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This form of organization is popular among personal service enterprises, as well as in the legal and public accounting professions. The important features of and accounting procedures for partnerships are discussed and illustrated below. Contents [hide]
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1 Accounting for Initial Investments 2 Capital Interest 3 Capital account 4 Compensation for Services and Capital 5 Guaranteed Payments 6 Allocation of Net Income 7 Closing Process 8 Statements for Partnerships 9 Admitting a new partner 10 Allocation of ownership interest 11 Partnership bonus 12 Withdrawal of Partner 13 Purchasing of Partner's Interest 14 Death of a Partner 15 Liquidation of a Partnership 16 Schedule M-1 17 Schedule K-1 18 References
Accounting for Initial Investments Because ownership rights in a partnership are divided among two or more partners, separate capital anddrawing accounts are maintained for each partner. Investment of cash If a partner invested cash in a partnership, the Cash account of the partnership is debited, and the partner's capital account is credited for the invested amount. Investment of assets other than cash If a partner invested an asset other than cash, an asset account is debited, and the partner's capital account is credited for the market value of the asset. If a certain amount of money is owed for the asset, the partnership may assume liability. In that case an asset account is debited, and the partner's capital account is credited for the difference between the market value of the asset invested and liabilities assumed. Capital Interest A capital interest is an interest that would give the holder a share of the proceeds in either of the following situations:
The owner withdraws from the partnership.
Salary and interest allowances are guaranteed payments. The increased in the capital will record in credit side of the capital account. is reduced by $500. Drawing $500 Cash $500 $500 . Compensation for services is provided in the form of salary allowance. To illustrate. and the capital account is increased by the same amount. while the other partner contributed a smaller amount of assets and does not provide as much services to the partnership. Partnership earned profits. This determination generally is made at the time of receipt of the partnership interest. it is treated as a withdrawal. or drawing. Capital account of a partner is increased in the following situations: The owner made additional investments during the year. and a share of profits was allocated to the partner. When the partner makes a cash withdrawal of moneys he received as an allowance. Capital account Capital account of each partner represents his equity in the partnership. the above entry Income Summary. The owner received guaranteed payments from the partnership. Amount of compensation is added to the capital account of the partner. one partner contributed more of the assets. For example. The amount is included in the net income/loss distribution entry when the books are closed to the capital accounts at year end: Debit Credit Partner A. Capital account of a partner is decreased when the owner makes withdrawals of cash or property Compensation for Services and Capital The partnership agreement may specify that partners should be compensated for services they provide to the partnership and for capital invested by partners. and works full time in the partnership. discussed later. which is a temporary equity closing account used for year-end. The partnership liquidates. Compensation for capital is provided in the form of interest allowance. The mere right to share in earnings and profits is not a capital interest in the partnership. assume that a partner received $500 as an interest allowance. Debit Credit Partner A. Capital Income Summary $500 As a result.
They are also listed on Schedules K and K-1 of the partnership return. Partner A and Partner B. profits and losses must be shared equally regardless of the ratio of the partners' investments. For other tax purposes. . At the end of the accounting period the drawing account is closed to the capital account of the partner. Closing Process Closing process at the end of the accounting period includes closing of all temporary accounts by making the following entries. Net income does not includes gains or losses from the partnership investment. Close Income Summary by allocating each partner's share of net income or loss to the individual capital account. This treatment is for purposes of determining gross income and deductible business expenses only. Close all revenues accounts to Income Summary. Close all expenses accounts to Income Summary. guaranteed payments are treated as a partner's distributive share of ordinary income. The capital account will be reduced by the amount of drawing made by the partner during the accounting period. Salary and interest allowances are guaranteed payments.Expenses = Net income If total revenues exceed total expenses of the period. If partners pay themselves high salaries. It's the net income. or for the use of capital. Guaranteed Payments Guaranteed payments are those made by a partnership to a partner that are determined without regard to the partnership's income. along with his distributive share of the partnership's other ordinary income.As a result. Partner compensation and allocated net income are considered ordinary income for tax purposes and as such are reported on the form 1040. the excess is a net loss of the partnership for the period. Net income or loss is allocated to the partners in accordance with the partnership agreement. The partnership agreement specifies that after providing for salary and interest allowances the remaining income is divided equally. but it does not matter for tax purposes. and the Cash account of the partnership is reduced by the same account. If the partnership agreement specifies how profits are to be shared. If expenses exceed revenues of the period. The individual partner reports guaranteed payments on Schedule E (Form 1040) as ordinary income. as if they were made to a person who is not a partner. Management fees. and his compensation from the partnership that are taxed. assume that there are two equal partners. not the amount withdrawn. A partnership treats guaranteed payments for services. losses must be shared on the same basis as profits. It does not matter whether or not a partner withdrew any amount of money from his capital account. net income will be low. In the absence of any agreement between partners. Guaranteed payments are not subject to income tax withholding. allocated to the partner. Drawing account increased by $500. Allocation of Net Income Revenues . Compensation for services and capital are guaranteed payments. Close each partner's drawing account to the individual capital accounts. The partnership generally deducts guaranteed payments on line 10 of Form 1065 as business expenses. the excess is the net income of the partnership for the period. The partnership generally deducts guaranteed payments on line 10 of Form 1065 as business expenses. To illustrate.
made by the partners during the year. the statement of partners' equity reflects the equity of each partner and summarizes the allocation of net income for the year. Capital Partner B.000 10. which is divided equally in accordance with the partnership agreement.Assume also that net income of the partnership was $100.000 100.000 20. After that salary and interest allowances are subtracted from Net Income. All kind of allowances. and withdrawals. All three financial statements are affected: the income statement. Additional investments and allocated net income increase capital accounts of the partners.000 50. and the result is Remaining Income.000 and the two partners received allowances as indicated in the table below.000 20.000 Salary allowances Interest allowances Remaining income 30.000 10. . Net Income $100. At the end of the accounting period each partner's allocated share is closed to his capital account.000 10. and balance sheet. like salary allowances and capital allowances. The allocation of net income would be reported on the income statement as shown.000 $40.000 40. A sample statement of partners' equity is shown below. In addition. and reflects additional investments. Statement of Partners' Equity Statement of partners' equity starts with capital balances at the beginning of the accounting period. net income for the period. The end result is capital balances of the partners at the end of the accounting period. the closing entry is: Debit Income Summary $100.000 Net Income of the partnership is calculated by subtracting total expenses from total revenues. Capital $60.000 Partner A Partner B Total Allocation of net income 60. statement of owners (partners') equity.000 Credit Statements for Partnerships The allocation of net income and its impact on the partners' capital balances must be disclosed in the financial statements. Withdrawals reduce capital accounts.000 30. are treated as withdrawals.000 20. Based on the net income allocation shown above.000 Partner A.
Capital Partner B. or by contributing assets from an existing business.000 $20.000 to Partner B for one-half of his interest.000 $70.000 $100. with a new partnership agreement. Partner C pays.000. when Partner A and Partner B have capital interests $30.000 $90.000 Net Income for the year $60. say.000 $150. 1. When this happens.000 Additional Investments $10. Capital Total partners' equity Admitting a new partner A new partner may be admitted by agreement among the existing partners. The following entry is made by the partnership. as illustrated below. $15.000 $200. not to the business. Debit Credit .000 $150.000 by purchasing an interest directly from existing partners by making an investment in the business. Dec. 31.000 $80.000 Equity section of the balance sheet The partners' equity section of the balance sheet reports the equity of each partner.000 $20.000 $30.Partner A Partner B Capital.000 $70.000 to Partner A for one-third of his interest. Jan.000 $100. respectively. 2008 $40.000 and $20. 2008 $110.000 $50. and $15.000 $50. A new partner may buy into the business in three ways: $80.000 Total $70.000 $30. Partner A.000 $30.000 Balance Withdrawals Capital.000 $40. Assume that Partner A and Partner B admit Partner C as a new partner. the old partnership is dissolved and a new partnership is created.000 Capital plus investments $50. These payments go to the partners directly.
the following entry would be made to admit Partner C.3% of his equity to the new partner.000 The extra $5. an equal share in the partnership. Partner B. Assume there are two unequal partners in the partnership. Now.7% of his equity to Partner C. The assets listed in the balance sheet are taken over. Assume that Partner A and Partner B have 50% interest each. In either case. all partners must agree to the specific way to realign their partnership interests as a result of admitting a new partner. Debit Credit Cash Partner C. represents profit to them.3% interest each. but it has no effect on the partnership's financial statements. In effect. so that each of the two partners will have 50% interest in the partnership. let's assume that Partner C had been operating his own business. Allocation of ownership interest Equal partners. In this case. Unequal partners. In effect. In this case the balance sheet for the new partner's business would serve as a basis for preparing the opening entry. and they agreed to admit a fourth equal partner. . Capital 20. Capital 10. and the new partner's capital account is credited for the difference. Partner A sold 50% of his equity to Partner B. Example 2. Partner C has several options to join the partnership. Interests of Partner A and Partner B will be reduced from 50% each to 33. Assume there are three equal partners. 100% interest of the sole proprietor will be divided in half.000 cash in the new partnership. Example 1.3% interest in the partnership.000 Partner C paid to each of the partners. Example 3.3% each to 25% each.000 Partner C. the liabilities are assumed. Each of the three partners will have 33. who have 33.000 30.3% each. assume instead that Partner C invested $30. In effect. Interests of the three partners will be reduced from 33.000 Finally.000 Partner B. Example 1. will give the new partner. which was then taken over by the new partnership. each of the three partners sold 8. Partner A owns 60% equity. each of the two partners sold 16. and they agreed to admit Partner C and give him an equal share of ownership.Partner A. Capital 10. Capital 30. Each of the four partners will have 25% interest in the partnership. Partner B owns 40% equity. Partner A. Assume that a sole proprietor agreed to admit a single equal partner for a certain amount of money. and they agreed to admit a third partner. The sole proprietor.
The three partners may agree to reduce their equity by equal percentage. There are more than one way to realign partnership interests. Equal percentage reduction. Partner C will own (15% + 20%) 35% of the partnership equity. who owned 100% interest. In that case. selling 20% interest would reduce ownership interest of the original owner by 20%. Collectively. Partner B may decide to sell 50% of his equity to partner C. each of the partners has to sell (20% : 3) 6. the old partnership is dissolved and a new partnership is created. Partner B will have 20%. Partner A and Partner B may both agree to sell 50% of their equity to Partner C. He can buy equity from Partner A and Partner B. Partnership bonus . He can buy shares of interest from one of the partners. and Partner C will own (30% + 20%) 50% interest in the partnership. with a new partnership agreement. and Partner C owns 20% interest. In order to sell 20% equity to the new partner. Partner A may decide to sell 25% of his equity to partner C. Partner A and Partner B may both agree to sell 25% of their equity to Partner C. He can buy equity from Partner A. or from more than one partner. A new partner can be admitted only by agreement among the existing partners. Equal proportion reduction. Partner D has a number of options. Assume now that there are three partners. The three partners may chose equal proportion reduction instead of equal percentage reduction. In that case. They agreed to admit a fourth partner. The same approach can be used to buy equity from each of the partners. they own 100% interest in the partnership. there does not exist any standard way to admit a new partner. Assume that the three partners agreed to sell 20% of interest in the partnership to the new partner. This table illustrates realignment of ownership interests before and after admitting the new partner. Example 2. The result for the new partner will be the same as if a single owner sold him 20% interest. When this happens. Partner B owns 30% interest. He can buy equity from Partner B.7% of his equity to the new partner. As in the previous case. Partner 3 will own (15% + 10%) 25% interest in the partnership. Each of the existing partners may agree to sell 20% of his equity to the new partner. Before Partner A 50% Partner B 30% Partner C 20% Partner D 0% After (50% * 80%) 40% (30% * 80%) 24% (20% * 80%) 16% 20% To summarize. Had there been only one partner. Partner D. Partner A owns 50% interest. Partner A will have 30% interest.
In return.000 $2.000 $10.000 In this case. Equity of Partner A Equity of Partner B Contribution of Partner C Total equity after admitting Partner C Equity percentage of Partner C Equity of Partner C Contribution of Partner C Minus equity of Partner C Bonus paid to "A & B Partnership" $10. The amount of any bonus paid to the partnership is distributed among the partners. Debit Cash Partner C.000.000 33. Assume that Partner A and Partner B have balances $10. $16. The following table illustrates calculation of the bonus. A new partner may pay a bonus in order to join the partnership.3% $12.000 $16. The following table illustrates the distribution of the bonus.000 Credit . Bonus is the difference between the amount contributed to the partnership and equity received in return.000 each on their capital accounts. Capital Bonus paid to a partner. Capital Partner B.Bonus paid to the partnership .000 $12.000 $4.000 $36.000 $2. Partner C paid $4.000 $12. Partner C will receive one-third equity in the partnership.000 $16. Capital Partner A.000 bonus to join the partnership. The partners agree to admit Partner C to the partnership for $16.
Capital $1.000 $10. Capital $1.000 $27.000 . Why would the existing partners allow a new partner to buy an equal share of equity with smaller contribution? It might be because the new partner brings something very valuable to the partnership.3% $9.000 $9.000 $7. while debit to a capital account of a partner decreases the account. Debit to Cash increases the account. Capital Partner A. The following table illustrates the distribution of the bonus. In return. Partner C received $2.000.000 bonus to join the partnership. Partner C will receive one-third equity in the partnership.000 $9. Equity of Partner A Equity of Partner B Contribution of Partner C Total equity after admitting Partner C Equity percentage of Partner C Equity of Partner C Contribution of Partner C Minus equity of Partner C Bonus paid to Partner C $10.000 Partner B. Debit Credit Cash Partner C.000 $7.Assume now that Partner A and Partner B have balances $10.000 $2. The following table illustrates calculation of the bonus.000 33.000 $7.000 each on their capital accounts.000 In this case. It might be special skills. The amount of the bonus paid by the partnership is distributed among the partners according to the partnership agreement. The partners agree to admit Partner C to the partnership for $7.
Capital Partner A.000 . The balance is computed after all profits or losses have been allocated in accordance with the partnership agreement.000 ($4.000 Partner B $40.000.000 cash. Partner B will pay ($4.000 $5. a partner may retire and be permitted to withdraw assets equal to.000 If Partner C withdraws $30. The book value of a partner's interest is shown by the credit balance of the partner's capital account. Debit Cash Partner C.000) bonus paid to Partner C would be distributed as follows: Partner A will pay ($4.000 ($4.000. assume that several years after the formation of "A. and the books closed. the transaction will have no effect on the capital of the remaining partners. Partner C was admitted to the partnership. In an unequal partnership bonus is distributed according to the partnership agreement.000 * 75%) Partner B.000 Partner A $60. The partners agreed to the withdrawal of cash equal to the amount of Partner C's equity in the assets of the partnership. and Partner B is a 25% partner.000 ($9. If a retiring partner withdraws cash or other assets equal to the credit balance of his capital account.000 Partner C $30.000.000 * 25%) Withdrawal of Partner By agreement. To illustrate.In an equal partnership bonus paid to a new partner is distributed equally among the partners.B.000 Cash 30.000 * 75%) $3. Capital $3. His capital account will be debited $1. In return. Assume that Partner A is a 75% partner.000 $9. less than.000.000 equity in the partnership. the entry on the books is as follows: Debit Credit Partner C. A $4.000 in cash. His capital account will be debited $3. or greater than the amount of his interest in the partnership. & C" partnership Partner C decided to retire. He paid $5. Assume that the partners' capital accounts had credit balances as follows: Credit $5. Capital 30. he received $9. Capital $1.000 * 25%) $1.
000. .000 Partner B.$20.000 in settlement of the interest. Capital 20.If a retiring partner agrees to withdraw less than the amount in his capital account. For example.000 Cash Partner A. For example. Purchasing of Partner's Interest When a partner retires from the business. On this basis. the retiring partner's equity is merely transferred to the other partner. if Partner C withdraws only $20. The excess of the amount withdrawn over retiring partner's equity in the partnership is divided between the remaining partners on the basis stated in the partnership agreement. Capital 30. If the retiring partner's interest is sold to one of the remaining partners. the partner's interest may be purchased directly by one or more of the remaining partners or by an outside party.000).000 6.000 and Partner B's is credited for $4.000 4. The entry in the books of the partnership is as follows: Debit Credit Partner C. Any gain or loss resulting from the transaction is a personal gain or loss of the withdrawing partner and not of the business.000 The amount paid to Partner C by Partner B is a personal transaction and has no effect on the above entry. the difference between Partner C's equity in the assets of the partnership and the amount of cash withdrawn is $10. Capital 30.000 If a retiring partner withdraws more than the amount in his capital account. Partner A's capital account is credited for $6.000 . If the retiring partner's interest is purchased by an outside party. The entry for the transaction on the books of the partnership is as follows: Debit Credit Partner C. assume that Partner C's equity is sold to Partner B. Partner D. the transaction will increase the capital accounts of the remaining partners. Capital 30. the retiring partner's equity is transferred to the capital account of the new partner. Assume that the partnership agreement specifies that in such a case the difference is divided according to the ratio of their capital interests after allocating net income and closing their drawing accounts. the transaction will decrease the capital accounts of the remaining partners.000 ($30. This difference is divided between the remaining partners on the basis stated in the partnership agreement. Capital Partner B.
Debit Credit Partner C. In other words.000 Partner D. Thus. liabilities and partners' equity accounts remain open. Schedule K-1 Purpose of Schedule K-1 The partnership uses Schedule K-1 to report a partner's share of the partnership’s income.000 The amount paid to Partner C by Partner D is also a personal transaction and has no effect on the above entry. The purpose of Schedule M-1 is reconciliation of income (loss) per accounting books with income (loss) per Return of the partnership. As the assets are sold. as well as for depreciation and other expenses. and the remaining cash or other assets are distributed to the partners. . among others. the procedures for settling with the estate are the same as those described earlier for the withdrawal of a partner. On the date of death. only the assets. The balance of the deceased partner's capital account is then transferred to a liability account with the deceased's estate. etc. Liquidation of a Partnership Liquidation of a partnership generally means that the assets are sold. If the business continues. Schedule M-1. because not all accounting income is taxable. accounting income of a partnership is adjusted. Return of Partnership Income (IRS Form 1065)  contains. Capital 30. The partner must only keep Schedule K-1 for his records. the accounts are closed and the net income for the year to date is allocated to the partners' capital accounts. liabilities are paid. deductions. Death of a Partner The death of a partner dissolves the partnership. The surviving partners may continue the business or liquidate. a gain on the sale is recognized. Schedule M-1 Purpose of Schedule M-1 U. Most agreements call for an audit and revaluation of the assets at this time. it means reconciliation of accounting income with taxable income. Capital 30. Schedule M-1 starts with Net income (loss) per books. As a result. the cash is applied first to the claims of creditors. The loss is allocated to the partners' capital accounts according to the partnership agreement. the remaining cash and other assets are distributed to the partners according to their ownership interests as indicated by their capital accounts. a loss on the sale is recognized. If noncash assets are sold for less than their book value. If noncash assets are sold for more than their book value. Adjustments are made for guaranteed payments. adjusting and closing entries are made. When normal operations are discontinued. credits. to taxable income. The gain is allocated to the partners' capital accounts according to the partnership agreement. Once all liabilities are paid. The partnership must file a copy of Schedule K-1 for each partner with the IRS. but not file it with his tax return. or reconciled.S.
whether or not distributed.Although the partnership generally is not subject to income tax. every partner is liable for tax on his share of the partnership income. .
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