CHAPTER 5

Accounting for Partnerships in Ethiopia

5.0 Definitions of Partnership? A partnership is an agreement in which you and one or more
people combine resources in a business with a view to making a profit. The first requirement that must
be fulfilled to form partnership is to have agreement among partners. Their agreement is known as a
partnership agreement or articles of a partnership or partnership deed. The partnership agreement
does not have to be in writing. However, good business practice calls for a written document.

 The articles of partnership should make the following points clear;

1. Name, location, and nature of the business

2. Name, capital investment, and duties of each partner
3. Method of sharing profits and losses among the partners
4. Withdrawals of assets allowed to the partners
5. Procedures for admitting new partners and withdraws from the firm
6. Procedures for liquidating the partnership - selling the assets, paying the liabilities, and
disbursing remaining cash to the partners

There is also partnership law, which governs the basic relationships between partners and which they
may use to resolve their disputes in a court of law if there is no partnership deed, or if the partnership
deed has not covered some aspect of the partnership.

5.1. Type and basic characteristics of partnership

Types of Partnerships
The partnership form of business can take several legal forms amongst the common ones are general and
limited partnership.
A general partnership consists of several general partners who may act publicly on behalf of the firm
and who are personally liable for obligations of the partnership.
Limited partnership: The limited partners invest money as owners but are not allowed to participate in
the management of the company. These partners can still incur a loss on their investment, but the
amount is restricted to that which has been contributed. To protect the creditors of a limited partner, one
or more general partners must be designed to assume responsibility for all obligations created in the
name of the business. Many limited partnerships were originally formed as tax shelters to create
immediate losses (to reduce the taxable income of the partners) with projects spread out into the future.

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Characteristics of Partnership

A partnership differs in many ways from the other forms of business. The following characteristics
distinguish partnerships from sole proprietorships and corporations

1. Voluntary Association: - A person cannot be forced to join a partnership, and partners cannot
be forced to accept another person as a partner.
2. Limited Life: - Because a partnership is formed by the consent of two or more partners, it has a
limited life. This means that, anything that ends the contract dissolves the partnership when a
new partner is admitted or a partner withdraws, retires, dies or becomes bankrupt.
3. Mutual Agency: - Each partner is an agent of the partnership within the scope of the business.
This means that a partner’s act to any contract is binding the remaining partners as long as it is
within the scope of the business’ operations and become the obligations of all partners.
4. Unlimited liability: - Each partner is liable for all the debts of the partnership. When and if the
partnership fails to pay its debts, creditors can seize (take) each partner’s personal assets to
satisfy their claims. Therefore, partnership’s creditor claims are not limited to the assets of the
business, but is extends to the personal property of the partners. If one partner’s personal assets
are used up before the debts are paid, the creditors can claim additional assets from the
remaining partners who are able to pay.
5. Co- ownership of partnership property: - The property invested in a partnership by a partner
becomes the joint property of all the partners. The partner who invested the asset is no longer its
sole owner.
6. No partnership income taxes: - A partnership pays no income tax on its business income.
Instead, the net income of the partnership becomes the taxable income of the partners. The firm
would pay no income tax as a business entity.

7. Partners’ owner’s equity accounts: - A partnership has more than one owner, so every partner
in the business has an individual owner’s equity account. Often these accounts carry the name of the
particular partner and the word capital. Similarly, each partner has a withdrawal account.

5.2 Formation and Equity reporting of Partnership

Each partner invests cash, other assets, or both in the partnership according to the partnership agreement.
Noncash assets valued and recorded at an agreed upon value between partners or current market value
on the date transferred to the partnership. The assets invested by a partner are debited to the proper
account, and the total amount is credited to the partner’s Capital account.
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Example: 1. Assume that Lema and Kassa established a partnership, called LK partnership on October
10, 2018. Lemmas contribute cash of birr 50,000, and Kassa contribute equipment, which was purchased
4 years ago for birr70,000. The partners agreed that the market value of this equipment is birr 40,000.
Required: Prepare the journal entry to record partner’s initial investments

 To record Lemmas investment

Cash-------------------------------------------50,000

Lemma, Capital-------------------------------------50,000

 To record Kassas investment

Equipment------------------------------------40,000

Kassa, Capital-----------------------------------------------40,000

 Note that after each partner’s investment is recorded properly, the capital of the partnership can
be determined.

Lemma, capital-------------------------------------- 50,000

Kassa, capital---------------------------------------- 40,000

Total capital------------------------------------------ 90,000

2. On March 1, 2012 X and Y form a partnership to operate a fitness center.

Y’s Contributions

1. Cash Br 5,000
2. Computer cost Br 18,000 ( Market value Br 100,000)

X’s Contributions

1. Cash Br10, 000; Inventory Br 21,000 and Accounts payable Br 85,000 (The current
market values of inventory is Br 20,000)
2. Accounts receivable Br 30,000, Allowance for doubtful accounts of Br 5,000 (They
agreed that allowance for uncollectible has to be valued at Br 3,000)
3. Sport equipment cost Br 800,000; Accumulated depreciation Br 200,000 ( market value
Br 450,000)
Required: Prepare the journal entry to record X’s and Y’s initial investments.

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Advantages and Disadvantages of Partnership

 A partnership form of business ownership has the following advantages:

1. Easy and inexpensive to form than a corporation /only requires the consent of two or more parties.
2. Advantageous to raise a large amount of capital and managerial skill (talent) than a sole
proprietorship.
3. Not subject to separate taxation as a case in a corporation because each partner reports his/her
own share of partnership income and is individually taxed, and
4. Not required to observe on many restrictive laws / limited regulation , unlike a corporation

 Partnership has the following disadvantages also:

1. Unlimited liability.
2. Disadvantageous of a single partner’s act can bind a partnership into a contract.
3. Limited life due to many uncontrollable circumstances such as the death of a partner
4. Difficulty to transfer ownership right
5. Hard to find suitable partners

5.3 Dividing partnership net income and net loss

Once a partnership has formed and starts its operation generating profit or incurrence of a loss is
inevitable.

1. A partnership’s income and losses can be distributed according to whatever method the partners
specify in the partnership agreement.
2. If a partnership agreement does not indicate any condition regarding distribution of income and
losses, the law requires to be shared equally, regardless of the differences in time devoted or
capital contributed.
3. Also, if a partnership agreement specifies only the distribution of income, but keeps silent as to
losses, the law requires that losses be distributed in the same ratio as income. For example: a
partner who gets 75% of the profits likewise absorbs 75% of any losses.
Therefore, net income or loss can be shared among partners based one of the following ways;
1. Based on a stated ratio
a. Equal ratio
b. Agreed upon ratio / other than equal ratio
c. Ratio of capital balances

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2. Based on paying salaries (for time spent) or interest (for money invested) and sharing the any
remaining income according to stated ratios.

Salaries and interest here are not salaries expense or interest expense in the ordinary sense of the terms.
They refer to ways of determining each partner’s share of net income or net loss on the basis of time
spent and money invested in the partnership.

Generally, the partnership recognizes a partner’s share of net income or net loss in the accounts through
closing entries. These are;

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

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

3. Debit Income Summary for its balance, and credit each partner’s capital account for his or her
share of net income. Or, credit Income Summary, and debit each partner’s capital account for his
or her share of net loss.

4. Debit each partner’s capital account for the balance in that partner’s drawing account, and credit
each partner’s drawing account for the same amount.

Distributing NI/NL based on stated ratio

Example: Suppose that TR partnership has a NI of birr 30,000 for year [Link] partner, Tesfa
and Rahel, agreed to share NI using a proportion of 6:4 ratio.
Required: a. Compute the share of NI for each partner’s
Tesfa = 30,000 X 6/10 = birr 18, 000
Rahel = 30,000 X 4/10 = birr 12,000
b. Prepare Closing Entry.
Income Summary---------------------------30,000
Tesfa, Capital----------------------------------18,000
Rahel, Capital---------------------------------12,000
Distributing NI/NL based beginning capital balances
Example: Assume that R and S have beginning balance of birr 45,000 and birr 55,000
respectively. The net income of the partnership is birr 20,000 for year 2017.
Required: a. Compute the share of NI for each partner’s
R= 45,000 X 20,000 = birr 9,000
100,000

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 S= 55,000 X 20,000 = birr 11,000
100,000
b. Prepare Closing Entry.
Income Summary---------------------------20,000
R, Capital-------------------------------------9,000
S, Capital-------------------------------------11,000
Distributing NI/NL based partner’s Salaries and the remaining on the some
basis
Example: Assume that the article of partnership of Hanna and Sosina provide
for monthly salary allowance of birr 500 and birr 600 respectively. The NI for
the year is birr 60,000. The remaining NI is divided equally.
Required:
a. Compute the share of NI for each partner’s
 Partner’s Annual Salaries
Hanna = birr 500 X 12 = birr 6,000
Sosina = birr 600 X 12 = birr 7,200
 Division of Net Income:-
Hanna Sosina Total
Salary Allowance 6,000 7,200
13,200
Remaining Income 23,400 23,400
46,800
Net Income 29,500 30,600
60,000
b. Prepare Closing Entry.
Income Summary---------------------------60,000
Hanna, Capital-------------------------------------29,400
Sosina, Capital-------------------------------------30,600
5.4 Admission of new partners
A new partner may be admitted to the partnership with the consent of all old partners through either
purchase of an interest (ownership right) from one or more of partners or contributing (investing) assets
to the partnership.

A. Admission by purchasing the capital of the existing partners

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It is a personal transaction between one or more of old partners and the new partner. Therefore, the
partnership asset and liability remain unchanged. An entry is needed in the partnership only to
transfer the purchased capital from the capital account of the selling partner to the capital account of the
new partner regardless of the amount paid by entering partner.

Example: Partners Mr. X and Mr. Y have capital balances of Br 40,000 each. On March 3 each
partners sells one-fourth of his equity to Mr. Z for Br 10,000 in cash.

Required: Record the admission of Mr. Z in the partnership.

Solution

Mr. X, Capital (40,000 x ¼) ------------------------- 10,000

Mr. Y, Capital (40,000 x ¼) ------------------------- 10,000

Mr. Z, Capital (40,000 x ¼ x 2) ------------------------- 20,000

B. Admission by investing assets

It is a transaction between the new partner and the partnership which increase the partnerships total asset
and capital. To record such admissions the invested assets debited by its current market value and the
capital of entering (new) partner will be credited.

Example: Mr. X and Mr. Y are partners with capital accounts of Br 25,000 and Br 35,000. On
December 26, Mr. Z invests Br 15,000 cash in the business for ownership equity of Br 15,000.

Required: Record the admission of Mr. Z in the partnership

Solution
 Total capital before Mr. Z addition:
Mr. X, capital-------------------------------------25,000
Mr. Y, capital-------------------------------------35,000
Total capital-------------------------------------60,000
 Entry to record Mr. Z admission is:
Cash--------------------------------------------15,000
Mr. Z, Capital---------------------------------15,000
Total partnership capital after Mr. Z admission:
Mr. X, capital-------------------------------------25,000
Mr. Y, capital-------------------------------------35,000
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 Mr. Z, Capital------------------------------------15,000
Total capital-------------------------------------75,000
5.5. Withdrawal or death of partners,

an existing partner can be withdraw from the partnership through either of the following alternatives of
partner withdraw;

1. Selling his / her ownership right to the remaining partner or outsider

2. Withdraw assets from the partnership
The partner can withdraw assets equal to his or her capital balance, less than his or her capital balance
(in this case, the remaining partners receive a bonus), or greater than his or her capital balance (in this
case, the withdrawing partner receives a bonus).
1. Sales of interest
It is sales of ownership interest to existing partner or to an outsider (new partner). It is personal
transaction and does not change the partnership total asset or the partners’ total equity. Its effect limited
to changes in the partners’ capital balances.
Example: Assume XYZ partnership is owned by Mr. X, Mr. Y and Mr. Z, which have capital balances
of Br. 50,000, Br. 60,000, and Br. 45,000 respectively. Assume further that Mr. Y decides to withdraw
from the partnership, and Mr. X and Mr. Z agree to buy Mr. Y ownership equity. Each of them agreed
to pay Mr. Y Br. 35,000 in exchange for one- half of Mr. Y ownership interest of Br. 60,000.
Required: Record withdrawals of Mr. X from the partnership through sales of interest
Solution
 Total Capital before withdraw:
Mr. X----------------------------------------------------- 50,000
Mr. Y ---------------------------------------------------- 60,000
Mr. Z------------------------------------------------------ 45,000
Total Capital-------------------------------------------- 155,000
 To record the withdrawer :
Mr. Y ---------------------------------------------------- 60,000
Mr. X----------------------------------------------------- 30,000
Mr. Z----------------------------------------------------- 30,000
 Capital balance after withdrawer:
Mr. X----------------------------------------------------- 80,000
Mr. Z------------------------------------------------------ 75,000
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 Total Capital-------------------------------------------- 155,000

2. Withdraw of interest
This is a transaction between the partnership and the leaving partner i.e. the drawing partner’s interest
paid by the business. It is the reverse of admitting a partner through the investment of assets in the
partnership. As a result, both partnership assets and total capital decreases.
Example: When Mr. B withdrew from the partnership, all three partners (Mr. A, Mr. B and Mr. C)
had a capital account balance of Br 20,000. Mr. B received Br 20,000 in cash from the partnership in
return for his voluntary withdrawal.
Required: Record Mr. B’s withdrawal from the partnership
Solution
 To record Mr. B withdrawal:
Mr. B Capital --------------------------------------------20,000
Cash---------------------------------------------------------20,000
Bonus to the Remaining Partners

Here the cash payment to the leaving partner is less than his / her capital balance. The retiring partner
may give a bonus to the remaining partners when the market value of the partner’s assets may be less
than their book value, or the partner may wish to leave the partnership as quickly as possible, or
partnership has a poor earnings record.
Thus, the partnership allocates (credits) the bonus to the capital accounts of the remaining partners on
the basis of their income ratios.
5 Bonus To The Exiting Partner The partnership paid the exiting partner more than his/ her capital
account balance. This is a bonus to a retiring partner when the remaining partners are eager to
remove the partner from the firm, the fair market value of the partner’s assets higher than their book
value, or the partner may enjoy exceptional earnings. Thus, partnership deducts the bonus from the
remaining partners’ capital balances on the basis of their income ratios.

Example: The following capital balances exist in the RST partnership: Mr. R Br 50,000, Mr. S Br
30,000, and Mr. T Br 20,000. The partners share income in the ratio of 3: 2: 1 respectively.
Required: What would be the entries required, if Mr. T retires from the partnership and receives the
following cash payment from the firm;
1. Br 20,000

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 2. Br 25,000

3. Br 18,000

5.6 Liquidating partnerships

It is the process of ending (terminating) the business, of selling non cash assets to pay the partnership’s
liabilities and distributing any remaining assets among the partners. This may be by mutual agreement of
partners or bankruptcy.

Before the liquidating process begins, the accounting cycle should be completed. That is, adjustments
should be made, financial statements prepared, and closing entries recorded and posted.

 The four steps in liquidating the partnership;

1. Sell all non-cash assets of the partnership for cash and recognize the resulting gain or loss

2. Allocate the gain or loss on non-cash assets sale to the partners based on their income and loss
sharing ratio
3. Pay the partnership liabilities in cash
4. Distribute the remaining cash to the partners on the basis of their capital balances.

The final step in liquidation is the distribution of the remaining cash to the partners based on their capital
balances. However, two possibilities exist with regard to the partners’ capital accounts: No capital
deficiency, all partners have zero or credit balance in their capital accounts for final distribution of cash
or Capital deficiency, at least one partner has a debit balance (deficit) in his / her capital account for
final distribution of cash. The capital deficiency can be handled in two ways; the deficient partner may
repay or the partners share it based on their income or loss sharing ratio.

Example: Assume that HM Partnership is liquidated when its Ledger Shows the following Assets,
Liabilities, and Owners Equity accounts:-
Assets Liabilities
Cash-----------------------------$ 6,000 A/P-----------------------$ 15,000
A/R-----------------------------$ 13,000 Owners Equity
Inventory-----------------------$ 20,000 H, Capital-----------------$ 38,000
Equipment----------------------$45,000 M, Capital------------------$ 21,000
Acc. Depreciation------------ ($10,000)
Total Assets----------------------- $ 74, 0000 Total Liabilities and OE-------------$ 74,000

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  Accounts have been adjusted and closed. H & M share income on 6:4 (6/4) basis. Assume further
all non- cash assets are sold for $ 80,000. The liquidation process started on November 26, 2020.
Required: a. Prepare Statement of Partnership liquidation.
b. Prepare the entry to record transaction in the liquidation process.
Solution a. Statement of partnership liquidation
HM partnership
Statement of partnership liquidation
For November 3 – November 26, 2020
Items Cash + Non-cash asset = Liabilities + H, capital + M, Capital
Bal. before realization 6,000 + 68,000 = 15,000 + 38,000 + 21,000
Sales of non-cash asset &
Allocation of gain 80,000 + (68,000) = 0 + 7, 200 + 4,800
New Balance 86,0000 + 0 = 15,000 + 45,200 + 25,800
Payment of Liabilities (15,000) + 0 = (15,000) + 0 + 0
New Balance 71,000 + 0 = 0 + 45,200 + 25,800
Cash distribution to partners (71,000) + 0 = 0 + (45,200) + (25,800)
Final Balance -0- -0- = -0- -0- -0-
a. To record necessary journal entry concerning liquidation of partnership:-
1. # To record realization of non-cash assets
Cash---------------------------------------------80,000
Acc. Depreciation (Equipment) ------------10,000
A/R ------------------------------------------------13,000
Inventory------------------------------------------20,000
Equipment----------------------------------------45,000
Gain on Realization------------------------------12,000
2. # To record the payment of liabilities
A/P-----------------------------------------------15,000
Cash--------------------------------------------------- 15,000
3. # To record the allocation of gain to the partners accounts
Gain on Realization-------------------------------------12,000
H, Capital-------------------------------------------------------7,200
M, Capital-------------------------------------------------------4,800

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 4. # To record the distribution of the remaining cash to partners
H, Capital-------------------------------------------------45,200
M, Capital-------------------------------------------------25,800
Cash--------------------------------------------------------71,000
2. Assume on the above example further that, the non-cash assets are sold for $ 50,000 in steady of
80,000. In this case, loss on realization is equal to $ 18,000 (i.e. 68,000 - 50,000 =18,000). The
statement of partnership liquidation is prepared as follows:-

HM partnership
Statement of partnership liquidation
For November 3 – November 26, 2020
Items Cash + Non-cash asset = Liabilities + H, capital + M, Capital
Bal. before realization 6,000 + 68,000 = 15,000 + 38,000 + 21,000
Sales of non-cash asset &
Allocation of gain 50,000 + (68,000) = 0 + (10,800) + (7,200)
New Balance 56, 000 + 0 = 15,000 + 27,200 + 13,800
Payment of Liabilities (15,000) + 0 = (15,000) + 0 + 0
New Balance 41,000 +0 = 0 + 27,200 + 13,800
Cash distribution to partners (41,000) + 0 = 0 + (27,200) + (13,800)
Final Balance -0- -0- = -0- -0- -0-
b. To record necessary journal entry concerning liquidation of partnership:-
# To record realization of non-cash assets
Cash---------------------------------------------50,000
Acc. Depreciation (Equipment) ------------10,000
A/R ------------------------------------------------13,000
Inventory------------------------------------------20,000
Equipment----------------------------------------45,000
# To record the payment of liabilities
A/P-----------------------------------------------15,000
Cash--------------------------------------------------- 15,000
# To record the allocation of gain to the partners accounts
H, Capital---------------------------------------10,800
M, Capital----------------------------------------7,200
Loss on Realization------------------------------------18,0000
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# To record the distribution of the remaining cash to partners
H, Capital-------------------------------------------------27,200
M, Capital-------------------------------------------------13,800
Cash--------------------------------------------------------41,000

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