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Partnership Accounting
What is a Partnership?
A partnership is defined as the relationship that exists between persons carrying on a business. These persons agree to combine some or all of their property, labour, and skills. This relationship is based on a contract.
What are the Advantages and Disadvantages of Partnerships?
Advantages:
- Partnerships allow for a greater amount of money, skill, and other resources to be pooled.
- They are relatively easy to organize.
- They are subject to limited government regulations and do not face high tax rates.
Disadvantages:
- Partnerships have a limited life.
- Each partner is subject to unlimited liability. This means that if the company fails, creditors can take action against both the partnership and the persons who are in it.
- Partners have mutual agency. This means that one partner can make decisions without consulting the other(s).
Accounting for Partnerships
Each partner must use a Capital and a Withdrawals account to record changes in their financial positions. They must allocate for division of profits and/or losses amongst themselves.
Allocation of Earnings
There are three methods of dividing earnings. They can be divided on a stated fractional basis, divided according to the ratio of capital investment, or they can be divided through the use of salary and interest allowances.
1. Divided on a Stated Fractional Basis
Each partner receives a fraction of the total. For example,
Two partners agree to split earnings on a fractional basis where one partner gets 2/5 and the other gets 3/5. Total earnings were $100,000.
One would get 2/5 * $100,000 = $40,000
The other would get 3/5 * $100,000 = $60,000
2. According to the Ratio of Capital Investments
Under this scenario, the earnings are divided according to the amount each partner has invested. For example:
Doug invested $20,000; Bob invested $40,000
The total amount invested is $60,000
Therefore, Doug invested $20,000/$60,000 or 1/3 of the total capital
Bob invested $40,000/$60,000 or 2/3 of the total capital
Therefore, Doug would get 1/3 of the total earnings, while Bob would get 2/3.
3. Salary and Interest Allowances
Using this method, partners may be given part of the earnings as salary and/or interest. Generally, the interest payments are percentages based on their capital investments. The remaining earnings are divided according to an aforementioned fixed ratio. For example,
Tom and Sue are partners. They each invested $50,000 into the business. Tom gets a salary of $25,000 per year. They each receive an interest allowance of 10% of their capital investment. The net income for this year is $50,000. What does each partner get?
Tom |
Sue |
Total |
|
| Net Income | 0 | 0 | $ 50,000 |
| Salary | $ 25,000 | 0 | $ 25,000 |
| Interest Allowance | $ 5,000 | $ 5,000 | $ 15,000 |
| Remainder Split Equally | $ 7,500 | $ 7,500 | 0 |
| Total Incomes | $ 37,500 | $ 12,500 | 0 |
Note--> An interest allowance of 10% of their initial investment means that each year they are given 10% of what they had initially invested. In this case, since both had initially invested $50,000, their interest allowances were $5,000 each ($50,000 * 10%) per year.
Therefore, after all monies are divided, Tom gets $37,500 and Sue gets $12,500.
Journal Entries
Allocation of Earnings
In order to account for the allocation of earnings, we must do the following:
Dr. Income Summary $xxx
Cr. Partner 1, capital $xxx
Partner 2, capital $xxx
Partner 3, capital $xxx
We debit the income summary only if the company shows a profit. Were the company to incur losses, the partners would have to invest money into the income summary account causing it to be credited.
Withdrawals and Additions of Partners
Quite often, persons may leave or join an existing partnership. When this happens, we sometimes have one of the two following scenarios:
1. The partnership share is bought/sold for less than it is worth (discount).
2. The partnership share is bought/sold for more than it is worth (premium).
Under these situations, we need to account for the differences between the sale price and the actual worth.
For the addition of a new partner
The buyer manages to get a share of the partnership for less than it is worth (the partner has bought the share at a discount). In this situation, the existing partners must make up the difference:
Dr. Cash $90,000
Old Partner 1,capital $4,000
Old Partner 2, capital $6,000
Cr. New Partner, capital $100,000
The old partners are debited for the difference in what was paid for the share and what it was actually worth. They divide the investment according to the ratio decided at the start of the business. The actual worth of the share is $100,000, but the buyer only pays $90,000. So, if Partner 1 has a 2/5 earnings ratio, he is responsible for paying 2/5 of the difference ($4,000). Partner 2, then, would pay 3/5 ($6,000).
If the buyer paid at a premium (more than the share was worth), the old partners would be credited in their capital accounts according to their already existing ratio.
For the withdrawal of a partner
In this situation, the withdrawing partner often gets more or less than his share is actually worth. For instance, if he's looking to retire, he may accept less than the share value simply to make the transition quick and painless. On the flip side, were a partner to withdraw from a very successful partnership, someone may really want his/her share. He/She may actually want it badly enough to pay for it at a premium. In either case, the existing partners either benefit or incur a loss according to the situation, and their capital accounts are debited or credited accordingly.