain three types of
accounts for each partner:
 Capital accounts
 Drawing or personal accounts
 Accounts for loans to and from partners
Capital accounts
Are used to record:
o The initial investment of a partner
o Any subsequent capital contributions
o Profit or loss distributions
o Any withdrawals are ultimately recorded in the partner’s capital
account
 Each partner has one capital account. This account usually has a
credit balance representing the partner’s share in the net assets of
the partnership.
 A partner’s capital account may have a debit balance in some
occasions called a deficit. Such a deficit should be eliminated by
additional capital contribution.
Drawing accounts

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  Used to record the periodic withdrawals of cash or other assets by
a partner in anticipation of profit
 The balance of this account is closed to the partner’s capital
account at the end of the period
Loan accounts
 The partnership may borrow from or lend money to its partners.
Such transactions are recorded in loan accounts opened in the
name of each partner like any other loan.
1.2.2 Loans to and from Partners
A partner may withdraw cash from the partnership with the intension of
repaying the amount. Such a transaction may be debited to the Loans
Receivable from Partner account rather than the drawing account.
Conversely, a partner may make a cash advance to the partnership that
is considered a loan than a capital contribution. This transaction may
also be credited to Loan Payable to Partner than the capital account and
accompanied by a promissory note. Amounts due from partners are
reported as assets in the balance sheet and amounts owing to partners
shown as liabilities.
If a substantial unsecured loan is made to a partner and repayment
appears doubtful, it is preferable to offset the receivable against the
partner’s capital account. A separate listing of any receivables from
partners should be made as per the disclosure principle.
1.2.3 Valuation of Investment by Partners
Investment by partners in the firm often includes assets other than cash.
It is imperative that partners agree on the current fair value of assets at
the time of investment and that the assets be recorded at such values.
Equitable treatment of individual partners requires a starting point of
current fair values recorded for all non cash assets invested by each
partner.
1.2.4 Income Sharing Plans

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The equity of a partner in the net assets of the partnership should be
distinguished from a partner’s share in earnings as partners may agree
of income sharing plan regardless of their respective capital account
balances. If partners fail to specify a profit sharing plan, it shall be
assumed that they intend to share equally.

The many possible plans for sharing of net income or loss may be
summarized in the following four categories:
 Equally or in some other ratio
 In the ratio of partners’ capital account balances in particular date,
or in the ratio of average capital account balances during the year.
 Allowing salaries to partners and dividing the remaining net
income or loss in a specified ratio
 Allowing salaries to partners, allowing interest on capital account
balances, and dividing the remaining net income or loss in a
specified ratio.
These variations of income sharing plans emphasize that the value of
personal services rendered by individual partners may vary widely, as
may the amounts of capital invested by each partner. The amount and
quality of managerial service rendered and the amount of capital invested
often are important factors in the success or failure of a partnership.
Therefore, provisions may be made for salaries to partners and interest
on their respective capital as preliminary step in the division of net
income or loss.
Other factors contributing to the success of the partnership like personal
financial resources of partners and popularity in profession or industry
may also be considered while selecting an income sharing ratio.
Illustration
An illustration of partnership formation and operation follows
Example 1: Partnership Formation

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A, a sole proprietor, has been developing software for several types of
microcomputers. The business has the following account balances as of
Dec. 31, 20X0:

Cash 3,000
Inventory 7,000
Equipment 20,000
Accumulated Dep.-Equipment 5,000
Liabilities 10,000
A, Capital 15,000

A needs additional technical assistance to meet the increasing sales and

offers B an interest in the business. A and B agree to form a partnership.
A’s business is audited, and its net assets appraised. The audit and
appraisal disclosed that:
 Br. 1,000 of liabilities has not been recorded
 Inventory has a market value of Br. 9,000
 Equipment has a fair value of Br. 19,000
A and B prepare and sign articles of partnership that include all
significant operating policies. Accordingly, B will contribute Br. 10,000
for a one-third capital interest. The AB partnership is to acquire all of A’s
business and assume its debts.
Required: Prepare a journal entry to record the initial capital
contribution of AB partnership.
January 1, 20X1
Cash 13,000
Inventory 9,000
Equipment 19,000

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 Liabilities 11,000
A, Capital 20,000
B, Capital 10,000

Example 2: Cash withdrawal by a partner

Partner B made cash withdrawal of Br. 3,000 on May 1, 20X1. The
journal entry for this transaction would be:

B, Drawing 3,000
Cash 3,000

Example 3: Loan from a partner

A Br. 4,000, 10 % one year loan agreement is signed by the partnership
with partner A and cash received on July 1, 20X1. The entry to record
this transaction would be:

Cash 4,000
Loan Payable, A 4,000

Example 4: Profit allocation

During 20X1, the AB partnership earned a profit of Br. 10, 000. A maintained a capital
balance of Br. 20, 000 during the year, but B’s capital made the movements shown
below:
Date Debit Credit Balance
January 1 10, 000
May 1 3, 000 7,000
September 1 500 7,500
November 1 1,000 6,500
December 1 6,500

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The debits of Br. 3, 000 and Br. 1, 000 are recorded in B’s drawing
account, while the Additional investment is credited to the partner’s
capital account.
Case 1: If A and B agree upon a profit share ratio of 60 % to A and 40%
to B, the net income is to be distributed as follows:
A B Total
Net income 10,000
Allocation 60: 40 6,000 4,000 (10,000)
Total 6,000 4,000 -0-

This schedule shows the allocation of net income to the partners, the
actual distribution is accomplished by closing the Income Summary
account to partners’ capital accounts. The drawing accounts are also
closed to capital accounts. The following are the closing entries.
December 31, 20X1
B, Capital 4, 000
B, Drawing 4,000
To close B’s drawing account

Income Summary 10,000

A, Capital 6,000
B, Capital 4,000
To close income summary account
Case 2: A and B agreed to allow interest of 15 % on the weighted-average
capital balances with any remaining profit to be distributed in 60: 40
ratio.
A’s capital was 20,000 throughout the year; the average capital of B is
computed as follows:

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Date Debit Credit Balance Month Month times
Maintained Birr Balance
January 1 10,000 4 40,000
May 1 3,000 7,000 4 28,000
September 1 500 7,500 2 15,000
November 1 1,000 6,500 2 13,000
Total 12 96,000
Average capital (96,000/12 months) 8,000

Distribution of the Br. 10,000 profit under this alternative would be as

follows:
A B Total
Net income 10,000
Interest on average cap (15%) 3, 000 1,200 (4,200)
Residual income 3:2 3,480 2,320 (5,800)
Total 6,480 3,520 -0–

Journal entry to record the profit allocation is:

Income Summary 10,000
A, Capital 6,480
B, Capital 3,520
To close income summary account
Case 3: The partnership agreement provides for salaries of Br. 2,000 to A
and Br. 5,000 to B. Any remainder is to be distributed at 60: 40 ratio.
The profit distribution, under this alternative, is computed as follows:
A B Total
Net income 10,000
Salary 2, 000 5,200 (7,000)
Residual income 3:2 1,800 1,200 (3,000)
Total 3,800 6,200 -0–

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Case 4: The income sharing agreement provides that a bonus of 10 % on
income in excess of Br. 5,000 is to be credited to B before distributing
the remaining profit in 60: 40 ratio. In this case, there are two
alternatives to compute the bonus:
 As a percentage of income before subtracting bonus, or
 As a percentage of income after subtracting bonus
Alternative 1:
Bonus = X% (NI-MIN)
Where:
X% is the bonus percentage
NI is net income
MIN is minimum amount of income
Hence, Bonus = 0.1(10,000-5,000) = 500
Alternative 2:
Bonus = X% (NI-MIN-bonus)
= 0.1(10,000-5,000-bonus)
= 0.1(5000-bonus)
= 500-0.1bonus
1.1bonus = 500
Bonus = 454.55
The distribution of income based on alternative 2 would be as here
under:

A B Total
Net income 10,000
Bonus 455 (455)
Residual income 3:2 5,727 3,818 (9,545)
Total 5,727 4,273 -0–

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Case 5: The income sharing plan of AB partnership specifies the
following profit or loss allocation method:
 Interest of 15% on weighted average capital balances
 Salaries of Br. 2,000 for A and Br. 5,000 for B
 A bonus of 10% to B on income exceeding Br. 5,000
 Any residual income to be allocated 60% to A and 40% to B
Income distribution as per the above would be:

A B Total
Net income 10,000
Interest (15%) 3,000 1,200 (4,200)
Remaining balance 5,800
Salary 2,000 5,000 (7,000)
Deficiency (1,200)
Bonus 500 (500)
Deficiency (1,700)
Allocation 60: 40 (1,020) (680) 1,700
Total 3,980 6,020 -0–

Partnership Financial Statements

The three financial statements viz. income statement, balance sheet, and
statement of cash flows are typically prepared for the partnership at the
end of each reporting period. A statement of partners’ capital is also
prepared in addition to present the changes in the partners’ capital
accounts during the period. The statement of partners’ capital account
for the AB Partnership for the year ended December 31, 20X1 under the
multiple base profit distribution described above would be as follows:

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 AB Partnership
Statement of Partners’ Capital
For the Year Ended December 31, 20X1
A B Total
Balance, Jan. 1, 20X1 20,000 10,000 30,000
Add: Additional investment 500 500
Net income distribution 3,980 6,020 10,000
23,980 16,520 40,500
Less: Withdrawal - (4,000) (4,000)
Balance Dec. 31, 20X1 23,980 12,520 36,500
2.2.5 Changes in Personnel\Changes in Ownership
Most changes in ownership of partnerships are accomplished without
interruption of its operations and there is usually no significant change
in the finances or operating routines of the partnership. However, from a
legal view point a partnership is dissolved by the retirement or death of a
partner or by the admission of a new partner.
Admission of a New Partner
Adjustment of the partnership accounting records may be necessary to
restate the carrying amounts of assets and liabilities to current fair value
before a new partner is admitted. As an alternative to revaluation of the
existing partnership assets, it may be preferable to evaluate any
discrepancies between the carrying amounts and current fair values and
adjust the terms of admission of a new partner. In this way, the amount
invested by the incoming partner may be set at a level that reflects the
current fair value of the partnership, even though the carrying amounts
of existing partnership assets remain unchanged in the accounting
records.
The admission of new partner to a partnership may be effected either by
an acquisition of all or part of the interest of one or more of the existing

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partners or by an investment of assets by the new partner with a
resultant increase in the net assets of the partnership.
Acquisition of an Interest by Direct Payment to One or More Partners
If a new partner acquires an interest from one or more of the existing
partners, the event is recorded by establishing a capital account for the
new partner and decreasing the capital account balances of the selling
partners by the same amount. No assets are received by the partnership;
the transfer ownership is a personal transaction between the partners.
Illustration: L and M are partners of L&M Partnership sharing earnings
equally and each has a capital account balance of 60,000. Partner N
(with the consent of M) acquires one half of L’s interest in the
partnership. The journal entry to record this change would be:

L, Capital (1/2of 60,000) 30,000

N, Capital 30,000
To record transfer of one-half of L’s capital to N
 This transfer has caused no change in the assets, liabilities or total
partners’ capital.
 The price paid for a partnership interest by a new partner to an
existing partner does not provide sufficient evidence to support
changes in the carrying amounts of the partnership’s assets.
Investment in Partnership by a New Partner
A new partner may gain admission by investing assets in the
partnership, thus increasing the total assets and partners’ capital of the
partnership.
Assume that X and Y, partners of the X&Y Partnership, share net income
or net loss equally and that each has a capital account balance of Br.
60,000. Assume also that the carrying amounts of the partnership assets
are approximately equal to current fair values and that Z owns land that
could be used for expansion of partnership operations. X and Y agree to

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admit Z to the partnership by investment of the land; net income and
loss of the new firm are to be shared equally. The land had cost Z
Br. 50, 000, but has a current fair value of 80,000. The admission of Z to
the partnership is recorded as follows:
Land 80,000
Z, Capital 80,000
To record admission of Z to partnership.
Z has 80,000 capital account balance and owns 40% interest in the firm.

Bonus or Goodwill Allowed to Existing Partners

In a profitable well-established firm, the partners may insist that a
portion of the investment by a new partner be allocated to them as bonus
or that goodwill be recorded and credited to existing partners.
Bonus to Existing Partners
In the C&D Partnership, C and D share net income or losses equally and
have capital account balances of Br. 45,000 each. The carrying amounts
of the partnership net assets approximate current fair values. The
partners agree to admit E to a one third in capital and a one third
interest in earnings for a cash investment of Br. 60,000. The total capital
of the new firm amounts to Br. 150,000 (45,000+45,000+60,000) and
one third of that is Br. 50,000 resulting in bonus of 10,000 to the
existing partners. Hence, the following entry:

Cash 60,000
C, Capital (10,000*1/2) 5,000
D, Capital (10,000*1/2) 5,000
E, Capital (150,000*1/3) 50,000
To record investment by E for one third interest in capital, with bonus of
10,000 divided equally between C and D.
Goodwill to Existing Partners

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In the previous illustration, E might prefer that the full amount invested,
60,000, be credited to his account. That could be done while still
allotting E a one third interest if goodwill is recorded by the partnership,
with the offsetting credit divided between the two existing partners.
If a one third interest given to E is represented by a capital account
balance of 60,000, the total capital of the partnership is Br. 180,000
(60,000*3) and the total capital of C and D must equal 120,000. A write
up of 30,000 is required as their present combined capital balance is Br.
90,000. Journal entry;
Cash 60,000
Goodwill 30,000
C, Capital (30,000*1/2) 15,000
D, Capital (30,000*1/2) 15,000
E, Capital 60,000
To record investment by E for a one third interest in capital, with credit
offsetting goodwill of 30,000 divided equally between C and D.

Evaluation of Bonus and Goodwill Methods

When a new partner invests an amount larger than the carrying amount
of the interest acquired, the transaction should be recorded by allowing
bonus to the existing partners. The bonus method adheres to the
valuation principle and treats the partnership as a going concern while
use of the goodwill method signifies the substitution of estimated current
fair value of an asset rather than valuation on a cost basis. The existence
of goodwill is implied by the amount invested by the new partner.
The presence of goodwill created in this manner is likely to evoke
criticism of the partnership’s financial statements, and such criticism
may cause the partnership to write off the goodwill.
Does the recording of goodwill and its subsequent write off injure one
partner and benefit another? The net results to the individual partners

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will be the same under the bonus and goodwill methods only if two
specific conditions are met:
 the new partner’s share of net income or losses must be equal to
the percentage equity in net assets the new partner receives at the
time of admission
 the existing partners must continue to share net income or loss
between themselves in the same ratio as in the original
partnership
Assume, however, that C, D, &E agreed to share net income or losses
40%, 40%, and 20% respectively. The goodwill method would benefit E
and injure C and D as compared with the bonus method.

Partner C Partner D Partner E Combined

Capital a\c balance:
Bonus method 50,000 50,000 50,000 150,000
Capital a\c balance:
Goodwill method 60,000 60,000 60,000 180,000
Write off of goodwill
(40%, 40%, 20%) (12,000) (12,000) (6,000) (30,000)
Capital a/c balance
after write off 48,000 48,000 54,000 150,000

From the above analysis we can conclude that: when the new partner’s
share of net income or loss is less than the new partner’s share of assets,
the new partner will benefit from the use of the goodwill method.
Under the above illustration it is assumed that the carrying amounts of
assets in the original partnership approximated current fair values. But
if the current fair values some assets like land building is different from
the book values, write up of such assets with a corresponding increase in
the capital account balances of the existing partners would avoid the
necessity for a bonus or the recognition of goodwill to record the
admission of the new partner.

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Bonus or Goodwill Allowed to New Partner
The present firm may offer a new partner a larger equity in net assets
than the amount invested by the new partner in recognition of the new
partner’s skill and business contacts or its cash needs.
Bonus to New Partner
F and G, who share net income and losses equally and have capital
account balances of Br. 35,000 each, offer H a one-third interest in net
assets and a one-third share of net income or losses for an investment of
Br. 20,000 cash. The investment by H when added to the existing capital
of Br. 70,000 brings the total capital to Br. 90,000 and H’s interest there
in is Br. 30,000 (90,000*1/3). The difference between H’s investment and
interest in capital (30,000-20,000 = 10,000) represents bonus allowed to
H by F and G. the journal entry to record admission of H to the
partnership would be:

Cash 20,000
F, Capital (10,000*1/2) 5,000
H, Capital (10,000*1/2) 5,000
H, Capital 30,000
To record admission of H, with bonus of Br.10,000 from F and G.
 In the above illustration it is assumed that the net assets of the
partnership were valued properly
 Writing down of the assets to 40, 000 should be considered
especially if trade accounts receivable included doubtful accounts
or if inventories were obsolete.
Goodwill to New Partner
Assume all the other data is the same as above except that H is the
owner of a successful single partnership that H invests in the
partnership rather than a cash investment. The identifiable tangible and
intangible net assets of the proprietorship are worth 20,000 but a

24
current fair value for the assets is agreed to be 35,000. The admission of
H to the partnership is recorded as follows:

Identifiable tangible and intangible net assets 20,000

Goodwill 15,000
H, Capital 35,000
To record admission of H; goodwill is assigned to single proprietorship
invested by H.
 Goodwill is recognized as part of the investment of a new partner
only when the new partner invests in the partnership a business
enterprise of superior earning power.
Retirement of a Partner
A partner has always the authority to withdraw, as distinguished from
the right to withdraw. A partner who withdraws in violation of the terms
of the partnership contract, and without consent of the other partners,
may be liable for damages to the other partners.
In measuring the equity of a retiring partner:
 The partner’s capital account is the starting point. Adjustments for
correction of errors or for differences between the carrying values
and current fair values of net assets may be necessary.
 The partnership contract should be referred to for provisions
regarding computation of the amount to be paid a retiring partner.
The contract may require audit by independent auditors or
valuation of the partnership as a going concern.
 If the partnership doesn’t contain provisions for the computation of
retiring partner’s equity, the accountant may obtain authorization
from the partners to use a specific method to determine an
equitable settlement price.
 The equity of a retiring partner is computed on the basis of current
fair values of partnership net assets with gain or loss arising from

25
 the difference between the current fair value and carrying value
divided in the income sharing ratio.
 The partners may agree to settle by payment of the computed
amount or a different amount.
Payment of Bonus to Retiring Partner
Assume that L is to retire from the J, K &L Partnership. Each partner
has a capital account balance of Br. 60,000, and net income and losses
are shared equally. The partnership contract provides that a retiring
partner is to receive the balance of his\her capital account plus a share
of any goodwill. At the time of L’s retirement, goodwill in the amount of
Br. 30,000 is computed to the mutual satisfaction of the partners.
But there is no reliable evidence to record such goodwill in the accounts
except estimate of the partners. Therefore, it is not appropriate to enter
this goodwill in the accounting records of the partnership. The portion
paid to the retiring partner would, however, be treated as bonus as
shown in the following journal entry.
L, Capital 60,000
J, Capital (10,000*1/2) 5,000
K, Capital (10,000*1/2) 5,000
Cash 70,000
To record payment to retiring partner L, including bonus of Br. 10,000.
Settlement with Retiring Partner for Less than Carrying Amount
A retiring partner may accept less than his\her equity on retirement due
to:
o Anxiety to escape from an unsatisfactory business situation
o Personal problems
o Consideration that the partnership assets are overvalued
o Anticipation of less net income in future years
The preferred accounting treatment under such circumstances is to leave
net asset valuation undisturbed unless a large amount of goodwill is

26
carried in the accounting records. The difference between the retiring
partner’s capital account and the amount paid in settlement should be
credited as a bonus to the continuing partners.
M, N and P share net income or losses equally, and that each has a
capital account balance of Br. 60,000. N retires from the partnership and
receives Br. 50,000. The journal entry to record N’s retirement is:
N, Capital 60,000
Cash 50,000
M, Capital (10,000*1/2) 5,000
P, Capital (10,000*1/2) 5,000
To record retirement of partner N for an amount less than carrying
amount of N’s equity.
The final settlement with retiring partner is often differed for some time
to permit:
o The accumulation of cash
o Measurement of net income to date of withdrawal
o Obtaining of bank loans
o Or other acts needed to complete the transaction
The retirement of a partner doesn’t terminate the retiring partner’s
responsibility for general partnership liabilities existing on the retirement
date.
Death of a Partner
A partnership contract often provides:
o Partners shall acquire life insurance policies on each others’ lives
so that cash will be available for settlement with the estate of a
deceased partner.
o A buy-sell agreement wherein the surviving partners acquire
equities of the deceased partner

27
 o The surviving partners are given an option to buy, or right of first
refusal, rather than imposing on the partnership an obligation to
acquire the deceased partner’s equity.

1.3 Accounting for Dissolution and Liquidation of Partnerships

1.3.1 Conditions for Dissolution and Liquidation
Dissolution is a term used to describe events ranging from a minor
change of ownership interest not affecting operations of the partnership
to a decision by the partners to terminate a partnership.
Conditions for dissolution of a partnership may, therefore, be:
 Bankruptcy of the firm or any partner
 The expiration of the time period stated in the partnership contract
 Mutual agreement of the partners to end their association
Accountants are concerned with the economic substance of a transaction
than its legal form and evaluate all the circumstances of the individual
case and determine how the change should be recorded.
Liquidation means winding up partnership activities, usually by selling
assets, paying liabilities and distributing any remaining cash to partners.
A business enterprise that has ended normal operations and is in the
process of converting its assets to cash and making settlement with its
creditors is said to be in liquidation, or in the process of being liquidated.
Another commonly used term in liquidation is realization, which means
the conversion of assets to cash.
1.3.2 Distribution of Loss or Gain
When the decision to liquidate the partnership is made, the accounting
records of the partnership should be adjusted and closed, and the net
income or loss for the final period of operations entered in the accounts
of the partners.
The losses or gains from realization of assets are divided among the
partners in the income sharing ratio and entered in their capital

28
accounts. The underlying theme under the circumstances is: Divide the
loss or gain from realization before distributing the cash.
The income sharing ratio used during the operation is applicable upon
liquidation also unless the partners have a different agreement.
When the net loss or gain from liquidation is divided among the partners,
the final balance of the partner’s capital and loan ledger accounts will be
equal to the cash available for distribution. Payments are then made in
the amounts of the partner’s respective equities in the partnership.
1.3.3 Distribution of Cash
The Uniform Partnership Act lists the order for distribution of cash by a
liquidating partnership as:
 Payment of creditors in full
 Payment of loans from partners
 Payment of partners’ capital account credit balances
The indicated priority of partners’ loan over partners’ capital appears to
be a legal provision which is usually nullified for practical purposes by
an established legal doctrine called the right of offset. If a partner’s
capital account has a debit balance or even a potential debit balance
depending upon possible future realization of losses, any credit balance
in the partner’s loan account must be offset against the deficit or
potential deficit in the capital account. However, if a partner with a loan
account receives any cash, it is debited to the loan account to the extent
of the balance of that account. Furthermore, the existence of a partner’s
loan account will not advance the time of payment to any partner during
liquidation.
The amount of cash, if any, that a partner is entitled to receive in
liquidation can not be determined until the partners’ capital accounts
have been adjusted for any loss or gain on the realization of the assets.
1.3.4 Settlement of Partners’ Capital Balances

29
The amount each partner receives from the liquidation of a partnership
will be equal to:
 The capital invested, whether recorded in a capital or loan account
 A share of operating net income or loss minus drawings
 A share of loss or gain from realization of assets
If the negative factors are larger, the partner will have a capital deficit (a
debit balance in the capital account), and must pay the amount of such
deficit. Failure to effect such payment would mean the partner had not
complied with provisions of the partnership contract for sharing net
income or loss and cause the other partners to receive less than their
equity in the partnership. Illustration follows:
Equity of Each Partner is Sufficient to Absorb Loss from Realization
Assume that A and B, who share net income and losses equally, decide
to liquidate their partnership. A balance sheet on 30 June 1999, just
prior to liquidation follows:
A & B Partnership
Balance Sheet
June 30, 1999
Assets
Cash 10,000.00
Other assets 75,000.00
Total 85,000.00

Liabilities and Partners’ Capital

Liabilities 20,000.00
Loan Payable to B 20,000.00
A, Capital 40,000.00
B, Capital 5,000.00
Total 85,000.00

 Non cash assets with a carrying amount of Br. 75,000.00 realized

cash of Br. 35,000.00, with the resultant loss absorbed by A and
B.
 The accountant exercises the right of offset by transferring Br.
15,000.00 from B’s loan account to his capital account.

30
 A & B Partnership
Statement of Realization and Liquidation
July 1-15, 1999

Assets Partners’ Capital

Cash Other Liabilities B Loan A (50%) B (50%)

Balances before liquid. 10,000 75,000 20,000 20,000 40,000 5,000

Realization at a loss of
40,000 35,000 (75,000) (20,000) (20,000)
Balances 45,000 20,000 20,000 20,000 (15,000)
Payment to Creditors (20,000) (20,000)
Balance 25,000 20,000 20,000 (15,000)
Offset B’s loan (15,000) 15,000
Balance 25,000 5,000 20,000 -
Payments to Partners (25,000) (5,000) (20,000)

From the above it is apparent that partner’s loan account has no special significance in the liquidation
process. Therefore, in succeeding illustrations, whenever a partner’s loan account is involved its balance will
be combined with the partner’s capital account balance.

31
Equity of One Partner Not Sufficient to Absorb Loss From
Realization
In this case, distribution of loss on realization of assets as per the
income sharing ratio results in debit balance in capital account of one
of the partners. The partner must pay sufficient cash to the
partnership to eliminate any capital deficit. If the partner is unable to
do so, the deficit must be absorbed by the other partners as an
additional loss in the same proportion as they have previously shared
net income or loss among themselves. To illustrate, assume the
following balance sheet for DEF Partnership just prior to liquidation:
D, E &F Partnership
Balance Sheet
May 20, 1999

Assets
Cash 20,000
Other assets 80,000
Total 100,000

Liabilities & Partners’ Capital

Liabilities 30,000
D, Capital 40,000
E, Capital 21,000
F, Capital 9,000
Total 100,000

 The income sharing ratio is 20%, 40%, and 40% to D, E, and F

respectively.
 The other assets with carrying amount of Br. 80,000 realized
Br. 50,000 cash.

32
 D,E &F Partnership
Statement of Realization and Liquidation
May 21 to 31, 1999

Assets Partners’ Capital

Cash Other Liabilities D (20%) E(40%) F(40%)

Balance before liquidation 20,000 80,000 30,000 40,000 21,000 9,000

Realization 50,000 (80,000) (6,000) (12,000) (12,000)
Balances 70,000 30,000 34,000 9,000 (3,000)
Payment to creditors (30,000) (30,000)
Balance 40,000 34,000 9,000 (3,000)
Cash from F 3,000 3,000
Balances 43,000 34,000 9,000 0
Payment to partners (43,000) (34,000) (9,000) 0

Change one condition of the following illustration by assuming that partner F was not able to pay the 3,000
capital deficit to the partnership. If the cash available is to be distributed without delay, the statement of
realization and liquidation would appear as:

33
 D,E &F Partnership
Statement of Realization and Liquidation
May 21 to 31, 1999

Assets Partners’ Capital

Cash Other Liabilities D (20%) E(40%) F(40%)

Balance before liquidation 20,000 80,000 30,000 40,000 21,000 9,000

Realization 50,000 (80,000) (6,000) (12,000) (12,000)
Balances 70,000 30,000 34,000 9,000 (3,000)
Payment to creditors (30,000) (30,000)
Balance 40,000 34,000 9,000 (3,000)
Payment to partners (40,000) (33,000) (7,000) 0
Balance 1,000 2,000 (3,000)

The cash payments made to D and E leaves both with a sufficient capital account balance to share their
share of the additional loss if F is unable to pay the Br. 3,000 to the partnership.
If the Br. 3,000 is later collected from F, this amount will be divided Br. 1,000 to D and Br. 2,000 to E.
However, if the 3,000 from F is uncollectible the statement of realization and liquidation is completed with
the write off of F’s capital deficit as additional loss to D and E.

34
Equities of Two Partners Are Not Sufficient to Absorb Their Shares
of Loss From Realization
One capital deficit, if uncollectible, may cause a second capital deficit
that may or may not be collectible. In other words, a partner may have
sufficient credit balance in his capital and loan accounts to cover losses
from realization but may not have sufficient equity to absorb loss caused
by inability of the partnership to collect the deficit in another partner’s
capital account.
Assume that J, K, L and M share net income and loss 10%, 20%, 30%,
and 40% respectively.

35
 J, K, L &M Partnership
Statement of Realization and Liquidation
August 1 to 15, 1999

Assets Partners’ Capital

Cash Other Liab. J (10%) K(20%) L(30%) M(40%)

Balance before liquidation 20,000 200,000 120,000 30,000 32,000 30,000 8,000
Realization 120,000 (200,000) (8,000) (16,000) (24,000)
(32,000)
Balances 140,000 120,000 22,000 16,000 6,000 (24,000)
Payment to creditors (120,000) (120,000)
Balance 20,000 22,000 16,000 6,000 (24,000)
Payment to partners (20,000) (16,000) (4,000)
Balance 6,000 12,00 0 6,000 (24,000)

J, K, L &M Partnership
Statement of Realization and Liquidation
August 1 to 15, 1999
Partners’ Capital
J (10%) K(20%) L(30%) M(40%)

Balance before cash dist 22,000 16,000 6,000 (24,000)

Additional loss to J, K, l, &M
(10: 20: 30) (4,000) (8,000) (12,000) 24,000
Balance 18,000 8,000 (6,000)
Additional loss to J & K (2,000) (4,000) 6,000

37
Amount that may be paid to partners 16,000 4,000

38
Partnership is Insolvent but Partners Are Solvent
A partnership is insolvent means it is unable to pay all outside creditors.
In such cases, the total of the capital account debit balances exceeds the
total of the credit balances. If the partner\partners with deficit pay the
required cash, the partnership will be able to pay its liabilities. However,
the partnership creditors may demand payment from any solvent partner
whose actions caused the partnership’s insolvency, regardless of whether
the partner’s capital account has a debit or a credit balance.
Any partner who makes payments to partnership creditors receives credit
to his or her capital account.
 N, O, & P partnership is liquidated on May 10,1999
 Other assets with Br. 85,000 carrying amount realize Br. 40,000
cash
 Total cash available of Br. 55,000 is paid to creditors leaving
unpaid balance of Br. 10,000

39
 N, O & P LLP
Statement of Realization and Liquidation
May 11 to 31, 1999

Assets Partners’ Capital

Cash Other Liabilities N (1/3) O(1/3) P(1/3)

Balance before liquidation 15,000 85,000 65,000 18,000 10,000 7,000

Realization 40,000 (85,000) (15,000) (15,000) (15,000)
Balances 55,000 65,000 3,000 (5,000) (8,000)
Partial Pmt to creditors (55,000) (55,000)
Balance 0 10,000 3,000 (5,000) (8,000)
Cash by O & P 13,000 5,000 8,000
Balance 13,000 10,000 3,000
Final Pmt to creditors (10,000) (10,000)
Balance 3,000 3,000
Payment to N (3,000) (3,000)

41
 General Partnership is Insolvent and Partners Are Insolvent
In an insolvent general partnership with one or more insolvent
partners, the relative right of the following groups would be:
 Assets of the general partnership are first available to
partnership creditors
 Assets of the partners are first available to their creditors
o After full payment to the partner’s creditors assets of the
partner are available to partnership creditors whether
that partner’s capital account has a debit or a credit
balance
To illustrate, R, S & T Partnership is a general partnership whose
partners share net income or loss equally. On 30 Nov. the partners have
the following assets and liabilities other than their equities in the
partnership.
Partner Personal Personal
Assets Liabilities
R 100,000 25,000
S 50,000 50,000
T 5,000 60,000

 Realization of other assets results in Br. 60,000 loss

43
 R, S & T PARTNERSHIP
Statement of Realization and Liquidation
December 1 to 12, 1999
Assets Partners’ Capital
Cash Other Liabilities R (1/3) S (1/3) T (1/3)
Balance before liquidation 10,000 100,000 60,000 5,000 15,000 30,000
Realization 40,000 (100,000) (20,000) (20,000) (20,000)
Balances 50,000 60,000 (15,000) (5,000) 10,000
Partial Pmt to creditors (50,000) (50,000)
Balance 0 10,000 (15,000) (5,000) 10,000
Pmt to PP creditors by R (10,000) 10,000
8,000
Balance 0 (5,000) (5,000) 10,000
Cash by R 5,000 5,000
Balances 5,000 (5,000) 10,000

Payment to T (5,000) (5,000)

Balance (5,000) 5,000
Write-off of S’s Deficit (2,500) 5,000 (2,500)
Balances (2,500) 2,500
Cash by R 2,500 2,500
Balances 2,500 2,500
Payment to T/T’s Creditors (2,500) (2,500)

45
46
Installment Payment to Partners
Occurs when realization of non cash assets takes longer periods and the
partners want to receive cash as it becomes available rather than waiting
until all non cash assets are realized.
Liquidation in installment is, therefore, a process of realizing some
assets, paying creditors, paying the remaining available cash to partners,
realizing additional assets, and making additional cash payment to
partners until all non cash assets are realized and all cash distributed.
General Principles Guiding Installment Payments
The only safe policy for determining cash payments to partners is
assuming the worst case scenario:
 Assume a total loss on all remaining non cash assets, and provide
for all possible losses, including potential liquidation costs and
unrecorded liabilities
 Any partner with a potential capital deficit will be unable to pay
anything;
Thus, distribute each installment of cash as if no more cash will be
forthcoming.
To illustrate, assume that the partners of UVW Partnership who share
net income or loss in a 4:3:2 ratio decide to liquidate the partnership and
distribute cash in installments. The balance sheet just prior to
liquidation on July 5, 1999 is as follows:
UVW Partnership
Balance Sheet
July 5, 1999

Assets Liabilities & Partners’ Capital

Cash 8,000 Liabilities 61,000
Other Assets 192,000 U, Capital 40,000
V, Capital 45,000
W, Capital 54,000
Total 200,000 Total 200,000

47
 UVW Partnership
Realization of Other Assets
July 6 to September 30, 1999

Date Book Value Proceed Loss

July 31 62,000 48,500 13,500

August 31 66,000 30,000 30,000
September 30 64,000 32,500 31,500
Total 192,000 111,000 81,000

 Cash distribution is to be made monthly

48
 UVW PARTNERSHIP
Statement of Realization and Liquidation
July 6 to September 30, 1999

Assets Partners’ Capital

Cash Other Liabilities U (4) V (3) W (2)

Balance before liquidation 8,000 192,000 61,000 40,000 45,000 54,000

Realization July, 31 48,500 (62,000) (6,000) (4,500) (3,000)
Balances 56,500 130,000 61,000 34,000 40,500 51,000
Partial Payment to Creditors (56,500) (56,500)
Balances 130,000 4,500 34,000 40,500 51,000
Realization August, 31 30,000 (66,000) (16,000) (12,000) (8,000)
Balances 30,000 64,000 4,500 18,000 28,500 43,000
Final Pmt to Creditors (4,500) (4,500)
Balances 25,500 64,000 18,000 28,500 43,000
Pay to Partners (Sch.2) (25,500) (900) (24,600)
Balances 64,000 18,000 27,600 18,400
Realization 32,500 (64,000) (14,000) (10,500) (7,000)
Balances 32,500 4,000 17,100 11,400
Final pmt to Partners (32,500) (4,000) (17,100) (11,400)

49
 UVW PARTNERSHIP
Schedule of Safe Payment to Partners
U (4) V (3) W (2)
Schedule 1: July 31

Balance before cash distribution 34,000 40,500 51,000

No cash distribution to partners
as creditors are not fully paid yet

Schedule 2: August 31
Balance before cash distribution 18,000 28,500 43,000
Full loss of Br. 64, 000 assets (28,445) (21,333)
(14,222)
Balances (10,445) 7,167 28,778
Full absorption of U’s deficit (3:2) 10,445 (6,267) (4,178)

Balances to be distributed 900 24,600

50